ii

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

This Study Material has been prepared by the faculty of the Board of Studies. The objective of the Study
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case students need any clarifications or have any suggestions to make for further improvement of the material
contained herein, they may write to the Director of Studies.

All care has been taken to provide interpretations and discussions in a manner useful for the students.
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© THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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BEFORE WE BEGIN

SKILL REQUIREMENTS AT FOUNDATION LEVEL

The Board of Studies, ICAI has revised and updated the study material for Foundation (Entry Level Exam to
the Chartered Accountancy Course). The contents have been designed and developed with an objective to
synchronize the syllabus with the guidelines prescribed by IAESB (International Accounting Education
Standards Board), IFAC (International Federation of Accountants), to instill and enhance the necessary pre-
requisites for becoming a well-rounded, competent and globally competitive Accounting Professional.
The level of complexity of the study material is as per standards accorded by IAESB comprising an ideal mix of
subjective and objective examination pattern to ensure discerning students get through and seek admission to
the CA Course.
The paper of 'Principles and Practice of Accounting' at Foundation level concentrates on conceptual
understanding of fundamentals of accounting. The objective of this paper is to develop an understanding of the
basic concepts and principles of Accounting and apply the same in preparing financial statements of non-
corporate entities and simple problem solving.
This Study Material endeavouring towards accounting education, is committed to provide a framework for
understanding accounting discipline and describing the fundamental accounting concepts and conventions of
the basic accounting system. An attempt has been made to provide a solid foundation on which students can
successfully build and enhance their studies.
KNOW YOUR SYLLABUS AND STUDY MATERIAL
The Study Material of Principles and Practice of Accounting has been designed having regard to the needs of
home study and distance learning students. The Study Material has been divided into ten chapters, each
addressing to a special aspect of accounting. Chapters 1 to 5 lay emphasis on bookkeeping aspect of
accounting whereas chapter 7 deals with preparation of financial statements of sole proprietors. Chapter 6
covers accounting for special transactions like consignment, bills of exchange, sale of goods on approval basis,
average due date and account current which are useful for different business entities. Chapter 8 discusses
accounting of partnership firms and chapter 9 deals with financial statements of Not-for-profit organizations.
Chapter 10 explains basic concepts of company accounts.
The study material has been bifurcated into two modules (Module I : Chapters 1 to 6 and Module II: Chapters 7
to 10) for easy handling and convenience of students. It is important to read the Study Material thoroughly and
practice the questions for understanding the coverage of syllabus.
FRAMEWORK OF CHAPTERS-UNIFORM STRUCTURE COMPRISING OF SPECIFIC
COMPONENTS
Efforts have been made to present each topic of the syllabus in a lucid manner. Care has been taken to present
the chapters in a logical sequence to facilitate easy understanding by the students. Sincere efforts have
been undertaken to review and update the study material so that it reflects the current position.

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The content for each chapter/unit of the study Material has been structured in the following manner –
Components of each Chapter about the component

1 Learning Outcomes Learning outcomes which you need to demonstrate after

learning each topic have been detailed in the first page of
each chapter/unit. Demonstration of these learning
outcomes would help you to achieve the desired level of
technical competence.
2 Chapter/Unit Overview As the name suggests, the flow chart/table/diagram given
at the beginning of each chapter would give a broad
outline of the contents covered in the chapter.
3 Content of each Unit/ Chapter The concepts and provisions of each topic is explained in
student-friendly manner with the aid of Examples/
Illustrations/ Diagrams/Flow charts. These value additions
would help you develop conceptual clarity and get a good
grasp of the topic. Diagrams and Flow charts would help
you understand the concept/ application of topic in a
better manner.
4 Illustrations Involving Conceptual Illustrations would help the students to understand the
Understanding application of concepts. In effect, it would test
understanding of concepts as well as ability to apply
the concepts learnt in solving problems and addressing
issues.
5 Summary A summary of the chapter is given at the end to help you
revise what you have learnt. It would especially facilitate
quick revision of the chapter the day before the
examination.
6 Test Your Knowledge This section comprises of number of multiple choice
questions, questions based on True and False
statements, theoretical questions and practical questions
which would help students to evaluate what they have
understood after studying the chapter. The questions
given in this section have also been supplemented with
the answers to help the students in evaluating their
solutions so that they can know where they have gone
wrong.
We hope that these student-friendly features in the Study Material makes your learning process more
enjoyable, enriches your knowledge and sharpens your application skills.

Happy Reading and Best Wishes!

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PAPER – 1: PRINCIPLES AND PRACTICE OF ACCOUNTING

(One Paper – Three Hours – 100 Marks)
Objective:

To develop an understanding of the basic concepts and principles of accounting and apply the same in
preparing financial statements and simple problem solving.
Contents:

1. Theoretical framework
(i) Meaning and Scope of accounting
(ii) Accounting Concepts, Principles and Conventions
(iii) Accounting terminology - Glossary
(iv) Capital and revenue expenditure, Capital and revenue receipts, Contingent assets and
contingent liabilities
(v) Accounting Policies
(vi) Accounting as a Measurement Discipline – Valuation Principles, Accounting Estimates.
(vii) Accounting Standards – Concepts and Objectives.
(viii) Indian Accounting Standards – Concepts and Objectives.
2. Accounting Process
(i) Books of Accounts
(ii) Preparation of Trial Balance
(iii) Rectification of Errors.
3. Bank reconciliation Statement
Introduction, reasons, preparation of bank reconciliation statement.
4. Inventories
Cost of inventory, Net realizable value, Basis and technique of inventory valuation and record keeping.
5. Concept and accounting of depreciation
Concepts, Methods of computation and accounting treatment of depreciation, Change in depreciation
methods.
6. Accounting for Special transactions
(i) Bills of exchange and promissory notes
Meaning of Bills of Exchange and Promissory Notes and their Accounting Treatment;
Accommodation bills.

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(ii) Sale of goods on approval or return basis

Meaning of goods sent on approval or return basis and accounting treatment.
(iii) Consignments
Meaning and Features of consignment business, Difference between sale and consignment,
Accounting treatments for consignment transactions and events in the books of consignor and
consignee.
(iv) Average due Date
Meaning, Calculation of average due date in various situations.
(v) Account Current
Meaning of Account Current, Methods of preparing Account Current.
7. Final accounts of Sole Proprietors
Elements of financial statements, Closing Adjustment Entries, Trading Account, Profit and Loss
Account and Balance Sheet of Manufacturing and Non-manufacturing entities.
8. Partnership accounts
(i) Final Accounts of Partnership Firms
(ii) Admission, Retirement and Death of a Partner including Treatment of Goodwill
(iii) Introduction to LLPs and Distinction of LLPs from Partnership.
9. Financial Statements of Not-for-Profit Organizations
Significance of Receipt and Payment Account, Income and Expenditure Account and Balance Sheet,
Difference between Profit and Loss Account and Income and Expenditure Account. Preparation of
Receipt and Payment Account, Income and Expenditure Account and Balance Sheet.
10. Introduction to Company Accounts
(i) Definition of shares and debentures
(ii) Issue of shares and debentures, forfeiture of shares, re-issue of forfeited shares
(iii) Statement of Profit and Loss and Balance Sheet as per Schedule III to the Companies
Act, 2013

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CONTENTS

MODULE 1
CHAPTER 1 : Theoretical Framework
CHAPTER 2 : Accounting Process
CHAPTER 3 : Bank Reconciliation Statement
CHAPTER 4 : Inventories
CHAPTER 5 : Concept and Accounting of Depreciation
CHAPTER 6 : Accounting for Special Transactions

MODULE 2
CHAPTER 7 : Preparation of Final Accounts of Sole Proprietors
CHAPTER 8 : Partnership Accounts
CHAPTER 9 : Financial Statements of Not-For-Profit Organizations
CHAPTER 10 : Company Accounts

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DETAILED CONTENTS: MODULE – 1

CHAPTER 1 : THEORETICAL FRAMEWORK ............................................................................ 1.1 – 1.104

Unit 1: Meaning and Scope of Accounting

Learning Outcomes.................................................................................................................................. 1.1

Unit overview ........................................................................................................................................... 1.2
1.1 Introduction ............................................................................................................................. 1.2
1.2 Meaning of Accounting ............................................................................................................ 1.3
1.3 Evolution of Accounting as a Social Science ............................................................................ 1.6
1.4 Objectives of Accounting ......................................................................................................... 1.7
1.5 Functions of Accounting .......................................................................................................... 1.8
1.6 Book-Keeping .......................................................................................................................... 1.8
1.7 Distinction Between Book-Keeping and Accounting .................................................................. 1.9
1.8 Sub-Fields of Accounting ....................................................................................................... 1.10
1.9 Users of Accounting Information ............................................................................................ 1.10
1.10 Relationship of Accounting with other Disciplines ................................................................... 1.11
1.11 Limitations of Accounting ....................................................................................................... 1.14
1.12 Role of Accountant in the Society .......................................................................................... 1.15
Summary ............................................................................................................................................... 1.18
Test Your Knowledge ............................................................................................................................. 1.19
Unit 2 : Accounting Concepts, Principles and Conventions

Learning Outcomes................................................................................................................................ 1.23

Unit Overview ........................................................................................................................................ 1.23
2.1 Introduction ........................................................................................................................... 1.24
2.2 Accounting Concepts ............................................................................................................. 1.24
2.3 Accounting Principles ............................................................................................................ 1.24
2.4 Accounting Conventions ........................................................................................................ 1.25
2.5 Concepts, Principles and Conventions - An Overview ............................................................. 1.25
2.6 Fundamental Accounting Assumptions ................................................................................... 1.36
2.7 Financial Statements ............................................................................................................. 1.36
Summary ............................................................................................................................................... 1.39

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Test Your Knowledge ............................................................................................................................. 1.40

Unit 3 : Accounting Terminology – Glossary

Learning Outcomes............................................................................................................................... 1.45

Accounting Terminology - Glossary ....................................................................................................... 1.45
Test Your Knowledge ............................................................................................................................ 1.59
Unit 4 : Capital and Revenue Expenditures and Receipts

Learning Outcomes............................................................................................................................... 1.61

Unit Overview ....................................................................................................................................... 1.61
4.1 Introduction .......................................................................................................................... 1.61
4.2 Considerations in Determining Capital and Revenue Expenditures ........................................ 1.62
4.3 Capital Expenditures and Revenue Expenditures .................................................................. 1.63
4.4 Capital Receipts and Revenue Receipts................................................................................ 1.64
Summary .............................................................................................................................................. 1.67
Test Your Knowledge ............................................................................................................................ 1.67
Unit 5 : Contingent Assets and Contingent Liabilities

Learning Outcomes............................................................................................................................... 1.70

Unit Overview ....................................................................................................................................... 1.70
5.1 Contingent Asset .................................................................................................................. 1.70
5.2 Contingent Liabilities ............................................................................................................ 1.71
5.3 Distinction Between Contingent Liabilities and Liabilities ....................................................... 1.71
5.4 Distinction Between Contingent Liabilities and Provisions ...................................................... 1.71
Summary .............................................................................................................................................. 1.72
Test Your Knowledge ............................................................................................................................ 1.73
Unit 6 : Accounting Policies

Learning Outcomes............................................................................................................................... 1.75

Unit Overview ....................................................................................................................................... 1.75
6.1 Meaning of Accounting Policies ............................................................................................ 1.75
6.2 Selection of Accounting Policies ........................................................................................... 1.76
6.3 Change in Accounting Policies .............................................................................................. 1.76
Summary .............................................................................................................................................. 1.77
Test Your Knowledge ............................................................................................................................ 1.77

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Unit 7 : Accounting as a Measurement Discipline – Valuation Principles, Accounting Estimates

Learning Outcomes............................................................................................................................... 1.79

Unit Overview ....................................................................................................................................... 1.79
7.1 Meaning of Measurement ..................................................................................................... 1.80
7.2 Objects or Events to be Measured ......................................................................................... 1.80
7.3 Standard or Scale of Measurement ........................................................................................ 1.80
7.4 Dimension of Measurement Scale .......................................................................................... 1.81
7.5 Accounting as a Measurement Discipline ............................................................................... 1.81
7.6 Valuation Principles ............................................................................................................... 1.82
7.7 Measurement and Valuation .................................................................................................. 1.85
7.8 Accounting Estimates ............................................................................................................ 1.85
Summary ............................................................................................................................................... 1.86
Test Your Knowledge ............................................................................................................................. 1.86
Unit 8 : Accounting Standards

Learning Outcomes................................................................................................................................ 1.89

Unit Overview ........................................................................................................................................ 1.89
8.1 Introduction of Accounting Standards ..................................................................................... 1.90
8.2 Objectives of Accounting Standards ....................................................................................... 1.90
8.3 Benefits and Limitations of Accounting Standards .................................................................. 1.90
8.4 Process of Formulation of Accounting Standards in India ....................................................... 1.92
8.5 List of Accounting Standards in India ..................................................................................... 1.93
Summary ............................................................................................................................................... 1.94
Test Your Knowledge ............................................................................................................................. 1.94
Unit 9 : Indian Accounting Standards

Learning Outcomes................................................................................................................................ 1.97

Unit overview ......................................................................................................................................... 1.97
9.1 Need for Convergence towards Global Standards .................................................................. 1.97
9.2 International Financial Reporting Standards as Global Standards ........................................... 1.98
9.3 Benefits of Convergence with IFRSS ..................................................................................... 1.99
9.4 Development in Indian Accounting Standards (Ind AS) ........................................................... 1.99
9.5 List of IND AS ..................................................................................................................... 1.101

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Test Your Knowledge ........................................................................................................................... 1.102

CHAPTER 2 : ACCOUNTING PROCESS .............................................................................. 2.1–2.125
Unit 1 : Basic Accounting Procedures - Journal entries

Learning Outcomes.................................................................................................................................. 2.1

Unit overview ........................................................................................................................................... 2.1
1.1 Double Entry System ............................................................................................................... 2.2
1.2 Advantages of Double Entry System ........................................................................................ 2.2
1.3 Account ................................................................................................................................... 2.2
1.4 Debit and Credit ...................................................................................................................... 2.4
1.5 Transactions ........................................................................................................................... 2.7
1.6 Accounting Equation Approach ................................................................................................ 2.8
1.7 Traditional Approach ............................................................................................................. 2.13
1.8 Modern Classification of Accounts ......................................................................................... 2.14
1.9 Journal .................................................................................................................................. 2.15
Summary ............................................................................................................................................... 2.26
Test Your Knowledge ............................................................................................................................. 2.26
Unit 2 : Ledgers

Learning Outcomes................................................................................................................................ 2.34

Unit Overview ........................................................................................................................................ 2.34
2.1 Introduction ........................................................................................................................... 2.34
2.2 Specimen of Ledger Accounts ............................................................................................... 2.34
2.3 Posting .................................................................................................................................. 2.35
2.4 Balancing an Account ............................................................................................................ 2.35
Summary ............................................................................................................................................... 2.41
Test Your Knowledge ............................................................................................................................. 2.41
Unit 3 : Trial Balance

Learning Outcomes................................................................................................................................ 2.46

Unit Overview ........................................................................................................................................ 2.46
3.1 Introduction ......................................................................................................................... 2.46
3.2. Objectives of Preparing the Trial Balance ............................................................................. 2.47
3.3 Limitations of Trial Balance .................................................................................................... 2.48

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3.4 Methods of Preparation of Trial Balance................................................................................. 2.48

3.5 Adjusted Trial Balance (Through Suspense Account) ............................................................. 2.52
3.6 Rules of Preparing the Trial Balance ...................................................................................... 2.52
Summary ............................................................................................................................................... 2.54
Test Your Knowledge ............................................................................................................................. 2.55
Unit 4 : Subsidiary Books

Learning Outcomes................................................................................................................................ 2.59

Unit Overview ........................................................................................................................................ 2.59
4.1 Introduction ........................................................................................................................... 2.59
4.2 Distinction between Subsidiary Books and Principal books ..................................................... 2.60
4.3 Purchases Book .................................................................................................................... 2.62
4.4 Sales Book ............................................................................................................................ 2.65
4.5 Sales Returns Book or Returns Inward Book .......................................................................... 2.67
4.6 Purchase Returns or Returns Outward Book .......................................................................... 2.67
4.7 Importance of Journal ............................................................................................................ 2.69
Summary ............................................................................................................................................... 2.71
Test Your Knowledge ............................................................................................................................. 2.71
Unit 5 : Cash Book

Learning Outcomes................................................................................................................................ 2.76

Unit Overview ........................................................................................................................................ 2.76
5.1 Cash Book - A Subsidiary Book and a Principal Book ............................................................. 2.77
5.2 Kinds of Cash Book ............................................................................................................... 2.77
5.3 Posting the Cash Book Entries............................................................................................... 2.82
5.4 Petty Cash Book.................................................................................................................... 2.83
5.5 Entries for Sale Through Credit/Debit Cards ........................................................................... 2.87
Summary ............................................................................................................................................... 2.89
Test Your Knowledge ............................................................................................................................. 2.89
Unit 6: Rectification of Errors

Learning Outcomes................................................................................................................................ 2.93

Unit Overview ........................................................................................................................................ 2.93
6.1 Introduction ........................................................................................................................... 2.94

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6.2 Stages of Errors .................................................................................................................... 2.96

6.3 Types of Errors...................................................................................................................... 2.97
6.4 Steps to Locate Errors ........................................................................................................... 2.99
6.5 Rectification of Errors ............................................................................................................ 2.99
Summary ............................................................................................................................................. 2.115
Test Your Knowledge ........................................................................................................................... 2.115
CHAPTER 3: BANK RECONCILIATION STATEMENT............................................................3.1–3.36

Learning Outcomes.................................................................................................................................. 3.1

Chapter Overview .................................................................................................................................... 3.1
1. Introduction ............................................................................................................................. 3.2
2. Bank Pass Book ...................................................................................................................... 3.3
3. Bank Reconciliation Statement ................................................................................................ 3.3
4. Importance of Bank Reconciliation Statement .......................................................................... 3.4
5. Procedure for Reconciling the Cash Book Balance with the Pass Book Balance ...................... 3.12
6. Methods of Bank Reconciliation ............................................................................................. 3.14
Summary ............................................................................................................................................... 3.28
Test Your Knowledge ............................................................................................................................. 3.29
CHAPTER 4: INVENTORIES .................................................................................................... 4.1–4.28

Learning Outcomes.................................................................................................................................. 4.1

Chapter Overview .................................................................................................................................... 4.1
1. Meaning .................................................................................................................................. 4.2
2. Inventory Valuation .................................................................................................................. 4.2
3. Basis of Inventory Valuation .................................................................................................... 4.4
4. Inventory Record Systems ....................................................................................................... 4.5
5. Formulae/Methods to Determine Cost of Inventory ................................................................... 4.6
6. Inventories Taking ................................................................................................................. 4.14
Summary ............................................................................................................................................... 4.19
Test Your Knowledge ............................................................................................................................. 4.19
CHAPTER 5: CONCEPT AND ACCOUNTING OF DEPRECIATION ................................. 5.1–5.35

Learning Outcomes.................................................................................................................................. 5.1

Chapter Overview .................................................................................................................................... 5.1
1. Introduction ............................................................................................................................. 5.2

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2. Factors in the Measurement of Depreciation ............................................................................ 5.4

3. Methods for Providing Depreciation ......................................................................................... 5.7
4. Profit or Loss on The Sale/Disposal of Property, Plant and Equipment .................................... 5.15
5. Change in the Method of Depreciation ................................................................................... 5.20
6. Revision of the Estimated Useful Life of Property, Plant and Equipment ................................. 5.21
7. Revaluation of Property, Plant and Equipment ....................................................................... 5.22
Summary ............................................................................................................................................... 5.23
Test Your Knowledge ............................................................................................................................. 5.24
CHAPTER 6: ACCOUNTING FOR SPECIAL TRANSACTIONS ....................................... 6.1–6.122
Unit 1: Bills of Exchange and Promissory Notes

Learning Outcomes................................................................................................................................. 6.1

Unit Overview ......................................................................................................................................... 6.1
1.1 Bills of Exchange .................................................................................................................... 6.2
1.2 Promissory Notes ................................................................................................................... 6.3
1.3 Differences - Bill of Exchange and Promissory Note ................................................................ 6.4
1.4 Record of Bills of Exchange and Promissory Notes ................................................................. 6.5
1.5 Term of a Bill .......................................................................................................................... 6.6
1.6 Expiry / Due Date of a Bill ....................................................................................................... 6.6
1.7 Days of Grace ........................................................................................................................ 6.6
1.8 Date of Maturity of Bill ............................................................................................................ 6.7
1.9 Bill at Sight ............................................................................................................................. 6.7
1.10 Bill after Date ......................................................................................................................... 6.7
1.11 How to Calculate Due Date of a Bill ........................................................................................ 6.8
1.12 Noting Charges ...................................................................................................................... 6.8
1.13 Renewal of Bill ....................................................................................................................... 6.9
1.14 Retirement of Bills of Exchange & Rebate ............................................................................... 6.9
1.15 Insolvency ............................................................................................................................ 6.15
1.16 Accommodation Bills ............................................................................................................ 6.17
1.17 Bills of Collection .................................................................................................................. 6.24
1.18 Bills Receivable and Bills Payable Books .............................................................................. 6.24
Summary .............................................................................................................................................. 6.25
Test Your Knowledge ............................................................................................................................ 6.25

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Unit 2 : Sale of Goods on Approval or Return Basis

Learning Outcomes............................................................................................................................... 6.32

Unit Overview ....................................................................................................................................... 6.32
2.1 Introduction .......................................................................................................................... 6.32
2.2 Accounting Records ............................................................................................................. 6.33
Summary .............................................................................................................................................. 6.43
Test Your Knowledge ............................................................................................................................ 6.43
Unit 3 : Consignment

Learning Outcomes............................................................................................................................... 6.49

Unit Overview ....................................................................................................................................... 6.49
3.1 Meaning of Consignment Account ......................................................................................... 6.50
3.2 Distinctions ........................................................................................................................... 6.50
3.3 Accounting for Consignment Transactions and Events in the Books of the
Consignor ............................................................................................................................. 6.51
3.4 Valuation of Inventories ......................................................................................................... 6.56
3.5 Goods Invoiced above Cost ................................................................................................... 6.56
3.6 Normal Loss .......................................................................................................................... 6.59
3.7 Abnormal Loss ...................................................................................................................... 6.59
3.8 Commission .......................................................................................................................... 6.61
3.9 Return of Goods from the Consignee ..................................................................................... 6.62
3.10 Account Sales ....................................................................................................................... 6.62
3.11 Accounting in the Books of the Consignee ............................................................................. 6.62
3.12 Advance by the Consignee Vs Security against the Consignment ........................................... 6.67
Summary ............................................................................................................................................... 6.73
Test Your Knowledge ............................................................................................................................. 6.74
Unit 4 : Average Due Date

Learning Outcomes................................................................................................................................ 6.85

Unit Overview ........................................................................................................................................ 6.85
4.1 Introduction ........................................................................................................................... 6.86
4.2 Concept of due date (Date of Maturity) ................................................................................... 6.87
4.3 Types of Problems................................................................................................................. 6.88
Summary ............................................................................................................................................. 6.102

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Test Your Knowledge ........................................................................................................................... 6.103

Unit 5 : Account Current

Learning Outcomes.............................................................................................................................. 6.107

Unit Overview ...................................................................................................................................... 6.107
5.1 Introduction ......................................................................................................................... 6.107
5.2 Preparation of Account Current ............................................................................................ 6.108
Summary ............................................................................................................................................. 6.119
Test Your Knowledge ........................................................................................................................... 6.119

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CHAPTER
1
THEORETICAL FRAMEWORK
UNIT -1 MEANING AND SCOPE OF ACCOUNTING
LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand the meaning and significance of accounting.
 Understand the meaning of book-keeping and the distinction of accounting with
book-keeping.
 Appreciate the evolutionary process of accounting as a social science.
 Explain sub-fields of accounting.
 Identify the various user groups for whom accounting information is to be generated.
 Understand the relationship of accounting with Economics, Statistics,
Mathematics, Law and Management.
 Explain the limitations of accounting.
 Appreciate the enlarged boundary of accounting profession and the areas where
in a chartered accountant plays an important role of rendering useful services to the
society.

© The Institute of Chartered Accountants of India

1.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT OVERVIEW

Procedure of Accounting

Generating financial Using the financial

Information Information

Recording classifying Summarising Analyzing Interpreting Communicating

Identification of transaction

Intput Accounting Cycle Output

Identification of Recording of Communicating information

Prepration
economic transactions Posting to preparation of of final
to users
events and in the books ledger trial balance
of original accounts
transations External Users
measured in entry Internal Users ▪ Investors
financial terms ▪ Board of ▪ Lenders
Directors ▪ Suppliers
▪ Partners ▪ Govt.
▪ Managers agencies
▪ Officers ▪ Customers

1.1 INTRODUCTION
Every individual performs some kind of economic activity. A salaried person gets salary and spends to buy
provisions and clothing, for children’s education, construction of house, etc. A sports club formed by a group of
individuals, a business run by an individual or a group of individuals, a local authority like Calcutta Municipal
Corporation, Delhi Development Authority, Governments, either Central or State, all are carrying some kind of
economic activities. Not necessarily all the economic activities are run for any individual benefit; such economic
activities may create social benefit i.e. benefit for the public, at large. Anyway such economic activities are
performed through ‘transactions and events’. Transaction is used to mean ‘a business, performance of an act,
an agreement’ while event is used to mean ‘a happening, as a consequence of transaction(s), a result.’
An individual invests ` 2,00,000 for running a stationery business. On 1st January, he purchases goods for
` 1,15,000 and sells for ` 1,47,000 during the month of January. He pays shop rent for the month ` 5,000 and
finds that still he has goods worth ` 15,000 in hand. The individual performs an economic activity. He carries
on a few transactions and encounters with some events. Is it not logical that he will want to know the result of his
activity?
We see that the individual, who runs the stationery business, earns a surplus of ` 42,000.

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3 ACCOUNTING PROCESS 1.3

`
Goods sold 1,47,000
Goods in hand 15,000
1,62,000
Less : Goods purchased 1,15,000
Shop rent paid 5,000 (1,20,000)
Surplus 42,000

Earning of ` 42,000 surplus is an event; also having the inventories in hand is another event, while purchase and
sale of goods, investment of money and payment of rent are transactions.
Similarly, a municipal corporation got government grant ` 500 lakhs for adult education; it spent ` 250 lakhs for
purchasing literacy kits, paid ` 200 lakhs to the tutors and is left with a balance of ` 50 lakhs. These are also
transactions and events.
Similarly, the Central Government raised money through taxes, paid salaries to the employees, and spent on
various developmental activities. Whenever receipts of the Government are more than expenses it has surplus,
but if expenses are more than receipts it runs in deficit. Here raising money through various sources can be termed
as transaction and surplus or deficit at the end of the accounting year can be termed as an event.
So, everybody wants to keep records of all transactions and events and to have adequate information about the
economic activity as an aid to decision-making. Accounting discipline has been developed to serve this purpose
as it deals with the measurement of economic activities involving inflow and outflow of economic resources, which
helps to develop useful information for decision-making process.
Accounting has universal application for recording transactions and events and presenting suitable information
to aid decision-making regarding any type of economic activity ranging from a family function to functions of the
national government. But hereinafter we shall concentrate only on business activities and their accounting
because the objective of this study material is to provide a basic understanding on accounting for business
activities. Nevertheless, it will give adequate knowledge to think coherently of accounting as a field of study for
universal application.
The growth of accounting discipline is closely associated with the development of the business world. Thus, to
understand accounting as a field of study for universal application, it is best identified with recording of business
transactions and communication of financial information about business enterprise to facilitate decision-making.
The aim of accounting is to meet the information needs of the rational and sound decision- makers, and thus, called
the language of business.

1.2 MEANING OF ACCOUNTING

The Committee on Terminology set up by the American Institute of Certified Public Accountants formulated the
following definition of accounting in 1961:
“Accounting is the art of recording, classifying, and summarising in a significant manner and in terms of money,
transactions and events which are, in part at least, of a financial character, and interpreting the result thereof.”
As per this definition, accounting is simply an art of record keeping. The process of accounting starts by first
identifying the events and transactions which are of financial character and then be recorded in the books of

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account. This recording is done in Journal or subsidiary books, also known as primary books. Every good record
keeping system includes suitable classification of transactions and events as well as their summarisation for
ready reference. After the transactions and events are recorded, they are transferred to secondary books i.e.
Ledger. In ledger, transactions and events are classified in terms of income, expense, assets and liabilities
according to their characteristics and summarised in profit and loss account and balance sheet. Essentially the
transactions and events are to be measured in terms of money. Measurement in terms of money means measuring
at the ruling currency of a country, for example, rupee in India, dollar in U.S.A. and like. The transactions and
events must have at least in part, financial characteristics. The inauguration of a new branch of a bank is an
event without having financial character, while the business disposed of by the branch is an event having financial
character. Accounting also interprets the recorded, classified and summarised transactions and events.
However, the above-mentioned definition does not reflect the present day accounting function. The dimension of
accounting is much broader than that described in the above definition. According to the above definition,
accounting ends with interpretation of the results of the financial transactions and events but in the modern world
with the diversification of management and ownership, globalisation of business and society gaining more interest
in the functioning of the enterprises, the importance of communicating the accounting results has increased and
therefore, this requirement of communicating and motivating informed judgement has also become the part of
accounting as defined in the widely accepted definition of accounting, given by the American Accounting
Association in 1966 which treated accounting as:
“The process of identifying, measuring and communicating economic information to permit informed judgments
and decisions by the users of accounts.”
In 1970, the Accounting Principles Board (APB) of American Institute of Certified Public Accountants (AICPA)
enumerated the functions of accounting as follows:
“The function of accounting is to provide quantitative information, primarily of financial nature, about economic
entities, that is needed to be useful in making economic decisions.”
Thus, accounting may be defined as the process of recording, classifying, summarising, analysing and
interpreting the financial transactions and communicating the results thereof to the persons interested in such
information.

1.2.1 Procedural aspects of Accounting

On the basis of the above definitions, procedure of accounting can be basically divided into two parts:
(i) Generating financial information and
(ii) Using the financial information.

Generating Financial Information

1. Recording – This is the basic function of accounting. All business transactions of a financial character,
as evidenced by some documents such as sales bill, pass book, salary slip etc. are recorded in the books
of account. Recording is done in a book called “Journal.” This book may further be divided into several
subsidiary books according to the nature and size of the business. Students will learn how to prepare
journal and various subsidiary books in chapter 2.
2. Classifying – Classification is concerned with the systematic analysis of the recorded data, with a view
to group transactions or entries of one nature at one place so as to put information in compact and

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usable form. The book containing classified information is called “Ledger”. This book contains on
different pages, individual account heads under which, all financial transactions of similar nature are
collected. For example, there may be separate account heads for Salaries, Rent, Printing and
Stationeries, Advertisement etc. All expenses under these heads, after being recorded in the Journal,
will be classified under separate heads in the Ledger. This will help in finding out the total expenditure
incurred under each of the above heads. Students will learn how to prepare ledger books in chapter 2.
3. Summarising – It is concerned with the preparation and presentation of the classified data in a manner
useful to the internal as well as the external users of financial statements. This process leads to the
preparation of the financial statements.
4. Analysing – The term ‘Analysis’ means methodical classification of the data given in the financial statements.
The figures given in the financial statements will not help anyone unless they are in a simplified form. For
example, all items relating to fixed assets are put at one place while all items relating to current assets are
put at another place. It is concerned with the establishment of relationship between the items of the Profit and
Loss Account and Balance Sheet i.e. it provides the basis for interpretation. Students will learn this aspect of
financial statements in the later stages of the Chartered Accountancy Course.
5. Interpreting – This is the final function of accounting. It is concerned with explaining the meaning and
significance of the relationship as established by the analysis of accounting data. The recorded financial
data is analysed and interpreted in a manner that will enable the end-users to make a meaningful
judgement about the financial condition and profitability of the business operations. The financial
statement should explain not only what had happened but also why it happened and what is likely to
happen under specified conditions.
6. Communicating – It is concerned with the transmission of summarised, analysed and interpreted
information to the end-users to enable them to make rational decisions. This is done through preparation and
distribution of accounting reports, which include besides the usual profit and loss account and the
balance sheet, additional information in the form of accounting ratios, graphs, diagrams, fund flow
statements etc. Students will learn this aspect of financial statements in the later stages of the Chartered
Accountancy Course.
The first two procedural stages of the process of generating financial information along with the preparation of trial
balance are covered under book-keeping while the preparation of financial statements and its analysis,
interpretation and also its communication to the various users are considered as accounting stages. Students will
learn the term book-keeping and its distinction with accounting, in the coming topics of this unit.

Using the Financial Information

There are certain users of accounts. Earlier it was viewed that accounting is meant for the proprietor or owner of
the business, but changing social relationships diluted the earlier thinking. It is now believed that besides the
owner or the management of the business enterprise, users of accounts include the investors, employees,
lenders, suppliers, customers, government and other agencies and the public at large. Accounting provides the art
of presenting information systematically to the users of accounts. Accounting data is more useful if it stresses
economic substance rather than technical form. Information is useless and meaningless unless it is relevant and
material to a user’s decision. The information should also be free of any biases. The users should understand not
only the financial results depicted by the accounting figures, but also should be able to assess its reliability and
compare it with information about alternative opportunities and the past experience. The owners or the

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management of the enterprise, commonly known as internal users, use the accounting information in an analytical
manner to take the valuable decisions for the business. So the information served to them is presented in a manner
different to the information presented to the external users. Even the small details which can affect the internal
working of the business are given in the management report while financial statements presented to the external
users contains key information regarding assets, liabilities and capital which are summarised in a logical manner
that helps them in their respective decision-making.

1.3 EVOLUTION OF ACCOUNTING AS A SOCIAL SCIENCE

In its oldest form, accounting aided the stewards to discharge their stewardship function. The wealthy men
employed stewards to manage their property; the stewards in turn rendered an account periodically of their
stewardship. This ‘Stewardship Accounting’ was the root of financial accounting system. The presently followed
system of double-entry book-keeping has been developed only in the 15th Century. However, historians found
records of debit and credit dating back to the 12th Century. Although double-entry system was followed,
‘stewardship accounting’ served the purpose of businessmen and wealthy persons at that time. In most of the
countries, stewardship accounting was prevalent till the emergence of large-scale enterprises in the form of public
limited companies.
In the second phase, the idea of financial accounting emerged with the concept of joint stock company and
divorce of ownership from the management. To safeguard the interest of the shareholders and investors,
disclosure of financial statements (mainly, profit and loss account and balance sheet) and other accounting
information was moulded by law. Financial statements give periodic performance report by way of profit and loss
account and financial position at the end of the period by way of Balance Sheet. It got the legal status due to
changing relationships between the owners, economic entity and the managers. With the democratisation of
society, the relationships between the enterprise on the one hand, the investors, employees, managers and
governments on the other, have also undergone a sea-change. Also the prospective investors and other business
contact groups want to know a lot about the business before entering into transactions. Thus, financial accounting
emerged as an information system to identify, measure and communicate useful information for informed
judgements and decisions by a broad group of users. In the third phase, accounting information was generated
to aid management decision- making in particular. It contributed a lot to improve the quality of management
decisions. This new dimension of accounting is called Management Accounting and it is the development of 20th
Century only. It is pervasive enough to cover all spheres of management decisions.
Lastly, Social Responsibility Accounting is in the formative process, which aims at accounting for the social cost
incurred by business as well as the social benefit, created by it. It emerges from the growing social awareness
about the undesirable by-products of economic activities. While earning profit, an enterprise incurs numerous
social costs like pollution, using the resources of society like materials, land, labour etc. To compensate for this
social cost, in today’s world, an enterprise is expected to generate some social benefits also like employment
opportunities, recreation activities, more choice to customers at reasonable price, better quality products etc.
Therefore, it is demanded that the accounting system should produce a report measuring the social cost incurred
and social benefits generated.
Social Science study man as a member of society; they concern about social processes and the results and
consequences of social relationships. The usefulness of accounting to society as a whole is the fundamental
criterion to treat it as a social science. Although individuals may benefit from the availability of accounting
information, the accounting system generates information for social good. It serves social purposes, it contributes

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for social progress; also it is being adapted to keep pace with social progress. So, accounting is treated as a
social science.

1.4 OBJECTIVES OF ACCOUNTING

The objectives of accounting can be given as follows:
1. Systematic recording of transactions – Basic objective of accounting is to systematically record the
financial aspects of business transactions i.e. book-keeping. These recorded transactions are later on
classified and summarized logically for the preparation of financial statements and for their analysis and
interpretation.
2. Ascertainment of results of above recorded transactions – Accountant prepares profit and loss account
to know the results of business operations for a particular period of time. If revenue exceed expenses then it
is said that business is running profitably but if expenses exceed revenue then it can be said that business
is running under loss. The profit and loss account helps the management and different stakeholders in taking
rational decisions. For example, if business is not proved to be remunerative or profitable, the cause of such
a state of affair can be investigated by the management for taking remedial steps.
3. Ascertainment of the financial position of the business – Businessman is not only interested in knowing
the results of the business in terms of profits or loss for a particular period but is also anxious to know
that what he owes (liability) to the outsiders and what he owns (assets) on a certain date. To know this,
accountant prepares a financial position statement popularly known as Balance Sheet. The balance
sheet is a statement of assets and liabilities of the business at a particular point of time and helps in
ascertaining the financial health of the business.
4. Providing information to the users for rational decision-making – Accounting as a ‘language of
business’ communicates the financial results of an enterprise to various stakeholders by means of
financial statements. Accounting aims to meet the information needs of the decision-makers and helps
them in rational decision-making.
5. To know the solvency position – By preparing the balance sheet, management not only reveals what is
owned and owed by the enterprise, but also it gives the information regarding concern’s ability to meet its
liabilities in the short run (liquidity position) and also in the long-run (solvency position) as and when they fall
due.
An overview of objectives of accounting is depicted in the chart given below:

Objectives of Accounting

Communicatinig
Systematic Recording Ascertainment of Ascertainment of
Information to varous
of Transactions Results Financial Position
Users

Book-keeping: Manufacturing,
Journal, Leader an Trading, Profit and Balance Sheet Financial Reports
Trial Balance Loss Account

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1.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.5 FUNCTIONS OF ACCOUNTING

The main functions of accounting are as follows:
(a) Measurement: Accounting measures past performance of the business entity and depicts its current
financial position.
(b) Forecasting: Accounting helps in forecasting future performance and financial position of the enterprise
using past data and analysing trends.
(c) Decision-making: Accounting provides relevant information to the users of accounts to aid rational
decision-making.
(d) Comparison & Evaluation: Accounting assesses performance achieved in relation to targets and
discloses information regarding accounting policies and contingent liabilities which play an important role
in predicting, comparing and evaluating the financial results.
(e) Control: Accounting also identifies weaknesses of the operational system and provides feedbacks
regarding effectiveness of measures adopted to check such weaknesses.
(f) Government Regulation and Taxation: Accounting provides necessary information to the government
to exercise control on the entity as well as in collection of tax revenues.

1.6 BOOK-KEEPING
Book-keeping is an activity concerned with the recording of financial data relating to business operations in a
significant and orderly manner. It covers procedural aspects of accounting work and embraces record keeping
function. Obviously, book-keeping procedures are governed by the end product, the financial statements. The
term ‘financial statements’ means Profit and Loss Account, Balance Sheet and cash flow statements including
Schedules and Notes forming part of Accounts.
Book-keeping also requires suitable classification of transactions and events. This is also determined with
reference to the requirement of financial statements. A book-keeper may be responsible for keeping all the
records of a business or only of a minor segment, such as position of the customers’ accounts in a departmental
store. Accounting is based on a careful and efficient book-keeping system.
The essential idea behind maintaining book-keeping records is to show correct position regarding each head of
income and expenditure. A business may purchase goods on credit as well as in cash. When the goods are
bought on credit, a record must be kept of the person to whom money is owed. The proprietor of the business may
like to know, from time to time, what amount is due on credit purchase and to whom. If proper record is not
maintained, it is not possible to get details of the transactions in regard to the income and expenses. At the end of the
accounting period, the proprietor wants to know how much profit has been earned or loss has been incurred
during the course of the period. For this lot of information is needed which can be gathered from a proper record
of the transactions. Therefore, in book-keeping, the proper maintenance of books of account is indispensable for
any business.
At this level, the major concern of the curriculum is with book-keeping and preparation of financial statements. It
seems important to mention at this point that book-keeping and preparation of financial statements have legal
implications also. Maintenance of books of accounts and the preparation of financial statements of a company are
guided by the Companies Act, banks and insurance companies by special Acts governing these institutions and so

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on. However, for sole-proprietorship and partnership business, there is no specific legislation regarding
maintenance of books of accounts and preparation of financial statements.

1.6.1 Objectives of Book-keeping

1. Complete Recording of Transactions – It is concerned with complete and permanent record of all
transactions in a systematic and logical manner to show its financial effect on the business.
2. Ascertainment of financial Effect on the Business – It is concerned with the combined effect of all
the transactions made during the accounting period upon the financial position of the business as a
whole.

1.7 DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

Some people mistake book-keeping and accounting to be synonymous terms, but in fact they are different from
each other. Accounting is a broad subject. It calls for a greater understanding of records obtained from book-keeping
and an ability to analyse and interpret the information provided by book-keeping records. Book-keeping is the
recording phase while accounting is concerned with the summarising phase of an accounting system. Book-
keeping provides necessary data for accounting and accounting starts where book-keeping ends.
S.No. Book-keeping Accounting
1. It is a process concerned with recording of It is a process concerned with summarising of
transactions. the recorded transactions.
2. It constitutes as a base for accounting. It is considered as a language of the business.
3. Financial statements do not form part of this Financial statements are prepared in this
process. process on the basis of book-keeping records.
4. Managerial decisions cannot be taken with Management takes decisions on the basis of
the help of these records. these records.
5. There is no sub-field of book-keeping. It has several sub-fields like financial
accounting, management accounting etc.
6. Financial position of the business cannot be Financial position of the business is
ascertained through book-keeping records. ascertained on the basis of the accounting
reports.
Relationship of Accounting and Book-keeping can be depicted in the following chart as

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1.8 SUB-FIELDS OF ACCOUNTING

The various sub-fields of accounting are:
(i) Financial Accounting – It covers the preparation and interpretation of financial statements and
communication to the users of accounts. It is historical in nature as it records transactions which had
already been occurred. The final step of financial accounting is the preparation of Profit and Loss
Account and the Balance Sheet. It primarily helps in determination of the net result for an accounting
period and the financial position as on the given date.
(ii) Management Accounting – It is concerned with internal reporting to the managers of a business unit. To
discharge the functions of stewardship, planning, control and decision- making, the management needs
variety of information. The different ways of grouping information and preparing reports as desired by
managers for discharging their functions are referred to as management accounting. A very important
component of the management accounting is cost accounting which deals with cost ascertainment and
cost control. Management Accounting will be dealt with at higher levels of the Chartered Accountancy
Course.
(iii) Cost Accounting – The terminology of Cost Accounting published by the Institute of Cost and
Management Accountants of England defines cost accounting as:
“the process of accounting for cost which begins with the recording of income and expenditure or the
bases on which they are calculated and ends with the preparation of periodical statements and reports for
ascertaining and controlling costs.”
(iv) Social Responsibility Accounting – The demand for social responsibility accounting stems from increasing
social awareness about the undesirable by-products of economic activities. As already discussed earlier,
social responsibility accounting is concerned with accounting for social costs incurred by the enterprise
and social benefits created.
(v) Human Resource Accounting – Human resource accounting is an attempt to identify, quantify and report
investments made in human resources of an organisation that are not presently accounted for under
conventional accounting practice.

1.9 USERS OF ACCOUNTING INFORMATION

Generally users of accounts are classified into two categories, (a) internal users and (b) external users.
Management accounting is concerned with identifying information requirements as well as methods of providing
such information to management while information requirements of the outside users are generally served by
financial statements. Following are the various users of accounting information:
(i) Investors: They provide risk capital to the business. They need information to assess whether to buy,
hold or sell their investment. Also they are interested to know the ability of the business to survive,
prosper and to pay dividend. In non-corporate sector, where ownership and management are not
essentially separated, the owners still need information about performance of the business and its
financial position to decide whether to continue or shut down.

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(ii) Employees: Growth of the employees is directly related to the growth of the organisation and therefore, they
are interested to know the stability, continuity and growth of the enterprise and its ability to provide
remuneration, retirement and other benefits and to enhance employment opportunities.
(iii) Leaders: They are interested to know whether their loan-principal and interest will be paid back when
due.
(iv) Suppliers and Creditors: They are also interested to know the ability of the enterprise to pay their dues,
that helps them to decide the credit policy for the relevant concern, rates to be charged and so on.
Sometimes, they also become interested in long-term continuation of the enterprise if their existence
becomes dependent on the survival of that business.
(v) Customers: Customers are also concerned with the stability and profitability of the enterprise because
their functioning is more or less dependent on the supply of goods, suppose, a company produces some
chemicals used by pharmaceutical companies and supplies chemicals on three month’s credit. If all of a
sudden it faces some trouble and is unable to supply the chemical, the customers will also be in trouble.
(vi) Government and their agencies: They regulate the functioning of business enterprises for public good,
allocate scarce resources among competing enterprises, control prices, charge excise duties and taxes,
and so they have continued interest in the business enterprise.
(vii) Public: The public at large is interested in the functioning of the enterprise because it may make a
substantial contribution to the local economy in many ways including the number of people employed and
their patronage to local suppliers.
(viii) Management: Management as whole is also interested in the accounts for various managerial decisions.
On the basis of the accounts, management determines the effects of their various decisions on the
functioning of the organisation. This helps them to make further managerial decisions.

1.10 RELATIONSHIP OF ACCOUNTING WITH OTHER DISCIPLINES

Accounting is closely related with several other disciplines and thus to acquire a good knowledge in accounting
one should be conversant with the relevant portions of such disciplines. In many cases they overlap accounting.
The Accountant should have a working knowledge of the related disciplines so that he can understand such
overlapping areas and apply the knowledge of other disciplines in his own work wherever possible, or he can take
the expert advice.
(a) Accounting and Economics: Economics is viewed as a science of rational decision-making about the
use of scarce resources. It is concerned with the analysis of efficient use of scarce resources for satisfying
human wants. This may be viewed either from the perspective of a single firm or of the country as a
whole.
Accounting is viewed as a system, which provides data to the users to permit informed judgement and
decisions. Some non-accounting data are also relevant for decision-making.
Accounting overlaps economics in many respects. It contributed a lot in improving the management
decision-making process. But, economic theories influenced the development of the decision-making
tools used in accounting.

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However, there exists a wide gulf between economists’ and accountants’ concepts of income and capital.
Accountants got the ideas of value, income and capital maintenance from economists, but brushed
suitably to make them usable in practical circumstances. Accountants developed the valuation,
measurement and decision-making techniques which may owe to the economic theorems for origin but
these are moulded in the work environment and suitably tempered with reference to relevance,
verifiability, freedom from bias, timeliness, comparability, reliability and understand ability.
An example may be given to explain the nexus between accounting and economics. Economists think
that value of an asset is the present value of all future earnings which can be derived from such assets.
Now think about a plant whose working life is more than one hundred years. How can you estimate future
stream of earnings? So accountants developed the workable valuation base – the acquisition cost i.e.,
the price paid to acquire the assets.
At the macro-level, accounting provides the database over which the economic decision models have
been developed; micro-level data arranged by the accounting system is summed up to get macro-level
database.
Non-overlapping zones of accounting are not negligible. Development of the systems of recording,
classifying and summarising transactions and events, harmonising the systems by uniform rules and
communicating the data is essentially a non-overlapping area of accounting.
(b) Accounting and Statistics: The use of statistics in accounting can be appreciated better in the context of the
nature of accounting records. Accounting information is very precise; it is exact to the last paisa. But, for
decision-making purposes such precision is not necessary and hence, the statistical approximations are
sought.
In accounts, all values are important individually because they relate to business transactions. As against
this, statistics is concerned with the typical value, behaviour or trend over a period of time or the degree
of variation over a series of observations. Therefore, wherever a need arises for only broad
generalisations or the average of relationships, statistical methods have to be applied in accounting
data.
Further, in accountancy, the classification of assets and liabilities as well as the heads of income and
expenditure has been done as per the needs of financial recording to ascertain financial results of various
operations. Other types of classification like the geographical and historical ones and ad hoc
classification are done depending on the purpose to make such classification meaningful.
Accounting records generally take a short-term view of events and are confined to a year while statistical
analysis is more useful if a longer view is taken for the purpose. For example, to fit the trend line a longer
period will be required. However, statistical methods do use past accounting records maintained on a
consistent basis.
The functional relations showing mathematical relations of one variable with one or more other variables
are based on statistical work. These relations are used widely in making cost or price estimates for some
estimated future values assigned to the given independent variables. For example, given the functional
relation of total cost to the price of an input, the effect of changes in future prices on the cost of production
can be calculated.

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In accountancy, a number of financial and other ratios are based on statistical methods, which help in
averaging them over a period of time. Several accounting and financial calculations are based on
statistical formulae.
Statistical methods are helpful in developing accounting data and in their interpretation. For example, time
series and cross-sectional comparison of accounting data is based on statistical techniques. Now- a-days
multiple discriminate analysis is popularly used to identify symptoms of sickness of a business firm. Therefore,
the study and application of statistical methods would add extra edge to the accounting data.
(c) Accounting and Mathematics: Double Entry book-keeping can be converted in algebraic form; in fact the
first known book on this subject was part of a treatise on algebra. The fundamental accounting equation
will be discussed in detail under ‘Dual Aspect Concept’ of this chapter.
Knowledge of arithmetic and algebra is a pre-requisite for accounting computations and measurements.
Calculations of interest and annuity are the examples of such fundamental uses. While computing
depreciation, finding out installments in hire-purchase and instalments payment transactions, calculating
amount to be set aside for repayment of loan and replacement of assets and calculating lease rentals,
mathematical techniques are frequently used. Accounting data are also presented in ratio form.
With the advent of the computer, mathematics is becoming a vital part of accounting. Instead of writing
accounts in traditional fashion, the transactions and events can be recorded in the matrix form and the
rules of matrix algebra can be applied for classifying and summarising data.
Now-a-days statistics and econometric models are largely used for developing decision models for the
users of accounts. Also, Operations Research Techniques provide lot of decision models. Since
accounting is meant for providing information to the users, to be effective, accounting data should feed
the information requirements of such statistical, econometric and operations research models.
Understanding mathematics has become a must to grasp the decision models framed by statisticians,
econometricians and the O.R. experts.
Presently graphs and charts are being extensively used for communicating accounting information. In
addition to statistical knowledge, knowledge in geometry and trigonometry seems to be essential to have
a better understanding about the accounting communications system.
(d) Accounting and Law: An economic entity operates within a legal environment. All transactions with suppliers
and customers are governed by the Contract Act, the Sale of Goods Act, the Negotiable Instruments
Act, etc. The entity itself is created and controlled by laws. For example, a company is created by the
Companies Act and also controlled by Companies Act.
Similarly, every country has a set of economic, fiscal and labour laws. Transactions and events are always
guided by laws of the land. Very often the accounting system to be followed has been prescribed by the
law. For example, the Companies Act has prescribed the format of financial statements for companies.
Banking, insurance and electric supply undertakings may also have to produce financial statements as
prescribed by the respective legislations controlling such entities.
However, legal prescription about the accounting system is the product of developments in accounting
knowledge. That is to say, legislation about accounting system cannot be enacted unless there is a
corresponding development in the accounting discipline. In that way accounting influences law and is also
influenced by law.

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(e) Accounting and Management: Management is a broad occupational field, which comprises many
functions and encompasses application of many disciplines including those mentioned above.
Accountants are well placed in the management and play a key role in the management team. A large
portion of accounting information is prepared for management decision-making. Although management
relies on other data sources, accounting data are used as basic source documents. In the management
team, an accountant is in a better position to understand and use such data. In other words, since an
accountant plays an active role in management, he understands the data requirements. So the
accounting system can be moulded to serve the management purpose.

1.11 LIMITATIONS OF ACCOUNTING

There are certain misconceptions regarding financial statements. A common man presumes that an income
statement shows the correct income or loss of the enterprise and that a balance sheet depicts a perfectly true
and fair picture of financial standing of that enterprise. It must be recognised that the accounting as a language
has its own limitations. The figures of profit or loss generated by the accounting process are subject to various
constraints within which the accounting works. The assumptions and conventions, on which the accounting is
based, become the limitations of accounting. The financial statements are never free from subjectivity factor as
these are largely the outcome of personal judgement of the accountant with regard to the adoption of the accounting
policies. Following are certain instances:
1. The factors which may be relevant in assessing the worth of the enterprise don’t find place in the
accounts as they cannot be measured in terms of money. The Balance sheet cannot reflect the value of
certain factors like loyalty and skill of the personnel which may be the most valuable asset of an
enterprise these days.
2. Balance Sheet shows the position of the business on the day of its preparation and not on the future
date while the users of the accounts are interested in knowing the position of the business in the near
future and also in long run and not for the past date.
3. Accounting ignores changes in some money factors like inflation etc.
4. There are occasions when accounting principles conflict with each other.
5. Certain accounting estimates depend on the sheer personal judgement of the accountant, e.g., provision
for doubtful debts, method of depreciation adopted, recording certain expenditure as revenue
expenditure or capital expenditure, selection of method of valuation of inventories and the list is quite
long.
6. Financial statements consider those assets which can be expressed in monetary terms. Human
resources although the very important asset of the enterprise are not shown in the balance sheet. There
is no generally accepted formula for the valuation of human resources in money terms.
7. Different accounting policies for the treatment of same item adds to the probability of manipulations.
Though through various laws and Accounting Standards, efforts are made to reduce these options to
minimum but certainly could not be reduced to one.
In nutshell, it can be said that the language of accounting has certain practical limitations and, therefore, the
financial statements should be interpreted carefully keeping in mind all various factors influencing the true picture.

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15 ACCOUNTING PROCESS 1.15

1.12 ROLE OF ACCOUNTANT IN THE SOCIETY

There are only a few types of profession in the world which are held in high esteem in public eyes and there is
no denying the fact that the accounting profession is one of them. Goethe had called the accountant’s profession
as ‘the fairest invention of the human mind’. At the core of all types of learned profession, there is the desire of
public good and of finding the best way to serve society. By the use of the science of accountancy and under the
spell of its art, a dynamic pattern which assists business in planning its future is woven by accountants out of the
inert mass of non-speaking silent figures. This is what makes their profession an instrument of socio-economic
change and welfare of the society.
An accountant with his education, training, analytical mind and experience is best qualified to provide multiple
need-based services to the ever growing society. The accountants of today can do full justice not only to matters
relating to taxation, costing, management accounting, financial lay-out, company legislation and procedures but
they can delve deep into the fields relating to financial policies, budgetary policies and even economic principles.
The area of activities which can be undertaken by the accountants is not limited but it can also cover many
additional facets.

1.12.1 Areas of Service

The practice of accountancy has crossed its usual domain of preparation of financial statements, interpretation
of such statements and audit thereof. Accountants are presently taking active role in company laws and other
corporate legislation matters, in taxation laws matters (both direct and indirect) and in general management
problems. Some of the services rendered by accountants to the society are briefly mentioned hereunder:
(i) Maintenance of Books of Accounts: An accountant is able to maintain a systematic record of financial
transactions in order to establish the net result of the transactions entered into during a period and to
state the financial position of the concern as at a particular date.
For the fulfillment of the twin objective of ascertaining the profit earned or loss suffered and the financial
position, it is necessary that all transactions be recorded in a systematic manner, which can be done only
by an accountant. Proper maintenance of books of accounts assists management in planning, decision-
making, controlling functions.
(ii) Statutory Audit: Every limited company is required to appoint a chartered accountant or a firm of chartered
accountants as their auditor who are statutorily required to report each year whether in their opinion the
balance sheet shows a true and fair view of the state of affairs on the balance sheet date, and the profit and
loss account shows a true and fair view of the profit or loss for the year.
Auditing is not confined to the accounts of companies; other organisations may also have their accounts
audited, either because the law so requires (for example, the Co-operative Societies Act, the Income-tax Act,
etc.) or because the proprietors wisely decided so (for example, a partnership firm or an individual trader).
(iii) Internal Audit: It is a management tool whereby an internal auditor thoroughly examines the accounting
transactions and also the system, according to which these have been recorded with a view to ensure the
management that the accounts are being properly maintained and the system contains adequate
safeguards to check any leakage of revenue or misappropriation of property or assets and the operations
have been carried out in conformity with the plans of management.

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1.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

Now-a-days internal auditing has developed as a service to management. The internal auditor
constructively contributes in improving the operational efficiency of the business through an independent
review and appraisal of all business operations.
(iv) Taxation: An accountant can handle taxation matters of a business or a person and he can represent
that business or person before the tax authorities and settle the tax liability under the statute prevailing. He
can also assist in avoiding or reducing tax burden by proper planning of tax affairs.
Accountants also have a social obligation to express their views on broad tax policy, on the effect of tax
rate on business and the economy in general and on all other aspects of taxation in which they have
knowledge superior to that of the general public.
(v) Management Accounting and Consultancy Services: Management accountant performs an advisory
function. He is largely responsible for internal reporting to the management for planning and controlling
current operations, decision-making on special matters and for formulating long-range plans. His job is
to collect, analyse, interpret and present all accounting information which is useful to the management.
Accountant provides management consultancy services in the areas of management information system,
expenditure control and evaluation of appraisal techniques for new investments and divestments,
working capital management, corporate planning etc.
(vi) Financial Advice: Many people need help and guidance in planning their personal financial affairs. An
accountant who knows about finances, taxation and family problems is well placed to give such advice.
Some of the areas in which an accountant can render financial advice are:
(a) Investments: An accountant can explain the significance of the formidable documents which
shareholders receive from companies and help in making decisions relating to their investments.
(b) Insurance: An accountant can provide information to his clients on various insurance policies
and helps in choosing appropriate policy.
(c) Business Expansion: As businesses grow in size and complexity and mergers are being
considered, accountants are in the forefront in interpreting accounts, making suggestions as to
the form of schemes and the fairness of proposals considering cost and financial consequences
and generally advising their clients. They also advise on how to set about the problem of
borrowing money or whether this is an appropriate method of finance. Accountants can render
extremely useful service in connection of negotiations with foreign collaborators.
(d) Investigations: Financial investigations are required for a variety of purposes. Examples are:
(i) To ascertain the financial position of a business, for the information of interested parties
in connection with an issue of capital, the purchase or sale of the business or a
reconstruction or amalgamation.
(ii) To help the management to decide whether it is cheaper to manufacture an article or
to buy out.
(iii) To ascertain why profits have fallen.
(iv) To achieve greater efficiency in management.
(v) To ascertain whether fraud has occurred and if so, its nature and extent and to make
suggestions which will help to prevent a recurrence.

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17 ACCOUNTING PROCESS 1.17

(vi) To value businesses and shares in private companies for purposes such as purchase,
sale, estate duty or wealth tax etc.
For such problems requiring financial investigation, you need an accountant. His task as an
independent professional is to establish the facts fairly and clearly for the benefit of those who
have to make decisions and to give advice in many areas in which he has competence and
experience.
(e) Pension schemes: Specialist advice from actuaries, insurance agents or insurance company is
needed before launching or amending a provident fund or pension scheme in a business. But
before making a final decision, an accountant has to be consulted. Later on, his help may be
needed for managing the scheme or obtaining tax relief.
(vii) Other Services
(a) Secretarial Work: Companies, clubs, and associations indeed, virtually all organisations involve
secretarial work. Accountants frequently do this work.
(b) Share Registration Work: Accountants are often used by many companies to undertake the
work involved in registering share transfers and new issues.
(c) Company Formation: In conjunction with legal advisers, accountants help in the formation of a
company or advise against doing so.
(d) Receiverships, Liquidations, etc.: An accountant has to sometimes take on the onerous duties
of liquidator when a company is being wound up or receiver when a debenture holder exercises
a right to recover a loan on which the borrower has defaulted. Accountant is just the man for the
job. He is also just the man to help you to keep insolvency away if you consult him in time.
(e) Arbitrations: At times, accountants are invited by parties to act as arbitrators in a dispute or
settle disputes of various kinds.
(f) As regards the Cost Accounts: A cost accountant’s job is to continuously report cost data and
related information at frequent intervals to the management.
(g) Accountant and Information Services: An accountant will be effective in his role if he supplies
the information promptly and in an unambiguous language. He should develop a system by
which there is a regular flow of information both horizontally and vertically.
The information system should be such that comparability of financial statement is possible both
business-wise and year-wise so that it benefits both the management and the investors. Dependence
on data from the computerised information system will put new responsibilities on an accountant but his
product will command greater attention and respect.

1.12.2 Chartered Accountant in Industry

An accountant, though he is a part of the highest planning team is not a planner in an industry. He works with the
functional departments and translates the organisation’s aims in terms of financial expectations. Therefore, he has
to make a thorough study of the business and of individuals in the functional departments, whether they are
engineers or salesmen. A qualified accountant will be able to play an important role in performing important
functions of a business relating to accounting, costing and budgetary control, estimating and treasury.

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1.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.12.3 Chartered Accountant in Public Sector Enterprises

Both in the developed and developing countries, public sector enterprises have become a special feature of the
national economy. The system of financial and budgetary control and of accounting, auditing and reporting has,
therefore, become a matter of interest and concern to the nation, and does not remain confined merely to a limited
number of shareholders. The form of accounting followed by these corporations or companies is different from
that of ordinary government accounting. It is the duty of the accountants to prepare the accounts and reports of
these public corporations in such a way that they enable the general public to know how far the items appearing
in the various types of records and financial statements justify their existence.

1.12.4 Chartered Accountant in Framing Fiscal Policies

Accountants have a positive role to play in the determination of proper fiscal policies and advancement of trade,
commerce and industry. They should develop new techniques and prepare themselves for new fields of service
towards their commitment to the concept of the public goods and services. A business enterprise can be successful
in the commercial sense only if accounting and business knowledge are pooled together. It is a social obligation
for both accountants in industry and in practice to disclose greater information regarding the corporate results.
The state of affairs of the economy can be ascertained only when such consolidated corporate information is
disclosed.

1.12.5 Chartered Accountant and Economic Growth

In the present times accountants should conceive their duties as broadly as the conditions might require and do
not restrict them to only literal compliance of the law. Their aim should be not to allow any individual to gain at
the cost of the nation. Accountants have to accept a positive role and do their best to encourage efficiency in
individual business units and encourage those social objectives which form the main foundation of a welfare
state.

SUMMARY
♦ “Accounting is the art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and interpreting the
result thereof.”
♦ Accounting procedure can be basically divided into two parts:
(i) Generating financial information and
(ii) Using the financial information.
♦ The objectives of accounting can be given as follows:
(i) Systematic recording of transactions
(ii) Ascertainment of results of above recorded transactions
(iii) Ascertainment of the financial position of the business
(iv) Providing information to the users for rational decision-making
(v) To know the solvency position

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19 ACCOUNTING PROCESS 1.19

♦ The main functions of accounting are as follows:

(i) Measurement (ii) Forecasting
(iii) Decision-making (iv) Comparison & Evaluation
(v) Control (vi) Government Regulation and Taxation
♦ Objectives of Book-keeping:
(i) Complete Recording of Transactions and
(ii) Ascertainment of Financial Effect on the Business
♦ The various sub-fields of accounting are:
(i) Financial Accounting (ii) Management Accounting
(iii) Cost Accounting (iv) Social Responsibility Accounting
(v) Human Resource Accounting
♦ The various users of accounting information:
(i) Investors (ii) Employees
(iii) Lenders (iv) Suppliers and Creditors
(v) Customers (vi) Government and their agencies
(vii) Public (viii) Management
♦ Accounting is closely related with several other disciplines and thus to acquire a good knowledge in
accounting one should be conversant with the relevant portions of such disciplines.
An accountant with his education, training, analytical mind and experience is best qualified to provide multiple
need-based services to the ever growing society. The accountants of today can do full justice not only to matters
relating to taxation, costing, management accounting, financial lay-out, company legislation and procedures but
they can delve deep into the fields relating to financial policies, budgetary policies and even economic principles.

TEST YOUR KNOWLEDGE

True and False
1. There is no difference between book keeping and accounting, both are same.
2. Management Accounting covers the preparation and interpretation of financial statements and
communication to the users of accounts.
3. Financial accounting is concerned with internal reporting to the managers of a business unit.
4. Customers of business should not be considered as users of accounts prepared by business. They are
not interested to know performance of the business
5. Summarising is the basic function of accounting. All business transactions of a financial characters evidenced
by some documents such as sales bill, pass book, salary slip etc. are recorded in the books of account.
6. Balance sheet shows the position of the business on the day of its preparation and not on the future date.

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1.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

7. Objectives of book-keeping are complete recording of transactions & ascertainment of financial effect
on the business.

Multiple Choice Questions

1. Which of the following is not a subfield of accounting?
(a) Management accounting.
(b) Cost accounting.
(c) Book-keeping
2. Purposes of an accounting system include all the following except
(a) Interpret and record the effects of business transaction.
(b) Classify the effects of transactions to facilitate the preparation of reports.
(c) Dictate the specific types of business enterprise transactions that the enterprises may engage in.
3. Book-keeping is mainly concerned with
(a) Recording of financial data.
(b) Designing the systems in recording, classifying and summarising the recorded data.
(c) Interpreting the data for internal and external users.
4. All of the following are functions of Accounting except
(a) Decision making.
(b) Ledger posting.
(c) Forecasting.
5. Financial statements are part of
(a) Accounting.
(b) Book-keeping.
(c) Management Accounting.
6. Financial position of the business is ascertained on the basis of
(a) Records prepared under book-keeping process.
(b) Trial balance.
(c) Balance Sheet.
7. Users of accounting information include
(a) Creditors/Suppliers
(b) Lenders/ Customers
(c) Both (a) and (b)

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21 ACCOUNTING PROCESS 1.21

8. Financial statements do not consider

(a) Assets expressed in monetary terms.
(b) Liabilities expressed in monetary terms.
(c) Assets and liabilities expressed in non-monetary terms
9. On January 1, Sohan paid rent of ` 5,000. This can be classified as
(a) An event.
(b) A transaction.
(c) A transaction as well as an event.
10. On March 31, 2020 after sale of goods worth ` 2,000, he is left with the closing inventory of ` 10,000.
This is
(a) An event.
(b) A transaction.
(c) A transaction as well as an event.

Theoretical Questions
1. Define accounting. What are the sub-fields of accounting?
2. Who are the users of accounting information?
3. Discuss briefly the relationship of accounting with
(i) Economics (ii) Statistics (iii) Law
4. Discuss the limitations which must be kept in mind while evaluating the Financial Statements.
5. What services can a Chartered Accountant provide to the society?

ANSWER/HINTS
True and False
1. False: Book-keeping and accounting are different from each other. Accounting is a broad subject. It calls
for a greater understanding of records obtained from book-keeping and an ability to analyse and interpret
the information provided by book-keeping records.
Book-keeping is the recording phase while accounting is concerned with the summarizing phase of an
accounting system.
2. False: Financial accounting covers the preparation and interpretation of financial statements and
communication to the users of accounts.
3. False: Management accounting is concerned with internal reporting to the managers of a business unit.
4. False: Customers are also concerned with the stability and profitability of the enterprise because their
functioning is more or less dependent on the supply of goods

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1.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. False: Recording is the basic function of accounting. Summarising is concerned with the preparation and
presentation of the classified data in a manner useful to the internal as well as the external users of
financial statements
6. True: Balance Sheet is a statement of the financial position of an enterprise at a given date.
7. True: Book-keeping is concerned with complete recording and combined effect of transactions made
during the accounting period.

Multiple Choice Questions

1. (c) 2. (c) 3. (a) 4. (b) 5 (a) 6 (c)
7. (c) 8. (c) 9. (b) 10. (a)

Theoretical Questions
1. Accounting is the art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and interpreting the
result thereof. Various subfields of accounting are listed as: Financial Accounting; Management
Accounting; Cost Accounting; Social Responsibility Accounting and Human Resource Accounting.
2. Users of accounts can be listed as Investors, Employees, Lenders, Suppliers and Creditors, Customers,
Govt. and their agencies, public and Management.
3. Refer para 1.10 for understanding the relationship of Accounting with Economics, Statistics and Law.
4. Limitations which must be kept in mind while evaluating the Financial Statements are as follows:
♦ The factors which may be relevant in assessing the worth of the enterprise don’t find place in
the accounts as they cannot be measured in terms of money.
♦ Balance Sheet shows the position of the business on the day of its preparation and not on the
future date while the users of the accounts are interested in knowing the position of the business
in the near future and also in long run and not for the past date.
♦ Accounting ignores changes in some money factors like inflation etc.
♦ There are occasions when accounting principles conflict with each other.
♦ Certain accounting estimates depend on the sheer personal judgement of the accountant.
♦ Different accounting policies for the treatment of same item adds to the probability of
manipulations.
5. The practice of accountancy has crossed its usual domain of preparation of financial statements,
interpretation of such statements and audit thereof. Accountants are presently taking active role in
company laws and other corporate legislation matters, in taxation laws matters (both direct and indirect)
and in general management problems. For details, refer Para 1.12.

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23 ACCOUNTING PROCESS 1.23

UNIT – 2 ACCOUNTING CONCEPTS, PRINCIPLES AND

CONVENTIONS

LEARNING OUTCOMES
After studying this unit, you would be able to:
♦ Grasp the basic accounting concepts, principles and conventions and observe their implications while
recording transactions and events.
♦ Identify the three fundamental accounting assumptions:
• Going Concern
• Consistency
• Accrual
♦ Understand the qualitative characteristics that will help to develop the skill in course of time to prepare
financial statements.

UNIT OVERVIEW
Entity concept

Money measurement concept

Periodicity concept

Accrual concept
Concepts, Principles, Conventions

Matching concept

Going Concern concpet

Cost concept

Realisation Concept

Dual aspect concept

Conservatism

Consistency

Materiality

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1.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

2.1 INTRODUCTION
Let us imagine a situation where you are a proprietor and you take copies of your books of account to five different
accountants. You ask them to prepare the financial statements on the basis of the above records and to calculate
the profits of the business for the year. After few days, they are ready with the financial statements and all the
five accountants have calculated five different amounts of profits and that too with very wide variations among
them. Guess in such a situation what impact would it leave on you about accounting profession. To avoid this, a
generally accepted set of rules have been developed. This generally accepted set of rules provides unity of
understanding and unity of approach in the practice of accounting and also in better preparation and presentation
of the financial statements.
Accounting is a language of the business. Financial statements prepared by the accountant communicate
financial information to the various stakeholders for decision-making purpose. Therefore, it is important that
financial statements prepared by different organizations should be prepared on uniform basis. Also there should
be consistency over a period of time in the preparation of these financial statements. If every accountant starts
following his own norms and notions for accounting of different items then there will be an utter confusion.
To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual framework of
‘Generally Accepted Accounting Principles’(GAAPs). The term GAAPs is used to describe rules developed for the
preparation of the financial statements and are called concepts, conventions, postulates, principles etc. These
GAAPs are the backbone of the accounting information system, without which the whole system cannot even
stand erectly. These principles are the ground rules, which define the parameters and constraints within which
accounting reports are generated. Accounting principles are basic norms and assumptions on which the whole
accounting system has been developed and established. Accountant also adheres to various accounting
standards issued by the regulatory authority for the standardization of accounting policies to be followed under
specific circumstances. These conceptual frameworks, GAAPs and accounting standards are considered as the
theory base of accounting.

2.2 ACCOUNTING CONCEPTS

Accounting concepts define the assumptions on the basis of which financial statements of a business entity are
prepared. Certain concepts are perceived, assumed and accepted in accounting to provide a unifying structure
and internal logic to accounting process. The word concept means idea or notion, which has universal application.
Financial transactions are interpreted in the light of the concepts, which govern accounting methods. Concepts
are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid.
Unlike physical science, accounting concepts are only result of broad consensus. These accounting concepts lay
the foundation on the basis of which the accounting principles are formulated.

2.3 ACCOUNTING PRINCIPLES

“Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting
serving as an explanation of current practices and as a guide for selection of conventions or procedures where
alternatives exist.”
Accounting principles must satisfy the following conditions:
1. They should be based on real assumptions;

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25 ACCOUNTING PROCESS 1.25

2. They must be simple, understandable and explanatory;

3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.

2.4 ACCOUNTING CONVENTIONS

Accounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted
by various organizations over a period of time. These conventions are derived by usage and practice. The
accountancy bodies of the world may change any of the convention to improve the quality of accounting
information. Accounting conventions need not have universal application.
In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’ have
been used interchangeably to mean those basic points of agreement on which financial accounting theory and
practice are founded.

2.5 CONCEPTS, PRINCIPLES AND CONVENTIONS - AN OVERVIEW

Now we shall study in detail the various accounting concepts on which accounting is based. The following are
the widely accepted accounting concepts:
(a) Entity concept: Entity concept states that business enterprise is a separate identity apart from its owner.
Accountants should treat a business as distinct from its owner. Business transactions are recorded in the
business books of accounts and owner’s transactions in his personal books of accounts. The practice of
distinguishing the affairs of the business from the personal affairs of the owners originated only in the
early days of the double-entry book-keeping. This concept helps in keeping business affairs free from
the influence of the personal affairs of the owner. This basic concept is applied to all the organizations
whether sole proprietorship or partnership or corporate entities.
Entity concept means that the enterprise is liable to the owner for capital investment made by the owner.
Since the owner invested capital, which is also called risk capital, he has claim on the profit of the
enterprise. A portion of profit which is apportioned to the owner and is immediately payable becomes
current liability in the case of corporate entities.
Example: Mr. X started business investing ` 7,00,000 with which he purchased machinery for ` 5,00,000
and maintained the balance in hand. The financial position of the will be as follows:
`
Capital 7,00,000
Machinery 5,00,000
Cash 2,00,000

This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet his family
expenses from the business fund, then it should not be taken as business expenses and would be
charged to his capital account (i.e., his investment would be reduced by ` 5,000). Following the entity
concept the revised financial position would be

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1.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

Liability ` `
Capital 7,00,000
Less : Drawings (5,000) 6,95,000
Machinery 5,00,000
Cash 1,95,000

(b) Money measurement concept: As per this concept, only those transactions, which can be measured in
terms of money are recorded. Since money is the medium of exchange and the standard of economic
value, this concept requires that those transactions alone that are capable of being measured in terms
of money be only to be recorded in the books of accounts. Transactions, even if, they affect the results of
the business materially, are not recorded if they are not convertible in monetary terms. Transactions and
events that cannot be expressed in terms of money are not recorded in the business books. For example;
employees of the organization are, no doubt, the assets of the organizations but their measurement in
monetary terms is not possible therefore, not included in the books of account of the organization.
Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a
country provides a common denomination for the value of material objects.
It may be mentioned that when transactions occur across the boundary of a country, one may see many
currencies. Suppose a businessman sells goods worth ` 50 lakhs at home and he also sells goods worth
of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs plus 1 lakh Euro.
These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform
monetary unit i.e. in one currency. Suppose EURO 1 = ` 71.
Total Sales = ` 50 lakhs plus 71 lakhs = ` 121 lakhs. Money Measurement Concept imparts the essential
flexibility for measurement and interpretation of accounting data.
This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit
assumption that purchasing power of the money is not of sufficient importance as to require adjustment.
Also, many material transactions and events are not recorded in the books of accounts just because
they cannot be measured in monetary terms. Therefore, it is recognized by all the accountants that this
concept has its own limitations and inadequacies. Yet it is used for accounting purposes because it is
not possible to adopt a better measurement scale.
Entity and money measurement are viewed as the basic concepts on which other procedural concepts
hinge.
(c) Periodicity concept: This is also called the concept of definite accounting period. As per going concern’
concept an indefinite life of the entity is assumed. For a business entity it causes inconvenience to
measure performance achieved by the entity in the ordinary course of business.
If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial
position only at the end of its life.
So a small but workable fraction of time is chosen out of infinite life cycle of the business entity for
measuring performance and looking at the financial position. Generally one year period is taken up for
performance measurement and appraisal of financial position. However, it may also be 6 months or 9
months or 15 months.

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According to this concept accounts should be prepared after every period & not at the end of the life of the
entity. Usually this period is one calendar year. We generally follow from 1st April of a year to 31st March
of the immediately following year.
Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an unduly
long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful. If
one thinks of indefinite time-frame, nothing will accrue. There cannot be unpaid expenses and non-
receipt of revenue. Accrued expenses or accrued revenue is only with reference to a finite time-frame
which is called accounting period.
Thus, the periodicity concept facilitates in:
(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the business
(iii) Matching periodic revenues with expenses for getting correct results of the business operations
(d) Accrual concept: Under accrual concept, the effects of transactions and other events are recognised
on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and
they are recorded in the accounting records and reported in the financial statements of the periods to
which they relate. Financial statements prepared on the accrual basis inform users not only of past
events involving the payment and receipt of cash but also of obligations to pay cash in the future and of
resources that represent cash to be received in the future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the
gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities
of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s
resources yielding interest, royalties and dividends. For example, (1) Mr. X started a cloth merchandising.
He invested ` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for ` 60,000.
Customers paid him ` 50,000 cash and assure him to pay ` 10,000 shortly. His revenue is ` 60,000. It
arose in the ordinary course of cloth business; Mr. X received ` 50,000 in cash and ` 10,000 by way of
receivables.
Take another example; (2) an electricity supply undertaking supplies electricity spending ` 16,00,000
for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges.
This is also revenue which arose from rendering services.
Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying ` 1,00,000. He
rented it for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it arose from the use PG the
enterprise’s resources.
Expense is a cost relating to the operations of an accounting period or to the revenue earned during the
period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating revenue of
` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever any asset is used it has a
finite life to generate benefit. Suppose, the machine purchased by Mr. A in the third example will last for
10 years only. Then ` 10,000 is the expense every year relating to the cost of machinery.

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1.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

Accrual means recognition of revenue and costs as they are earned or incurred and not as money is
received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.
Example: Mr. J D buys clothing of ` 50,000 paying cash ` 20,000 and sells at ` 60,000 of which customers
paid only ` 50,000.
His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for the revenue) is
` 50,000, not ` 20,000 cash paid. So the accrual concept based profit is ` 10,000 (Revenue – Expenses).
As per Accrual Concept : Revenue – Expenses = Profit
Accrual Concept provides the foundation on which the structure of present day accounting has been
developed.
Alternative as per Cash basis
Cash received in ordinary course of business – Cash paid in ordinary course of business = profit.
Timing of revenue and expense booking could be different from cash receipt or paid.
(i) when cash received before revenue is - a liability is created when cash is received in
booked advance
(ii) when cash received after revenue is - an asset called Trade receivables is created
booked
(iii) when cash paid before expense is booked - creates an asset called Trade Advance when
cash is paid in advance
(iv) when cash paid after expense is booked - creates a liability called payables or Trade
payables or outstanding liabilities
(e) Matching concept: In this concept, all expenses matched with the revenue of that period should only be
taken into consideration. In the financial statements of the organization if any revenue is recognized then
expenses related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of expenses and income and
do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like
prepaid and outstanding expenses, unearned or accrued incomes.
It is not necessary that every expense identify every income. Some expenses are directly related to the
revenue and some are time bound. For example:- selling expenses are directly related to sales but rent,
salaries etc are recorded on accrual basis for a particular accounting period. In other words periodicity
concept has also been followed while applying matching concept.
Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and sold 8,000
pcs. @ ` 150 per piece during the accounting period of 12 months 1st January to 31st December, 2019.
He paid shop rent @ ` 3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments
and received ` 10,00,000 from the customers.
Let us see how the accrual and periodicity concepts operate.
Periodicity Concept fixes up the time-frame for which the performance is to be measured and financial
position is to be appraised. Here, it is January 2019 - December, 2019. So revenues and expenses are

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29 ACCOUNTING PROCESS 1.29

to be measured for the year 2019 and assets and liabilities are to be ascertained as on
31st December, 2019.
Accrual Concept operates to measure revenue of ` 12,00,000 (arising out of sale of garments 8,000 Pcs
× ` 150) which accrued during 2019, not the cash received ` 10,00,000 and also the expenses correctly.
Shop rent for 12 months is an expense item amounting to ` 36,000, not ` 33,000 the cash paid.
Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise? And should he treat
` 1,64,000 as profit? (Revenue ` 12,00,000-Merchandise ` 10,00,000. Shop Rent ` 36,000). Obviously
the answer is No. Matching links revenue with expenses.
Revenue – Expenses = Profit
But this unqualified equation may create misconception. It should be defined as : Periodic Profit =
Periodic Revenue – Matched Expenses
From the revenue of an accounting period such expenses are deducted which are expended to generate the
revenue to determine profit of that period.
In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000 pcs of
garments should be treated as expenses.
` `
Thus, Profit = Revenue 12,00,000
Loss Expenses:
Merchandise 8,00,000
Shop Rent 36,000 (8,36,000)
3,64,000
Assets:
Inventory (2,000 pcs x `100) 2,00,000
Trade receivables 2,00,000
Cash (Cash Receipts `10,00,000 – cash payments ` 8,33,000) 1,67,000
5,67,000
Liabilities:
Trade Payables 2,00,000
Expenses Payables 3,000
Capital (for Profit) 3,64,000
5,67,000

Thus, accrual, matching and periodicity concepts work together for income measurement and recognition
of assets and liabilities.
(f) Going Concern concept: The financial statements are normally prepared on the assumption that an
enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is
assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the

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1.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

scale of its operations; if such an intention or need exists, the financial statements may have to be
prepared on a different basis and, if so, the basis used needs to be disclosed.
The valuation of assets of a business entity is dependent on this assumption. Traditionally, accountants
follow historical cost in majority of the cases.
Suppose Mr. X purchased a machine for his business paying ` 5,00,000 out of ` 7,00,000 invested by
him. He also paid transportation expenses and installation charges amounting to ` 70,000. If he is still
willing to continue the business, his financial position will be as follows:
BALANCE SHEET
Liability ` Assets `
Capital 7,00,000 Machinery 5,70,000
Cash 1,30,000
7,00,000 7,00,000

Now if he decides to back out and desires to sell the machine, it may fetch more than or less than
` 5,70,000. So his financial position should be different. If going concern concept is taken, increase/
decrease in the value of assets in the short-run is ignored. The concept indicates that assets are kept for
generating benefit in future, not for immediate sale; current change in the asset value is not realisable
and so it should not be counted.
(g) Cost concept: By this concept, the value of an asset is to be determined on the basis of historical cost, in
other words, acquisition cost. Although there are various measurement bases, accountants traditionally
prefer this concept in the interests of objectivity. When a machine is acquired by paying ` 5,00,000,
following cost concept the value of the machine is taken as ` 5,00,000. It is highly objective and free
from all bias. Other measurement bases are not so objective. Current cost of an asset is not easily
determinable. If the asset is purchased on 1.1.1995 and such model is not available in the market, it
becomes difficult to determine which model is the appropriate equivalent to the existing one. Similarly,
unless the machine is actually sold, realisable value will give only a hypothetical figure. Lastly, present
value base is highly subjective because to know the value of the asset one has to chase the
uncertain future.
However, the cost concept creates a lot of distortion too as outlined below :
(a) In an inflationary situation when prices of all commodities go up on an average, acquisition cost
loses its relevance. For example, a piece of land purchased on 1.1.1995 for ` 2,000 may cost
` 1,00,000 as on 1.1.2020. So if the accountant makes valuation of asset at historical cost, the
accounts will not reflect the true position.
(b) Historical cost-based accounts may lose comparability. Mr. X invested ` 1,00,000 in a machine
on 1.1.1995 which produces ` 50,000 cash inflow during the year 2020, while Mr. Y invested
` 5,00,000 in a machine on 1.1.2005 which produced ` 50,000 cash inflows during the year. Mr. X
earned at the rate 50% while Mr. Y earned at the rate 10%. Who is more efficient? Since the assets
are recorded at the historical cost, the results are not comparable. Obviously it is a corollary
to (a).

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31 ACCOUNTING PROCESS 1.31

(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example. The
cost concept fails to recognise such asset although it is a very important asset of any
organization.
Many other controversial issues have arisen in financial accounting that revolves around the cost
concept which will be discussed at the advanced stage. However, later on we shall see that in many
circumstances, the cost convention is not followed. See conservatism concept for an example, which will
be discussed later on in this unit.
(h) Realisation concept: It closely follows the cost concept. Any change in value of an asset is to be
recorded only when the business realises it. When an asset is recorded at its historical cost of ` 5,00,000
and even if its current cost is ` 15,00,000 such change is not counted unless there is certainty that such
change will materialize.
However, accountants follow a more conservative path. They try to cover all probable losses but do not
count any probable gain. That is to say, if accountants anticipate decrease in value they count it, but if
there is increase in value they ignore it until it is realised. Economists are highly critical about the
realisation concept. According to them, this concept creates value distortion and makes accounting
meaningless.
Example: Mr. X purchased a piece of land on 1.1.1995 paying `2,000. Its current market value is
` 1,02,000 on 31.12.2020. Should the accountant show the land at `2,000 following cost concept and
ignoring `1,00,000 value increase since it is not realised? If he does so, the financial position would be:
BALANCE SHEET
Liabilities ` Asset `
Capital 2,000 Land 2,000
2,000 2,000
Is it not proper to show it in the following manner?
BALANCE SHEET
Liabilities ` Asset `
Capital Unrealised Gain 2,000 Land 1,02,000
1,00,000
1,02,000 1,02,000

Now-a-days the revaluation of assets has become a widely accepted practice when the change in value is
of permanent nature. Accountants adjust such value change through creation of revaluation (capital)
reserve.
Thus the going concern, cost concept and realization concept gives the valuation criteria.
(i) Dual aspect concept: This concept is the core of double entry book-keeping. Every transaction or event
has two aspects:
(1) It increases one Asset and decreases other Asset;
(2) It increases an Asset and simultaneously increases Liability;

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1.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

(3) It decreases one Asset, increases another Asset;

(4) It decreases one Asset, decreases a Liability.
Alternatively:
(5) It increases one Liability, decreases other Liability;
(6) It increases a Liability, increases an Asset;
(7) It decreases Liability, increases other Liability;
(8) It decreases Liability, decreases an Asset.
Example:
BALANCE SHEET
Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 75,000 Cash 1,00,000
Other Loan 75,000
3,00,000 3,00,000

Transactions:
(a) A new machine is purchased paying ` 50,000 in cash.
(b) A new machine is purchased for ` 50,000 on credit, cash is to be paid later on.
(c) Cash paid to repay bank loan to the extent of ` 50,000.
(d) Raised bank loan of ` 50,000 to pay off other loan.
Effect of the Transactions:
(a) Increase in machine value and decrease in cash balance by ` 50,000.
BALANCE SHEET (1 & 3)
Liabilities ` Assets `
Capital 1,50,000 Machinery 2,50,000
Bank Loan 75,000 Cash 50,000
Other Loan 75,000
3,00,000 3,00,000

(b) Increase in machine value and increase in Creditors by ` 50,000.

BALANCE SHEET (2 & 6)
Liabilities ` Assets `
Capital 1,50,000 Machinery 2,50,000
Creditors for machinery 50,000 Cash 1,00,000

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33 ACCOUNTING PROCESS 1.33

Bank Loan 75,000

Other Loan 75,000
3,50,000 3,50,000

(c) Decrease in bank loan and decrease in cash by ` 50,000.

BALANCE SHEET (4 & 8)
Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 25,000 Cash 50,000
Other Loan 75,000
2,50,000 2,50,000

(d) Increase in bank loan and decrease in other loan by ` 50,000.

BALANCE SHEET (5 & 7)
Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 1,25,000 Cash 1,00,000
Other Loan 25,000
3,00,000 3,00,000

So every transaction and event has two aspects.

This gives basic accounting equation :
Equity (E) + Liabilities (L) = Assets (A)
or
Equity (E)= Assets (A) – Liabilities(L)
Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets
Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities)
Or, Equity = Fixed Assets + Working Capital – Long Term Liabilities

ILLUSTRATION 1

Develop the accounting equation from the following information: -

Particulars March 31, 2019 March 31, 2020
(`) (`)
Capital 1,00,000 ?
12% Bank Loan 1,00,000 1,00,000
Trade Payables 75,000 70,000
Fixed Assets 1,25,000 1,10,000

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1.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

Trade Receivables 75,000 80,000

Inventory 70,000 80,000
Cash & Bank 5,000 6,000
Required
Find the profit for the year & the Balance sheet as on 31/3/2020.

SOLUTION

For the year ended March 31, 2019:

Equity = Capital ` 1,00,000
Liabilities = Bank Loan + Trade Payables
` 1,00,000 + ` 75,000 = ` 1,75,000
Assets = Fixed Assets + Trade Receivables + Inventory + Cash & Bank
` 1,25,000 + ` 75,000 + ` 70,000 + ` 5,000 = ` 2,75,000
Equity + Liabilities = Assets
` 1,00,000 + ` 1,75,000 = 2,75,000
For the year ended March 31, 2020:
Assets = ` 1,10,000 + ` 80,000 + ` 80,000 + ` 6,000 = ` 2,76,000
Liabilities = ` 1,00,000 + ` 70,000 = ` 1,70,000
Equity = Assets – Liabilities = ` 2,76,000 – ` 1,70,000 = ` 1,06,000 Profits = New Equity – Old Equity
= ` 1,06,000 – `1,00,000 = ` 6,000
(j) Conservatism: Conservatism states that the accountant should not anticipate any future income
however they should provide for all possible losses. When there are many alternative values of an asset,
an accountant should choose the method which leads to the lesser value. Later on we shall see that the
golden rule of current assets valuation - ‘cost or market price whichever is lower’ originated from this
concept.
The Realisation Concept also states that no change should be counted unless it has materialised. The
Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is
desirable to guard against all possible losses.
For this concept there should be at least three qualitative characteristics of financial statements, namely,
(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as
gains which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as
to exclude uncertain gains,
(iii) Faithful representation of alternative values.

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Many accounting authors, however, are of the view that conservatism essentially leads to understatement of
income and wealth and it should not be the basis for the preparation of financial statements.
(k) Consistency: In order to achieve comparability of the financial statements of an enterprise through time,
the accounting policies are followed consistently from one period to another; a change in an accounting
policy is made only in certain exceptional circumstances.
The concept of consistency is applied particularly when alternative methods of accounting are equally
acceptable. For example a company may adopt any of several methods of depreciation such as written-
down-value method, straight-line method, etc. Likewise there are many methods for valuation of
inventories. But following the principle of consistency it is advisable that the company should follow
consistently over years the same method of depreciation or the same method of valuation of Inventories
which is chosen. However in some cases though there is no inconsistency, they may seem to be
inconsistent apparently. In case of valuation of Inventories if the company applies the principle ‘at cost
or market price whichever is lower’ and if this principle accordingly results in the valuation of Inventories
in one year at cost price and the market price in the other year, there is no inconsistency here. It is only
an application of the principle.
But the concept of consistency does not imply non-flexibility as not to allow the introduction of improved
method of accounting.
An enterprise should change its accounting policy in any of the following circumstances only:
a. To bring the books of accounts in accordance with the issued Accounting Standards.
b. To comply with the provision of law.
c. When under changed circumstances, it is felt that new method will reflect more true and fair picture
in the financial statement.
(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not considered
material. This principle is an exception to full disclosure principle. According to materiality principle, all
the items having significant economic effect on the business of the enterprise should be disclosed in the
financial statements and any insignificant item which will only increase the work of the accountant but will
not be relevant to the users’ need should not be disclosed in the financial statements.
The term materiality is the subjective term. It is on the judgement, common sense and discretion of the
accountant that which item is material and which is not. For example stationary purchased by the
organization though not used fully in the accounting year purchased still shown as an expense of that
year because of the materiality concept. Similarly depreciation on small items like books, calculators etc.
is taken as 100% in the year of purchase though used by the entity for more than a year. This is because
the amount of books or calculator is very small to be shown in the balance sheet though it is the asset
of the company.
The materiality depends not only upon the amount of the item but also upon the size of the business,
nature and level of information, level of the person making the decision etc. Moreover an item material
to one person may be immaterial to another person. What is important is that omission of any information
should not impair the decision-making of various users.

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2.6 FUNDAMENTAL ACCOUNTING ASSUMPTIONS

There are three fundamental accounting assumptions :
(i) Going Concern
(ii) Consistency
(iii) Accrual
All the above three fundamental accounting assumptions have already been explained in para 2.5.
If nothing has been written about the fundamental accounting assumption in the financial statements then it is
assumed that they have already been followed in their preparation of financial statements. However, if any of the
above mentioned fundamental accounting assumption is not followed then this fact should be specifically
disclosed.

2.7 FINANCIAL STATEMENTS

The aim of accounting is to keep systematic records to ascertain financial performance and financial position of
an entity and to communicate the relevant financial information to the interested user groups. The financial
statements are basic means through which the management of an entity makes public communication of the
financial information along with selected quantitative details. They are structured financial representations of the
financial position and the performance of an enterprise. To have a record of all business transactions and also to
determine whether all these transactions resulted in either ‘profit or loss’ for the period, all the entities will prepare
financial statements viz., balance sheet, profit and loss account, cash flow statement etc. by following various
accounting concepts, principles, and conventions which have been already discussed in detail.

2.7.1 Qualitative Characteristics of financial Statements

Qualitative characteristics are the attributes that make the information provided in financial statements useful to
users. The following are the important qualitative characteristics of the financial statements:
1. Understandability: An essential quality of the information provided in financial statements is that it must be
readily understandable by users. For this purpose, it is assumed that users have a reasonable knowledge
of business, economic activities and accounting and study the information with reasonable diligence.
Information about complex matters that should be included in the financial statements because of its
relevance to the economic decision-making needs of users should not be excluded merely on the ground
that it may be too difficult for certain users to understand.
2. Relevance: To be useful, information must be relevant to the decision-making needs of users.
Information has the quality of relevance when it influences the economic decisions of users by helping
them evaluate past, present or future events or confirming, or correcting, their past evaluations.
The predictive and confirmatory roles of information are interrelated. For example, information about the
current level and structure of asset holdings has value to users when they endeavour to predict the ability
of the enterprise to take advantage of opportunities and its ability to react to adverse situations. The same
information plays a confirmatory role in respect of past predictions about, for example, the way in which
the enterprise would be structured or the outcome of planned operations.

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Information about financial position and past performance is frequently used as the basis for predicting
future financial position and performance and other matters in which users are directly interested, such as
dividend and wage payments, share price movements and the ability of the enterprise to meet its
commitments as they fall due. To have predictive value, information need not be in the form of an explicit
forecast. The ability to make predictions from financial statements is enhanced, however, by the manner in
which information on past transactions and events is displayed. For example, the predictive value of the
statement of profit and loss is enhanced if unusual, abnormal and infrequent items of income and
expense are separately disclosed.
3. Reliability: To be useful, information must also be reliable, Information has the quality of reliability when
it is free from material error and bias and can be depended upon by users to represent faithfully that
which it either purports to represent or could reasonably be expected to represent.
Information may be relevant but so unreliable in nature or representation that its recognition may be
potentially misleading. For example, if the validity and amount of a claim for damages under a legal
action against the enterprise are highly uncertain, it may be inappropriate for the enterprise to recognise
the amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and
circumstances of the claim.
4. Comparability: Users must be able to compare the financial statements of an enterprise through time in
order to identify trends in its financial position, performance and cash flows. Users must also be able to
compare the financial statements of different enterprises in order to evaluate their relative financial
position, performance and cash flows. Hence, the measurement and display of the financial effects of
like transactions and other events must be carried out in a consistent way throughout an enterprise and over
time for that enterprise and in a consistent way for different enterprises.
An important implication of the qualitative characteristic of comparability is that users be informed of the
accounting policies employed in the preparation of the financial statements, any changes in those polices
and the effects of such changes. Users need to be able to identify differences between the accounting
policies for like transactions and other events used by the same enterprise from period to period and by
different enterprises. Compliance with Accounting Standards, including the disclosure of the accounting
policies used by the enterprise, helps to achieve comparability.
The need for comparability should not be confused with mere uniformity and should not be allowed to
become an impediment to the introduction of improved accounting standards. It is not appropriate for an
enterprise to continue accounting in the same manner for a transaction or other event if the policy
adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also
inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and
reliable alternatives exist.
Users wish to compare the financial position, performance and cash flows of an enterprise over time.
Hence, it is important that the financial statements show corresponding information for the preceding
period(s).
The four principal qualitative characteristics are understandability, relevance, reliability and
comparability.
5. Materiality: The relevance of information is affected by its materiality. Information is material if its
misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users

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1.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

taken on the basis of the financial information. Materiality depends on the size and nature of the item or
error, judged in the particular circumstances of its misstatement. Materiality provides a threshold or cut-
off point rather than being a primary qualitative characteristic which the information must have if it is to
be useful.
6. Faithful Representation: To be reliable, information must represent faithfully the transactions and other
events it either purports to represent or could reasonably be expected to represent. Thus, for example,
a balance sheet should represent faithfully the transactions and other events that result in assets,
liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.
Most financial information is subject to some risk of being less than a faithful representation of that
which it purports to portray. This is not due to bias, but rather to inherent difficulties either in identifying
the transactions and other events to be measured or in devising and applying measurement and
presentation techniques that can convey messages that correspond with those transactions and events.
In certain cases, the measurement of the financial effects of items could be so uncertain that enterprises
generally would not recognise them in the financial statements; for example, although most enterprises
generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably. In
other cases, however, it may be relevant to recognise items and to disclose the risk of error surrounding
their recognition and measurement.
7. Substance over Form: If information is to represent faithfully the transactions and other events that it
purports to represent, it is necessary that they are accounted for and presented in accordance with their
substance and economic reality and not merely their legal form. The substance of transactions or other
events is not always consistent with that which is apparent from their legal or contrived form. For
example, where rights and beneficial interest in an immovable property are transferred but the
documentations and legal formalities are pending, the recording of acquisition/disposal (by the
transferee and transferor respectively) would in substance represent the transaction entered into.
8. Neutrality: To be reliable, the information contained in financial statements must be neutral, that is, free
from bias. Financial statements are not neutral if, by the selection or presentation of information, they
influence the making of a decision or judgement in order to achieve a predetermined result or outcome.
9. Prudence: The preparers of financial statements have to contend with the uncertainties that inevitably
surround many events and circumstances, such as the collectability of receivables, the probable useful
life of plant and machinery, and the warranty claims that may occur. Such uncertainties are recognised by
the disclosure of their nature and extent and by the exercise of prudence in the preparation of the
financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgments
needed in making the estimates required under conditions of uncertainty, such that assets or income are
not overstated and liabilities or expenses are not understated. However, the exercise of prudence does
not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate
understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because
the financial statements would then not be neutral and, therefore, not have the quality of reliability.
10. Full, fair and adequate disclosure: The financial statement must disclose all the reliable and relevant
information about the business enterprise to the management and also to their external users for which
they are meant, which in turn will help them to take a reasonable and rational decision. For it, it is
necessary that financial statements are prepared in conformity with generally accepted accounting
principles i.e the information is accounted for and presented in accordance with its substance and

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39 ACCOUNTING PROCESS 1.39

economic reality and not merely with its legal form. The disclosure should be full and final so that users
can correctly assess the financial position of the enterprise.
The principle of full disclosure implies that nothing should be omitted while principle of fair disclosure
implies that all the transactions recorded should be accounted in a manner that financial statement
purports true and fair view of the results of the business of the enterprise and adequate disclosure implies
that the information influencing the decision of the users should be disclosed in detail and should make
sense.
This principle is widely used in corporate organizations because of separation in management and
ownership. The Companies Act in pursuant of this principle has came out with the format of balance
sheet and profit and loss account. The disclosures of all the major accounting policies and other
information are to be provided in the form of footnotes, annexures etc. The practice of appending notes
to the financial statements is the outcome of this principle.
11. Completeness: To be reliable, the information in financial statements must be complete within the
bounds of materiality and cost. An omission can cause information to be false or misleading and thus
unreliable and deficient in terms of its relevance.
Thus, if accounting information is to present faithfully the transactions and other events that it purports
to represent, it is necessary that they are accounted for and presented in accordance with their
substance and economic reality, not by their legal form. For example, if a business enterprise sells its
assets to others but still uses the assets as usual for the purpose of the business by making some
arrangement with the seller, it simply becomes a legal transaction. The economic reality is that the
business is using the assets as usual for deriving the benefit. Financial statement information should
contain the substance of this transaction and should not only record going by legality. In order to be
reliable the financial statements information should be neutral i.e., free from bias. The prepares of
financial statements however, have to contend with the uncertainties that inevitably surround many
events and circumstances, such as the collectability of doubtful receivables, the probable useful life of
plant and equipment and the number of warranty claims that many occur. Such uncertainties are
recognised by the disclosure of their nature and extent and by exercise of prudence in the preparation
of financial statements. Prudence is the inclusion of a degree of caution in the exercise of judgement
needed in making the estimates required under condition of uncertainty such that assets and income are
not overstated and loss and liability are not understated.

SUMMARY
♦ Accounting concepts define the assumptions on the basis of which financial statements of a business
entity are prepared.
The following are the widely accepted accounting concepts:
(a) Entity concept (b) Money measurement concept
(c) Periodicity concept (d) Accrual concept
(e) Matching concept (f) Going Concern concept
(g) Cost concept (h) Realisation concept
(i) Dual aspect concept (j) Conservatism
(k) Materiality

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1.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

♦ Accounting principles are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practices and as a guide for selection of conventions or
procedures where alternatives exist.”
♦ Accounting conventions emerge out of accounting practices, commonly known as accounting principles,
adopted by various organizations over a period of time.
♦ There are three fundamental accounting assumptions:
(i) Going Concern (ii) Consistency (iii) Accrual
♦ Qualitative characteristics are the attributes that make the information provided in financial statements
useful to users. Understandability, Relevance, Reliability, Comparability, Materiality, Faithful
Representation, Substance over Form, Neutrality, Prudence, Full, fair and adequate disclosure and
Completeness are the important qualitative characteristics of the financial statements.

TEST YOUR KNOWLEDGE

True and False
1. The concept helps in keeping business affairs free from the influence of the personal affairs of the owner is
known as the matching concept.
2. Entity concept means that the enterprise is liable to the owner for capital investment made by the owner.
3. Accrual means recognition as money is received or paid and not of revenue and costs as they are earned
or incurred.
4. The Conservatism Concept also states that no change should be counted unless it has materialized.
5. The concept of consistency implies non-flexibility as not to allow the introduction of improved method of
accounting.
6. The materiality depends only upon the amount of the item and not upon the size of the business, nature
and level of information, level of the person making the decision etc.

Multiple Choice Questions

1. (i) All the following items are classified as fundamental accounting assumptions except
(a) Consistency. (b) Business entity.
(c) Going concern.
(ii) Two primary qualitative characteristics of financial statements are
(a) Understandability and materiality. (b) Relevance and reliability.
(c) Neutrality and understandability.
(iii) Kanika Enterprises follows the written down value method of depreciating machinery year after
year due to
(a) Comparability. (b) Convenience.
(c) Consistency.

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41 ACCOUNTING PROCESS 1.41

(iv) A purchased a car for ` 5,00,000, making a down payment of ` 1,00,000 and signing a ` 4,00,000
bill payable due in 60 days. As a result of this transaction
(a) Total assets increased by ` 5,00,000.
(b) Total liabilities increased by ` 4,00,000.
(c) Total assets increased by ` 4,00,000 with corresponding increase in liabilities by
` 4,00,000.
(v) Mohan purchased goods for `15,00,000 and sold 4/5th of the goods amounting `18,00,000 and
met expenses amounting ` 2,50,000 during the year, 2020. He counted net profit as ` 3,50,000.
Which of the accounting concept was followed by him?
(a) Entity. (b) Periodicity.
(c) Matching.
(vi) A businessman purchased goods for ` 25,00,000 and sold 80% of such goods during the
accounting year ended 31st March, 2020. The market value of the remaining goods was `
4,00,000. He valued the closing Inventory at cost. He violated the concept of
(a) Money measurement. (b) Conservatism.
(c) Cost.
(vii) Capital brought in by the proprietor is
(a) Increase in asset and increase in liability
(b) Increase in liability and decrease in asset
(c) Increase in asset and decrease in liability
2. (i) Assets are held in the business for the
(a) Resale. (b) Conversion into cash
(c) Earning revenue.
(ii) Revenue from sale of products, is generally, realised in the period in which
(a) Cash is collected. (b) Sale is made
(c) Products are manufactured.
(iii) The concept of conservatism when applied to the balance sheet results in
(a) Understatement of assets. (b) Overstatement of assets.
(c) Overstatement of capital.
(iv) Decrease in the amount of trade payables results in
(a) Increase in cash. (b) Decrease in bank over draft account.
(c) Decrease in assets.

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1.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

(v) The determination of expenses for an accounting period is based on the principle of
(a) Objectivity. (b) Materiality.
(c) Matching.
(vi) Economic life of an enterprise is split into the periodic interval to measure its performance is as
per
(a) Entity. (b) Matching.
(c) Periodicity.
3. (i) If an individual asset is increased, there will be a corresponding
(a) Increase of another asset or increase of capital.
(b) Decrease of another asset or increase of liability.
(c) Decrease of specific liability or decrease of capital.
(ii) Purchase of machinery for cash
(a) Decreases total assets. (b) Increases total assets.
(c) Retains total assets unchanged.
(iii) Consider the following data pertaining to Alpha Ltd.:
Particulars `
Cost of machinery purchased on 1st April, 2019 10,00,000
Installation charges 1,00,000
Market value as on 31st March, 2020 12,00,000
While finalizing the annual accounts, if the company values the machinery at ` 12,00,000.
Which of the following concepts is violated by the Alpha Ltd.?
(a) Cost. (b) Matching.
(c) Accrual.

Theoretical Questions
1. Write short notes on:
(i) Fundamental accounting assumptions.
(ii) Periodicity concept.
(iii) Accounting conventions.
2. Distinguish between:
(i) Money measurement concept and matching concept
(ii) Going concern and cost concept
3. Briefly explain the qualitative characteristics of the financial statements.

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ANSWERS/HINTS
Ture and False
1. False: Under matching concept all expenses matched with the revenue of that period should only be
taken into consideration. In the financial statements of the organization if any revenue is recognized then
expenses related to earn that revenue should also be recognized.
2. True: Since the owner invested capital, he has claim on the profits of the enterprise.
3. False: Under accrual concept, the effects of transactions and other events are recognised on mercantile
basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and they are
recorded in the accounting records and reported in the financial statements of the periods to which they
relate.
4. False: The Realisation Concept also states that no change should be counted unless it has materialised.
5. False: The concept of consistency does not imply non-flexibility as not to allow the introduction of
improved method of accounting.
6. True: As per materiality principle, all the items having significant economic effect on the business of the
enterprise should be disclosed in the financial statements.

Multiple Choice Questions

1.(i) (b) (ii) (b) (iii) (c) (iv) (c) (v) (c) (vi) (b)
(vii) (a) 2.(i) (c) (ii) (b) (iii) (a) (iv) (c) (v) (c)
(vi) (c) 3.(i) (b) (ii) (c) (iii) (a)

Theoretical Questions
1. (i) Fundamental accounting assumptions: There are three fundamental accounting
assumptions: Going Concern; Consistency and Accrual. If nothing has been written about the
fundamental accounting assumption in the financial statements then it is assumed that they
have already been followed in their preparation of financial statements.
(ii) Periodicity concept: According to this concept accounts should be prepared after every period
& not at the end of the life of the entity. For details, refer para 2.5.
(iii) Accounting conventions: Accounting conventions emerge out of accounting practices,
commonly known as accounting principles, adopted by various organizations over a period of
time. For details, refer para 2.4.
2. (i) Distinction between Money measurement concepts and matching concept
As per Money Measurement concept, only those transactions, which can be measured in
terms of money are recorded. Since money is the medium of exchange and the standard of
economic value, this concept requires that those transactions alone that are capable of being
measured in terms of money be only to be recorded in the books of accounts. Transactions
and events that cannot be expressed in terms of money are not recorded in the business books.

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1.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

In Matching concept all expenses matched with the revenue of that period should only be taken
into consideration. In the financial statements of the organization if any revenue is recognized
them expenses related to earn that revenue should also be recognized.
(ii) Distinction between Going concern and cost concept
Going Concern Concept
The financial statements are normally prepared on the assumption that an enterprise is a going
concern and will continue in operation for the foreseeable future.
Cost concept
By this concept, the value of an asset is to be determined on the basis of historical cost, in other
words, acquisition cost. For details refer para 2.5.
3. Qualitative characteristics are the attributes that make the information provided in financial statements
useful to users. For details, refer para 2.7.

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45 ACCOUNTING PROCESS 1.45

UNIT – 3 ACCOUNTING TERMINOLOGY GLOSSARY

LEARNING OUTCOMES
After studying this unit, you would be able to:
♦ Define basic accounting terms; and
♦ Understand the application of these accounting terms while recording transactions and events.

ACCOUNTING TERMINOLOGY - GLOSSARY

Acceptance
The drawee’s signed assent on bill of exchange, to the order of the drawer. This term is also used to describe a bill
of exchange that has been accepted.
Accounting policies
Accounting policies are the specific accounting principles and the methods of applying those principles adopted
by an enterprise in the preparation and presentation of financial statements.
Accrual
Recognition of revenues and costs as they are earned or incurred (and not as money is received or paid). It
includes recognition of transactions relating to assets and liabilities as they occur irrespective of the actual
receipts or payments.
Accrual/Mercantile Basis of Accounting
The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts
in the period in which they accrue. The ‘accrual basis of accounting’ includes considerations relating to deferrals,
allocations, depreciation and amortisation. This basis is also referred to as mercantile basis of accounting.
Accrued Asset
A developing but not yet enforceable claim against another person which accumulates with the passage of time or
the rendering of service or otherwise. It may arise from the rendering of services (including the use of money)
which at the date of accounting have been partly performed, and are not yet billable.
Accrued Expense
An expense which has been incurred in an accounting period but for which no enforceable claim has become
due in that period against the enterprise. It may arise from the purchase of services (including the use of money)
which at the date of accounting have been only partly performed, and are not yet billable.
Accrued Liability
A developing but not yet enforceable claim by another person which accumulates with the passage of time or the
receipt of service or otherwise. It may arise from the purchase of services (including the use of money) which at the
date of accounting have.

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Accrued Revenue
Revenue which has been earned in an accounting period but in respect of which no enforceable claim has become
due in that period by the enterprise. It may arise from the rendering of services (including the use of money)
which at the date of accounting have been partly performed, and are not yet billable.
Accumulated Depletion
The total to date of the periodic depletion charges on wasting assets.
Accumulated Depreciation
The total to date of the periodic depreciation charges on depreciable assets.
Advance
Payment made on account of, but before completion of, a contract, or before acquisition of goods or receipt of
services.
Amortised Value
The amortizable amount less any portion already provided by way of amortization.
Annual Report
The information provided annually by the management of an enterprise to the owners and other interested persons
concerning its operations and financial position. It includes the information statutorily required, e.g., in the case of
a company, the balance sheet, profit and loss statement and notes on accounts, the auditor’s report thereon, and
the report of the Board of Directors. It also includes other information voluntarily provided e.g., value added
statement, graphs, charts, etc.
Appropriation Account
An account sometimes included as a separate section of the profit and loss statement showing application of
profits towards dividends, reserves, etc.
Assets
Tangible objects or intangible rights owned by an enterprise and carrying probable future benefits.
Authorised Share Capital
The number and par value, of each class of shares that an enterprise may issue in accordance with its instrument
of incorporation. This is sometimes referred to as nominal share capital.
Average Cost
The cost of an item at a point of time as determined by applying an average of the cost of all items of the same
nature over a period. When weightages are also applied in the computation, it is termed as weighted average cost.
Bad Debts
Debts owed to an enterprise which are considered to be irrecoverable.

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Balance Sheet
A statement of the financial position of an enterprise as at a given date, which exhibits its assets, liabilities,
capital, reserves and other account balances at their respective book values.
Bill of Exchange
An instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay
a certain sum of money only, to or to the order of a certain person or to the bearer of the instrument.
Bonus Shares
Shares allotted by capitalization of the reserves or surplus of a corporate enterprise.
Book Value
The amount at which an item appears in the books of account or financial statements. It does not refer to any
particular basis on which the amount is determined e.g., cost, replacement value, etc.
Borrowing costs
Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of funds.
Bond/Debenture
A formal document constituting acknowledgment of a debt by an enterprise usually given under its common seal and
normally containing provisions regarding payment of interest, repayment of principal and security, if any. It is
transferable in the appropriate manner.
Call
A demand pursuant to terms of issue to pay a part or whole of the balance remaining payable on shares or
debentures after allotment.
Called-up Share Capital
That part of the subscribed share capital which shareholders have been required to pay.
Capital
Generally refers to the amount invested in an enterprise by its owners e.g. paid-upsharecapital in a corporate
enterprise. It is also used to refer to the interest of owners in the assets of an enterprise.
Capital Assets
Assets, including investments not held for sale, conversion or consumption in the ordinary course of business.
Capital Commitment
Future liability for capital expenditure in respect of which contracts have been made.
Capital Employed
The finances deployed by an enterprise in its net fixed assets, investments and working capital. Capital employed
in an operation may, however, exclude investments made outside that operation.

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Capital Profit/Capital Loss

Excess of the proceeds realised from the sale, transfer, or exchange of the whole or a part of a capital asset over
its cost. When the result of this computation is negative, it is referred to as capital loss.
Capital Reserve
A reserve of a corporate enterprise which is not available for distribution as dividend.
Capital Work-in-progress
Expenditure on capital assets which are in the process of construction or completion.
Cash
Cash comprises cash on hand and demand deposits with banks
Cash equivalents
Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts of
cash and which are subject to an insignificant risk of changes in value.
Cash Basis of Accounting
The method of recording transactions by which revenues and costs and assets and liabilities are reflected in the
accounts in the period in which actual receipts or actual payments are made.
Cash Discount
A reduction granted by a supplier from the invoiced price in consideration of immediate payment or payment
within a stipulated period.
Cash Profit
The net profit as increased by non-cash costs, such as depreciation, amortization, etc. When the result of the
computation is negative, it is termed as cash loss.
Carrying amount
Carrying amount is the amount at which an asset is recognized in the balance sheet, net of any accumulated
amortization and accumulated impairment losses thereon.
Charge
An encumbrance on an asset to secure an indebtedness or other obligations. It may be fixed or floating.
Cheque
A bill of exchange drawn upon a specified banker and not expressed to be payable otherwise than on demand.
Collateral Security
Security which is given in addition to the principal security against the same liability or obligation.
Costs of disposal
Costs of disposal are incremental costs directly attributable to the disposal of an asset, excluding finance costs
and income tax expense.

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Contingency
A contingency is a condition or situation, the ultimate outcome of which, gain or loss, will be known or determined
only on the occurrence, or non-occurrence, of one or more uncertain future events.
Contingent Asset
An asset the existence, ownership or value of which may be known or determined only on the occurrence or non-
occurrence of one or more uncertain future events.
Contingent Liability
An obligation relating to an existing condition or situation which may arise in future depending on the occurrence
or non-occurrence of one or more uncertain future events.
Contra Account
One or two or more accounts which partially or wholly off-set another or other accounts.
Cost
The amount of expenditure incurred on or attributable to a specified article, product or activity.
Cost of Purchase
The purchase price including duties and taxes, freight inwards and other expenditure directly attributable to
acquisition, less trade discounts, rebates, duty drawbacks, and subsidies in respect of such purchase.
Cost of Goods Sold
The cost of goods sold during an accounting period. In manufacturing operations, it includes (i) cost of materials;
(ii) labour and factory overheads; selling and administrative expenses are normally excluded.
Conversion Cost
Cost incurred to convert raw materials or components into finished or semi-finished products. This normally includes
costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and
subcontracted work, and production overheads as applicable in accordance with either the direct cost or absorption
costing method. Production overheads exclude expenses which relate to general administration, finance, selling
and distribution.
Convertible Debenture
A debenture which gives the holder a right to its conversion, wholly or partly, in shares in accordance with the
terms of issue.
Cumulative Dividend
A dividend payable on cumulative preference shares which, if unpaid, accumulates as a claim against the
earnings of a corporate enterprise, before any distribution is made to the other shareholders.
Cumulative Preference Shares
A class of preference shares entitled to payment of cumulative dividends. Preference shares are always deemed
to be cumulative, unless they are expressly made non-cumulative.

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Current Assets
Cash and other assets that are expected to be converted into cash or consumed in the production of goods or
rendering of services in the normal course of business.
Current Liability
Liability including loans, deposits and bank overdraft which falls due for payment in a relatively short period, normally
not more than twelve months.
Deferral
Postponement of recognition of a revenue or expense after its related receipt or payment (or incurrence of a liability)
to a subsequent period to which it applies. Common examples of deferrals include prepaid rent and taxes, unearned
subscriptions received in advance by newspapers and magazine selling companies, etc.
Deficiency
The excess of liabilities over assets of an enterprise at a given date. The debit balance in the profit and loss
statement.
Deficit
The debit balance in the profit and loss statement.
Depletion
A measure of exhaustion of a wasting asset represented by periodic write off of cost or other substituted value.
Depreciation
Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising
from use, effluxion of time or obsolescence through technology and market changes. Depreciation is allocated
so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful
life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined.
Depreciable amount
Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in
the financial statements, less the estimated residual value.
Depreciable assets
Depreciable assets are assets which
(i) are expected to be used during more than one accounting period; and
(ii) have a limited useful life; and
(iii) are held by an enterprise for use in the production or supply of goods and services, for rental to others, or
for administrative purposes and not for the purpose of sale in the ordinary course of business.
Depreciation Method
Any method of calculating depreciation for an accounting period.

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Depreciation Rate
A percentage applied to the historical cost or the substituted amount of a depreciable asset (or in case of
diminishing balance method, the historical cost or the substituted amount less accumulated depreciation).
Diminishing Balance Method
A method under which the periodic charge for depreciation of an asset is computed by applying a fixed percentage
to its historical cost or substituted amount less accumulated depreciation (net book value). This is also referred
to as written down value method.
Discount
A reduction from a list price, quoted price or invoiced price. It also refers to the price for obtaining payment on a
bill before its maturity.
Dividend
A distribution to shareholders out of profits or reserves available for this purpose.
Entity Concept
The view of the relationship between the accounting entity and its owners which regards the entity as a separate
person, distinct and apart from its owners.
Equity Share
A share which is not a preference share. Also sometimes called ordinary share.
Exchange difference
Exchange difference is the difference resulting from reporting the same number of units of a foreign currency in the
reporting currency at different exchange rates.
Expenditure
Incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or
services.
Expense
A cost relating to the operations of an accounting period or to the revenue earned during the period or the benefits
of which do not extend beyond that period.
Expired Cost
That portion of an expenditure from which no further benefit is expected. Also termed as expense.
Extraordinary items
Extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from
the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly.
Fair value
Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable,
willing parties in an arm’s length transaction.

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Fair Market Value

The price that would be agreed to in an open and unrestricted market between knowledgeable and willing parties
dealing at arm’s length who are fully informed and are not under any compulsion to transact.
First Charge
A charge having priority over other charges.
First In, First Out (FIFO)
Computation of the cost of items sold or consumed during a period as though they were sold or consumed in
order of their acquisition.
Fixed asset
Asset held with the intention of being used for the purpose of producing or providing goods or services and is not
held for sale in the normal course of business.
Fixed Cost
That cost of production which by its very nature remains relatively unaffected in a defined period of time by
variations in the volume of production.
Fixed Deposit
Deposit for a specified period and at specified rate of interest.
Fixed or Specific Charge
A charge which attaches to a particular asset which is identified when the charge is created, and the identity of
the asset does not change during the subsistence of the charge.
Floating Charge
A general charge on some or all assets of an enterprise which are not attached to specific assets and are given
as security against a debt.
Financial Instrument
A financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial liability
or equity shares of another enterprise.
Foreign currency
Foreign currency is a currency other than the reporting currency of an enterprise.
Forfeited Share
A share to which title is lost by a member for non-payment of call money or default in fulfilling any engagement
between members or expulsion of members where the articles specifically provide therefor.
Free Reserve
A reserve the utilization of which is not restricted in any manner.

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Functional Classification
A system of classification of expenses and revenues and the corresponding assets and liabilities to each function
or activity, rather than by reference to their nature.
Fund
An account usually of the nature of a reserve or a provision which is represented by specifically earmarked
assets.
Fundamental Accounting Assumptions
Basic accounting assumptions which underlie the preparation and presentation of financial statements. They are
going concern, consistency and accrual. Usually, they are not specifically stated because their acceptance and
use are assumed. Disclosure is necessary if they are not followed.
Gain
A monetary benefit, profit or advantage resulting from a transaction or group of transactions.
General Reserve
A revenue reserve which is not earmarked for a specific purpose.
Going Concern Assumption
An accounting assumption according to which an enterprise is viewed as continuing in operation for the
foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of
curtailing materially the scale of its operations.
Goodwill
An intangible asset arising from business connections or trade name or reputation of an enterprise.
Gross Margin or Gross Profit
The excess of the proceeds of goods sold and services rendered during a period over their cost, before taking
into account administration, selling, distribution and financing expenses. When the result of this computation is
negative it is referred to as gross loss.
Government
Government refers to government, government agencies and similar bodies whether local, national or
international.
Government grants
Government grants are assistance by government in cash or kind to an enterprise for past or future compliance
with certain conditions. They exclude those forms of government assistance which cannot reasonably have a
value placed upon them and transactions with government which cannot be distinguished from the normal trading
transactions of the enterprise.
Gross book value
Gross book value of a fixed asset is its historical cost or other amount substituted for historical cost in the books of account
or financial statements. When this amount is shown net of accumulated depreciation, it is termed as net book value.

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Income and Expenditure Statement

A financial statement, often prepared by non-profit making enterprises like clubs, associations etc. to present their
revenues and expenses for an accounting period and to show the excess of revenues over expenses (or vice
versa) for that period. It is similar to profit and loss statement and is also called revenue and expense statement.
Intangible Asset
Asset which does not have a physical identity e.g. goodwill, patents, copyright etc.
Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of
services.
Investment
Expenditure on assets held to earn interest, income, profit or other benefits.
Investments
Assets held not for operational purposes or for rendering services i.e. assets other than fixed assets or current
assets (e.g. securities, shares, debentures, immovable properties).
Issued Share Capital
That portion of the authorized share capital which has actually been offered for subscription. This includes any
bonus shares allotted by the corporate enterprise.
Joint venture
A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity, which
is subject to joint control.
Last In, First Out (LIFO)
Computation of the cost of items sold or consumed during a period on the basis that the items last acquired were
sold or consumed first.
Liability
The financial obligation of an enterprise other than owners’ funds.
Lien
Right of one person to satisfy a claim against another by holding or retaining possession of that other’s
assets/property.
Long-term Liability
Liability which does not fall due for payment in a relatively short period, i.e., normally a period not more than twelve
months.

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Lease
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments
the right to use an asset for an agreed period of time.
Materiality
An accounting concept according to which all relatively important and relevant items, i.e., items the knowledge of which
might influence the decisions of the user of the financial statements are disclosed in the financial statements.
Mortgage
A transfer of interest in specific immovable property for the purpose of securing a loan advanced, or to be
advanced, an existing or future debt or the performance of an engagement which may give rise to a pecuniary
liability. The security is redeemed when the loan is repaid or the debt discharged or the obligations performed.
Net Assets/Shareholders’ funds/Net Worth
The excess of the book value of assets (other than fictitious assets) of an enterprise over its liabilities. This is
also referred to as net worth or shareholders’ funds.
Net Fixed Assets
Fixed assets less accumulated depreciation thereon up-to-date.
Net Profit/Net loss
The excess of revenue over expenses during a particular accounting period. When the result of this computation
is negative, it is referred to as net loss. The net profit may be shown before or after tax.
Net realizable value
Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale.
Obsolescence
Diminution in the value of an asset by reason of its becoming out-of date or less useful due to technological changes,
improvement in production methods, change in market demand for the product or service output of the asset, or
legal or other restrictions.
Operating Profit
The net profit arising from the normal operations and activities of an enterprise without taking account of
extraneous transactions and expenses of a purely financial nature.
Paid-up Share Capital
That part of the subscribed share capital for which consideration in cash or otherwise has been received. This
includes bonus shares allotted by the corporate enterprise.
Preference Share Capital
That part of the share capital of a corporate enterprise which enjoys preferential rights in respect of payments of fixed
dividend and repayment of capital. Preference shares may also have full or partial participating rights in surplus
profits or surplus capital.

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Preliminary Expenses
Expenses relating to the formation of an enterprise. These include legal, accounting and share issue expenses
incurred for formation of the enterprise.
Prepaid Expense
Payment for expense in an accounting period, the benefit for which will accrue in the subsequent accounting
period(s).
Prime Cost
The total cost of direct materials, direct wages and other direct production expenses.
Prior Period Item
Prior period items are income or expenses which arise in the current period as a result of errors or omissions in the
preparation of the financial statements of one or more prior periods.
Profit/Loss
A general term for the excess of revenue over related cost. When the result of this computation is negative it is
referred to as loss.
Profit and Loss Account
A financial statement which presents the revenues and expenses of an enterprise for an accounting period and
shows the excess of revenues over expenses (or vice versa). It is also known as profit and loss account.
Promissory Note
An instrument in writing (not being a bank note or currency note) containing an unconditional undertaking, signed
by the maker, to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the
instrument.
Provision
An amount written off or retained by way of providing for depreciation or diminution in value of assets or retained
by way of providing for any known liability the amount of which cannot be determined with substantial accuracy.
Provision for Doubtful Debts
A provision made for debts considered doubtful of recovery.
Prudence
A concept of care and caution used in accounting according to which (in view of the uncertainty attached to future
events) profits are not anticipated, but recognised only when realised, though not necessarily in cash. Under this
concept, provision is made for all known liabilities and losses, even though the amount cannot be determined with
certainty and represents only a best estimate in the light of available information.
Redeemable Preference Share
The preference share that is repayable either after a fixed or determinable period or at any time decided by the
management (by giving due notice), under certain conditions prescribed by the instrument of incorporation or the
terms of issue.

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Redemption
Repayment as per given terms normally used in connection with preference shares and debentures.
Reserve
The portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the
management for a general or a specific purpose other than a provision for depreciation or diminution in the value
of assets or for a known liability. The reserves are primarily of two types: capital reserves and revenue reserves.
Revaluation Reserve
A reserve created on the revaluation of assets or net assets of an enterprise represented by the surplus of the
estimated replacement cost or estimated market values over the book values thereof.
Residual value
Residual value is the amount which an enterprise expects to obtain for an asset at the end of its useful life after
deducting the expected costs of disposal.
Revenue/Income
Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary
activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of
enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to
customers or clients for goods supplied and services rendered to them and by the charges and rewards arising
from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not
the gross inflow of cash, receivables or other consideration.
Revenue Reserve
Any reserve other than a capital reserve.
Right Share
An allotment of shares on the issue of fresh capital by a corporate enterprise to which a shareholder is entitled
on payment, by virtue of his holding certain shares in the enterprise in proportion to the number of shares already
held by him. (Shares allotted to certain categories of debenture holders pursuant to the rights enjoyed by them are
sometimes called right shares)
Sales Turnover/Gross Turnover/Gross Sales
The aggregate amount for which sales are effected or services rendered by an enterprise. The terms gross
turnover and net turnover (or gross sales and net sales) are sometimes used to distinguish the sales
aggregate before and after deduction of returns and trade discounts.
Secured Loan
Loan secured wholly or partly against an asset.
Share Capital
Aggregate amount of money paid or credited as paid on the shares and/ or stocks of a corporate enterprise.

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Share Discount
The excess of the face value of shares over their issue price.
Shareholders’ Equity
The interest of the shareholders in the net assets of a corporate enterprise. However, in the case of liquidation it is
represented by the residual assets after meeting prior claims.
Share Issue Expenses
Costs incurred in connection with the issue and allotment of shares. These include legal and professional fees,
advertising expenses, printing costs, underwriting commission, brokerage, and also expenses in connection with
the issue of prospectus and allotment of shares.
Share warrants
Share warrants or options are financial instruments that give the holder the right to acquire equity shares.
Securities Premium
The excess of the issue price of shares over their face value.
Sinking Fund
A fund created for the repayment of a liability or for the replacement of an asset.
Straight Line Method
The method under which the periodic charge for depreciation is computed by dividing the depreciable amount of
a depreciable asset by the estimated number of years of its useful life.
Subscribed Share Capital
That portion of the issued share capital which has actually been subscribed and allotted. This includes any
bonus shares allotted by the corporate enterprise.
Substance over Form
An accounting concept according to which the substance and not merely the legal form of transactions and events
governs their accounting treatment and presentation in financial statements.
Sundry Creditors / Trade Creditors/Trade payables
Amount owed by an enterprise on account of goods purchased or services received or in respect of contractual
obligations. Also termed as trade creditors or account payables or Trade payables.
Sundry Debtors / Trade Debtors/ Trade Receivables
Person from whom amounts are due for goods sold or services rendered or in respect of contractual obligations.
Also termed as debtors, trade debtors, account receivables, trade receivables.
Surplus
Credit balance in the profit and loss statement after providing for proposed appropriations, e.g., dividend or reserves.

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Trade Discount
A reduction granted by a supplier from the list price of goods or services on business considerations other than
for prompt payment.
Unexpired Cost
That portion of an expenditure whose benefit has not yet been exhausted.
Unissued Share Capital
That portion of the authorised share capital for which shares have not been offered for subscription.
Unpaid Dividend
Dividend which has been declared by a corporate enterprise but has not been paid, or the warrant or cheque in
respect whereof has not been dispatched within the prescribed period.
Useful life
Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii)
the number of production or similar units expected to be obtained from the use of the asset by the enterprise

TEST YOUR KNOWLEDGE

True and False
1. The drawer’s signed assent on bill of exchange, to the order of the drawee is called an acceptance:
2. That portion of an expenditure whose benefit has been exhausted is called Unexpired Expenditure.
3. Accrual basis of accounting is the method of recording transactions by which revenues and costs and
assets and liabilities are reflected in the accounts in the period in which actual receipts or actual
payments are made.
4. Authorised Share capital is sometimes referred to as nominal share capital.
5. Fixed assets less interest on obligations undertaken to purchase asset less accumulated depreciation
thereon up-to-date are called Net Fixed Assets.
6. The credit balance in the profit and loss statement is called a deficit.

Theoretical Questions
Define following terms:
1. Accrual Basis of Accounting
2. Amortisation
3. Contingent Asset
4. Contingent Liability

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ANSWERS/HINTS
True and False
1. False: The drawee’s signed assent on bill of exchange, to the order of the drawer. This term is also used
to describe a bill of exchange that has been accepted.
2. False: Unexpired Cost - That portion of an expenditure whose benefit has not yet been exhausted.
3. False: Cash Basis of Accounting is the method of recording transactions by which revenues and costs
and assets and liabilities are reflected in the accounts in the period in which actual receipts or actual
payments are made.
4. True: Authorised share capital is number and par value of each class of shares that an enterprise may
issue in accordance with its instrument of incorporation and is sometimes referred as nominal share
capital.
5. False: Net Fixed Assets - Fixed assets less accumulated depreciation thereon up-to-date.
6. False: The debit balance in the profit and loss statement is deficit.

Theoretical Questions
1. Accrual Basis of Accounting
The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the
accounts in the period in which they accrue.
2. Amortisation
The gradual and systematic writing off of an asset or an account over an appropriate period.
3. Contingent Asset
An asset the existence, ownership or value of which may be known or determined only on the occurrence or
non-occurrence of one or more uncertain future events.
4. Contingent Liability
An obligation relating to an existing condition or situation which may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events.

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UNIT – 4 CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Learn the criteria for identifying Revenue Expenditure and distinguishing from Capital
Expenditure
♦ Learn the distinction between capital and revenue receipts.
♦ Understand the linkage of such distinction with the preparation of final accounts.

UNIT OVERVIEW

Capital
• Payments
• Receipts

Revenue
• Payments
• Receipts

4.1 INTRODUCTION
Accounting aims in ascertaining and presenting the results of the business for an accounting period. For
ascertaining the periodical business results, the nature of transactions should be analyzed whether they are of
capital or revenue nature. The Revenue Expense relates to the operations of the business of an accounting period
or to the revenue earned during the period or the items of expenditure, benefits of which do not extend beyond
that period. Capital Expenditure, on the other hand, generates enduring benefits and helps in revenue generation
over more than one accounting period. Revenue Expenses must be associated with a physical activity of the
entity. Therefore, whereas production and sales generate revenue in the earning process, use of goods and
services in support of those functions causes expenses to occur. Expenses are recognised in the Profit & Loss
Account through matching principal which tells us when and how much of the expenses to be charged against
revenue. A part of the expenditure can be capitalised only when these can be traced directly to definable streams
of future benefits.
The distinction of transaction into revenue and capital is done for the purpose of placing them in Profit and Loss
account or in the Balance Sheet. For example: revenue expenditures are shown in the profit and loss account as
their benefits are for one accounting period i.e. in which they are incurred while capital expenditures are placed

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on the asset side of the balance sheet as they will generate benefits for more than one accounting period and will
be transferred to profit and loss account of the year on the basis of utilisation of that benefit in particular accounting
year. Hence, both capital and revenue expenditures are ultimately transferred to profit and loss account.
Revenue expenditures are transferred to profit and loss account in the year of spending while capital expenditures
are transferred to profit and loss account of the year in which their benefits are utilised. Therefore we can conclude
that it is the time factor, which is the main determinant for transferring the expenditure to profit and loss account.
Also expenses are recognized in profit and loss account through matching concept which tells us when and how
much of the expenses to be charged against revenue. However, distinction between capital and revenue creates a
considerable difficulty. In many cases borderline between the two is very thin.

4.2 CONSIDERATIONS IN DETERMINING CAPITAL AND REVENUE

EXPENDITURES
The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business: For a trader dealing in furniture, purchase of furniture is revenue expenditure but
for any other trade, the purchase of furniture should be treated as capital expenditure and shown in the
balance sheet as asset. Therefore, the nature of business is a very important criteria in separating an
expenditure between capital and revenue.
(b) Recurring nature of expenditure: If the frequency of an expense is quite often in an accounting year
then it is said to be an expenditure of revenue nature while non-recurring expenditure is infrequent in
nature and do not occur often in an accounting year. Monthly salary or rent is the example of revenue
expenditure as they are incurred every month while purchase of assets is not the transaction done
regularly therefore, classified as capital expenditure unless materiality criteria defines it as revenue
expenditure.
(c) Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal maintenance
of the asset. Such expenses are revenue in nature. On the other hand, expenditure incurred for major
repair of the asset so as to increase its productive capacity is capital in nature. However, determination
of the cost of maintenance and ordinary repairs which should be expensed, as opposed to a cost which
ought to be capitalised, is not always simple.
(d) Effect on revenue generating capacity of business: The expenses which help to generate income/
revenue in the current period are revenue in nature and should be matched against the revenue earned in
the current period. On the other hand, if expenditure helps to generate revenue over more than one
accounting period, it is generally called capital expenditure.
When expenditure on improvements and repair of a fixed asset is done, it has to be charged to Profit
and Loss Account if the expected future benefits from fixed assets do not change, and it will be included in
book value of fixed asset, where the expected future benefits from assets increase.
(e) Materiality of the amount involved: Relative proportion of the amount involved is another important
consideration in distinction between revenue and capital.

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4.3 CAPITAL EXPENDITURES AND REVENUE EXPENDITURES

As we have already discussed, capital expenditure contributes to the revenue earning capacity of a business over
more than one accounting period whereas revenue expense is incurred to generate revenue for a particular
accounting period. The revenue expenses either occur in direct relation with the revenue or in relation with
accounting periods, for example cost of goods sold, salaries, rent, etc. Cost of goods sold is directly related to
sales revenue whereas rent is related to the particular accounting period. Capital expenditure may represent
acquisition of any tangible or intangible fixed assets for enduring future benefits. Therefore, the benefits arising out
of capital expenditure last for more than one accounting period whereas those arising out of revenue expenses
expire in the same accounting period.

ILLUSTRATION 1

State with reasons whether the following statements are ‘True’ or ‘False’.
(1) Overhaul expenses of second-hand machinery purchased are Revenue Expenditure.
(2) Money spent to reduce working expenses is Revenue Expenditure.
(3) Legal fees to acquire property is Capital Expenditure.
(4) Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the plaintiff’s
land is Capital Expenditure.
(5) Amount spent for replacement of worn out part of machine is Capital Expenditure.
(6) Expense incurred on the repairs and white washing for the first time on purchase of an old building are
Revenue Expenses.
(7) Expenses in connection with obtaining a license for running the cinema is Capital Expenditure.
(8) Amount spent for the construction of temporary huts, which were necessary for construction of the
Cinema House and were demolished when the cinema house was ready, is Capital Expenditure.

SOLUTION

(1) False: Overhaul expenses are incurred to put second-hand machinery in working condition to derive
endurable long-term advantage. So it should be capitalised.
(2) False: It may be reasonably presumed that money spent for reducing revenue expenditure would have
generated long-term benefits to the entity. It becomes part of intangible fixed assets if it is in the form of
technical know-how and tangible fixed assets if it is in the form of additional replacement of any of the
existing tangible fixed assets. So this is capital expenditure.
(3) True: Legal fee paid to acquire any property is part of the cost of that property. It is incurred to possess
the ownership right of the property and hence a capital expenditure.
(4) False: Legal expenses incurred to defend a suit claiming that the firm’s factory site belongs to the plaintiff
is maintenance expenditure of the asset. By this expense, neither any endurable benefit can be obtained
in future in addition to that what is presently available nor the capacity of the asset will be increased.
Maintenance expenditure in relation to an asset is revenue expenditure.

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1.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

(5) False: Amount spent for replacement of any worn out part of a machine is revenue expense since it is
part of its maintenance cost.
(6) False: Repairing and white washing expenses for the first time of an old building are incurred to put the
building in usable condition. These are the part of the cost of building. Accordingly, these are capital
expenditure.
(7) True: The Cinema Hall could not be started without license. Expenditure incurred to obtain the license
is pre-operative expense which is capitalised. Such expenses are amortised over a period of time.
(8) True: Cost of temporary huts constructed which were necessary for the construction of the cinema house
is part of the construction cost of the cinema house. Therefore such costs are to be capitalised.

ILLUSTRATION 2

State with reasons whether the following are Capital or Revenue Expenditure:
(1) Expenses incurred in connection with obtaining a license for starting the factory for ` 10,000.
(2) ` 1,000 paid for removal of Inventory to a new site.
(3) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get fuel efficiency.
(4) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) ` 8,000 for installing telephone in the office.
(5) A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred in the
construction of temporary huts for storing building material.

SOLUTION

(1) Money paid ` 10,000 for obtaining license to start a factory is a capital expenditure. This is an item of
expenditure incurred to acquire the right to carry on business.
(2) ` 1,000 paid for removal of Inventory to a new site is revenue expenditure. This is neither bringing
enduring benefit nor enhancing the value of the asset.
(3) ` 5,000 spent in changing Rings and Pistons of an engine to get fuel efficiency is capital expenditure.
This is an expenditure on improvement of a fixed asset. It results in increasing profit-earning capacity of
the business by cost reduction.
(4) Money deposited with MTNL for installation of telephone in office is not expenditure. This is treated as an
asset and the same is adjusted over a period of time against actual telephone bills.
(5) Cost of construction of building including cost of temporary huts is capital expenditure. Building is fixed
asset which will generate enduring benefit to the business over more than one accounting period.
Construction of temporary huts is incidental to the main construction. Such cost is also capitalised with the
cost of building.

4.4 CAPITAL RECEIPTS AND REVENUE RECEIPTS

Just as a clear distinction between Capital and Revenue expenditure is necessary, in the same manner capital
receipts must be distinguished from revenue receipts.

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65 ACCOUNTING PROCESS 1.65

Receipts which are obtained in course of normal business activities are revenue receipts (e.g. receipts from sale
of goods or services, interest income etc.). On the other hand, receipts which are not revenue in nature are capital
receipts (e.g. receipts from sale of fixed assets or investments, secured or unsecured loans, owners’ contributions
etc.). Revenue and capital receipts are recognised on accrual basis as soon as the right of receipt is established.
Revenue receipts should not be equated with the actual cash receipts. Revenue receipts are credited to the Profit
and Loss Account.
On the other hand, Capital receipts are not directly credited to Profit and Loss Account. For example, when a
fixed asset is sold for ` 92,000 (cost ` 90,000), the capital receipts ` 92,000 is not credited to Profit and Loss
Account. POMZ Profit PS Loss on sale of fixed assets is calculated and credited to Profit and Loss Account as follows:
Sale Proceeds ` 92,000
Cost (` 90,000)
Profit ` 2,000

ILLUSTRATION 3

Good Pictures Ltd., constructs a cinema house and incurs the following expenditure during the first year ending
31st March, 2020.
(1) Second-hand furniture worth ` 9,000 was purchased; repainting of the furniture costs ` 1,000. The
furniture was installed by own workmen, wages for this being ` 200.
(2) Expenses in connection with obtaining a license for running the cinema worth ` 20,000. During the
course of the year the cinema company was fined ` 1,000, for contravening rules. Renewal fee ` 2,000
for next year also paid.
(3) Fire insurance, ` 1,000 was paid on 1st October, 2019 for one year.
(4) Temporary huts were constructed costing ` 1,200. They were necessary for the construction of the
cinema. They were demolished when the cinema was ready.
Point out how you would classify the above items.

SOLUTION

(1) The total cost of the furniture should be treated as ` 10,200 i.e., all the amounts mentioned should be
capitalised since without such expenditure the furniture would not be available for use. If ` 1,000 and `
200 have been respectively debited to the Repairs Account and the Wages Account, these accounts will be
credited to the Furniture Account.
(2) License for running the cinema house is necessary, hence its cost should be capitalised. But the fine of
` 1,000 is revenue expenditure. The renewal fee for the next year is also revenue expenditure but pertains
to the next year; hence, it is a prepaid expense.
(3) Half of the insurance premium pertains to the year beginning on 1st April, 2020. Hence such amount
should be treated as prepaid expense. The remaining amount is revenue expense for the current year.
(4) Since the temporary huts were necessary for the construction, their cost should be added to the cost of the
cinema hall and thus capitalised.

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1.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 4

State with reasons, how you would classify the following items of expenditure:
(1) Overhauling expenses of ` 25,000 for the engine of a motor car to get better fuel efficiency.
(2) Inauguration expenses of ` 25 lacs incurred on the opening of a new manufacturing unit in an existing
business.
(3) Compensation of ` 2.5 crores paid to workers, who opted for voluntary retirement.

SOLUTION

(1) Overhauling expenses are incurred for the engine of a motor car to derive better fuel efficiency. These
expenses will reduce the running cost in future and thus the benefit is in form of endurable long-term
advantage. So this expenditure should be capitalised.
(2) Inauguration expenses incurred on the opening of a new unit may help to explore more customers This
expenditure is in the nature of revenue expenditure, as the expenditure may not generate any enduring
benefit to the business over more than one accounting period.
(3) The amount paid to workers on voluntary retirement is in the nature of revenue expenditure. Since the
magnitude of the amount of expenditure is very significant, it may be better to defer it over future years.

ILLUSTRATION 5

Classify the following expenditures and receipts as capital or revenue:

(i) ` 10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital assets.
(ii) Amount received from Trade receivables during the year.
(iii) Amount spent on demolition of building to construct a bigger building on the same site.
(iv) Insurance claim received on account of a machinery damaged by fire.

SOLUTION

(i) Capital expenditure.

(ii) Revenue receipt.
(iii) Capital expenditure.
(iv) Capital receipt.

ILLUSTRATION 6

Are the following expenditures capital in nature?

(i) M/s ABC & Co. run a restaurant. They renovate some of the old cabins. Because of this renovation some
space was made free and number of cabins was increased from 10 to 13. The total expenditure was
` 20,000.

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(ii) M/s New Delhi Financing Co. sold certain goods on installment payment basis. Five customers did not
pay installments. To recover such outstanding installments, the firm spent ` 10,000 on account of legal
expenses.
(iii) M/s Ballav & Co. of Delhi purchased a machinery from M/s Shah & Co. of Ahmedabad. M/s Ballav & Co.
spent ` 40,000 for transportation of such machinery. The year ending is 31st Dec, 2019.

SOLUTION

(i) Renovation of cabins increased the number of cabins. This has an effect on the future revenue generating
capability of the business. Thus, the renovation expense is capital expenditure in nature.
(ii) Expense incurred to recover installments due from customer do not increase the revenue generating
capability in future. It is a normal recurring expense of the business. Thus, the legal expenses incurred in
this case is revenue expenditure in nature.
(iii) Expenses incurred on account of transportation of fixed asset is capital expenditure in nature.

SUMMARY
♦ Revenue expenditures are shown in the profit and loss account while capital expenditures are placed on
the asset side of the balance sheet since they generate benefits for more than are accounting period.
♦ Prepaid expenses are future expenses that have been paid in advance. These are shown in the balance
sheet as an asset.
♦ Receipts obtained should be classified between revenue receipts and capital receipts.

TEST YOUR KNOWLEDGE

True and False
1. The nature of business is not an important criteria in separating an expenditure between capital and
revenue.
2. Expenditure incurred for major repair of the asset so as to increase its productive capacity is Revenue
in nature.
3. Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the
plaintiff’s land is Capital Expenditure.
4. Amount spent for replacement of worn out part of machine is Capital Expenditure.
5. Legal fees to acquire property is Capital Expenditure.
6. Amount spent for the construction of temporary huts, which were necessary for construction of the
cinema house and were demolished when the cinema house was ready, is Capital Expenditure.

Multiple Choice Questions

1. Money spent ` 10,000 as traveling expenses of the directors on trips abroad for purchase of capital assets is
(a) Capital expenditures (b) Revenue expenditures
(c) Prepaid revenue expenditures

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1.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. Amount of ` 5,000 spent as lawyers’ fee to defend a suit claiming that the firm’s factory site belonged to the
plaintiff’s land is
(a) Capital expenditures (b) Revenue expenditures
(c) Prepaid revenue expenditures
3. Entrance fee of ` 2,000 received by Ram and Shyam Social Club is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
4. Subsidy of ` 40,000 received from the government for working capital by a manufacturing concern is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
5. Insurance claim received on account of
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
6. Interest on investments received from
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
7. Amount received from IDBI as a medium term loan for augmenting working capital is
(a) Capital expenditures (b) Revenue expenditures
(c) Capital receipt
8. Revenue from sale of products, ordinarily, is reported as part of the earning in the period in which
(a) The sale is made. (b) The cash is collected.
(c) The products are manufactured.
9. If repair cost is ` 25,000, whitewash expenses are ` 5,000, (both these expenses relate to presently used
building) cost of extension of building is ` 2,50,000 and cost of improvement in electrical wiring system is
` 19,000; the amount to be expensed is
(a) ` 2,99,000. (b) ` 44,000.
(c) ` 30,000.

Theoretical Questions
1. What are the basic considerations in distinguishing between capital and revenue expenditures?
2. Define revenue receipts and give examples. How are these receipts treated?

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69 ACCOUNTING PROCESS 1.69

ANSWERS/HINTS
True and False
1. False: The nature of business is a very important criteria in separating an expenditure between capital
and revenue. For example- For a trader dealing in furniture, purchase of furniture is revenue expenditure
but for any other trade, the purchase of furniture should be treated as capital expenditure and shown in
the balance sheet as asset. .
2. False: Expenditure incurred for major repair of the asset so as to increase its productive capacity is
capital in nature.
3. False: Legal expenses incurred to defend a suit claiming that the firm’s factory site belongs to the plaintiff
is maintenance expenditure of the asset. By this expense, neither any endurable benefit can be obtained
in future in addition to that what is presently available nor the capacity of the asset will be increased.
Maintenance expenditure in relation to an asset is revenue expenditure.
4. False: Amount spent for replacement of any worn out part of a machine is revenue expense since it is
part of its maintenance cost.
5. True: Legal fee paid to acquire any property is a part of cost of that property. It is incurred to possess
the ownership right of the property and hence a capital expenditure.
6. True: Since temporary huts were necessary for the construction, their cost should be added to the cost
of the cinema hall and thus capitalised.

Multiple Choice Questions

1 (a), 2 (b), 3 (a), 4 (b), 5 (a), 6 (b),
7 (c), 8 (a), 9 (c)

Theoretical Questions
1. The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business.
(b) Recurring nature of expenditure.
(c) Purpose of expenses.
(d) Effect on revenue generating capacity of business.
(e) Materiality of the amount involved.
2. Receipts which are obtained in course of normal business activities are revenue receipts (e.g. receipts
from sale of goods or services, interest income etc.).
Revenue receipts should not be equated with the actual cash receipts. Revenue receipts are credited to
the Profit and Loss Account.

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1.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT – 5 CONTINGENT ASSETS AND CONTINGENT LIABILITES

LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Understand the meaning of the terms ‘Contingent Assets’ and ‘Contingent Liabilities’.
♦ Distinguish ‘Contingent Liabilities’ with ‘Liabilities’ and ‘Provisions’

UNIT OVERVIEW

• A possible asset arises from past events and their

Contingent Asset existence will be confirmed only after occurrence or non-
occurrence of one or more uncertain future events.

• A possible obligation arising from past events and may arise

Contingent Liability in future depending on the occurrence or non-occurrence of
one or more uncertain future events.

5.1 CONTINGENT ASSET

A contingent asset may be defined as a possible asset that arises from past events and whose existence will be
confirmed only after occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the enterprise. It usually arises from unplanned or unexpected events that give rise to the possibility
of an inflow of economic benefits to the business entity. For example, a claim that an enterprise is pursuing
through legal process, where the outcome is uncertain, is a contingent asset.
As per the concept of prudence as well as the present accounting standards, an enterprise should not recognise
a contingent asset. These assets are uncertain and may arise from a claim which an enterprise pursues through
a legal proceeding. There is uncertainty in realisation of claim. It is possible that recognition of contingent assets
may result in recognition of income that may never be realised. However, when the realisation of income is virtually
certain, then the related asset no longer remains as contingent asset.
A contingent asset need not be disclosed in the financial statements. A contingent asset is usually disclosed in the
report of the approving authority (Board of Directors in the case of a company, and the corresponding approving
authority in the case of any other enterprise), if an inflow of economic benefits is probable. Contingent assets are
assessed continually and if it has become virtually certain that an inflow of economic benefits will arise, the asset
and the related income are recognised in the financial statements of the period in which the change occurs.

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5.2 CONTINGENT LIABILITIES

The term ‘Contingent liability’ can be defined as
“(a) a possible obligation that arises from past events and the existence of which will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of
the enterprise; or
(b) a present obligation that arises from past events but is not recognised because:

(i) it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or
(ii) a reliable estimate of the amount of the obligation cannot be made.”
A contingent liability is a possible obligation arising from past events and may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events [part (a) of the definition]. A contingent
liability may also be a present obligation that arises from past events [(part (b) of the definition)].
An enterprise should not recognise a contingent liability in balance sheet, however it is required to be disclosed in
the notes to accounts, unless possibility of outflow of a resource embodying economic benefits is remote. These
liabilities are assessed continually to determine whether an outflow of resources embodying economic benefits
has become probable. If it becomes probable that an outflow or future economic benefits will be required for an
item previously dealt with as a contingent liability, a provision is recognised in financial statements of the period
in which the change in probability occurs except in the extremely rare circumstances where no reliable estimate
can be made.

5.3 DISTINCTION BETWEEN CONTINGENT LIABILITIES AND

LIABILITIES
The distinction between a liability and a contingent liability is generally based on the judgement of the
management. A liability is defined as the present financial obligation of an enterprise, which arises from past
events. The settlement of a liability results in an outflow from the enterprises of resources embodying economic
benefits. On the other hand, in the case of contingent liability, either outflow of resources to settle the obligation
is not probable or the amount expected to be paid to settle the liability cannot be measured with sufficient
reliability. Examples of contingent liabilities are claims against the enterprise not acknowledged as debts,
guarantees given in respect of third parties, liability in respect of bills discounted and statutory liabilities under
dispute etc. In addition to present obligations that are recognized as liabilities in the balance sheet, enterprises are
required to disclose contingent liability in their balance sheets by way of notes.

5.4 DISTINCTION BETWEEN CONTINGENT LIABILITIES AND

PROVISIONS
Provision means “any amount written off or retained by way of providing for depreciation, renewal or diminution
in the value of assets or retained by way of providing for any known liability of which the amount cannot be

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1.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

determined with substantial accuracy”.

It is important to know the difference between provisions and contingent liabilities. The distinction between both of
them can be explained as follows:
Provision Contingent liability
(1) Provision is a present liability of uncertain amount, A Contingent liability is a possible obligation that
which can be measured reliably by using a may or may not crystallise depending on the
substantial degree of estimation. occurrence or non-occurrence of one or more
uncertain future events.
(2) A provision meets the recognition criteria. A contingent liability fails to meet the same.
(3) Provision is recognised when (a) an enterprise Contingent liability includes present obligations
has a present obligation arising from past events; that do not meet the recognition criteria because
an outflow of resources embodying economic either it is not probable that settlement of those
benefits is probable, and (b) a reliable estimate obligations will require outflow of economic
can be made of the amount of the obligation. benefits, or the amount cannot be reliably
estimated.
(4) If the management estimates that it is probable If the management estimates, that it is less likely
that the settlement of an obligation will result in that any economic benefit will outflow the firm to
outflow of economic benefits, it recognises a settle the obligation, it discloses the obligation as
provision in the balance sheet. a contingent liability.

Let us take an example to understand the distinction between provisions and contingent liabilities. The Central
Excise Officer imposes a penalty on Alpha Ltd. for violation of a provision in the Central Excise Act. The company
goes on an appeal. If the management of the company estimates that it is probable that the company will have to
pay the penalty, it recognises a provision for the liability. On the other hand, if the management anticipates that the
judgement of the appellate authority will be in its favour and it is less likely that the company will have to pay the
penalty, it will disclose the obligation as a contingent liability instead of recognising a provision for the same.

SUMMARY
 A contingent asset may be defined as a possible asset that arises from past events and whose existence
will be confirmed only after occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the enterprise.

 A contingent liability is a possible obligation arising from past events and may arise in future depending
on the occurrence or non-occurrence of one or more uncertain future events.

 A liability is the present financial obligation of an enterprise, which arises from past events whereas
contingent liability is a possible obligation arising from past events.

 Provision is a present liability of uncertain amount, which can be measured reliably by using a substantial
degree of estimation whereas Contingent liability is a possible obligation that may or may not crystallise
depending on the occurrence or non-occurrence of one or more uncertain future events.

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73 ACCOUNTING PROCESS 1.73

TEST YOUR KNOWLEDGE

True and False
1. A contingent liability need not be disclosed in the financial statements.
2. A Provision fails to meet the recognition criteria.
3. A claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is a
contingent liability.
4. When it is probable that the firm will need to pay off the obligation, this gives rise to Contingent liability.
5. Present financial obligation of an enterprise, which arises from past event is termed as contingent
liability.

Multiple Choice Questions

1. (i) Contingent asset usually arises from unplanned or unexpected events that give rise to
(a) The possibility of an inflow of economic benefits to the business entity.
(b) The possibility of an outflow of economic benefits to the business entity.
(c) Either (a) or (b).
(ii) If an inflow of economic benefits is probable then a contingent asset is disclosed
(a) In the financial statements.
(b) In the report of the approving authority (Board of Directors in the case of a company,
and the corresponding approving authority in the case of any other enterprise).
(c) In the cash flow statement.
(iii) In the case of , either outflow of resources to settle the obligation is not probable or the
amount expected to be paid to settle the liability cannot be measured with sufficient reliability.
(a) Liability (b) Provision
(c) Contingent liabilities
(iv) Present liability of uncertain amount, which can be measured reliably by using a substantial
degree of estimation is termed as .
(a) Provision. (b) Liability.
(c) Contingent liability.
(v) In the financial statements, contingent liability is
(a) Recognised. (b) Not recognised.
(c) Adjusted.

Theoretical Questions
Differentiate between:
(i) Provision and Contingent Liability.
(ii) Liability and Contingent liability.

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1.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWERS/HINTS
True and False
1. False: A Contingent liability is required to be disclosed unless possibility of outflow of a resource
embodying economic benefits is remote.
2. False: A contingent liability fails to meet the recognition criteria.
3. False: A claim that an enterprise is pursuing through legal process, where the outcome is uncertain, is
a contingent asset
4. False: When it is probable that the firm will need to pay off the obligation, this gives rise to provision.
5. False: Present Financial obligation of an enterprise, which arises from past events is termed as liability,

Multiple Choice Questions

(i) (a) (ii) (b) (iii) (c) (iv) (a) (v) (b)

Theoretical Questions
1. Provision is a present liability of uncertain amount, which can be measured reliably by using a substantial
degree of estimation. On the other hand, a Contingent liability is a possible obligation that may or may not
crystallize depending on the occurrence or non-occurrence of one or more uncertain future events.
2. A liability is defined as the present financial obligation of an enterprise, which arises from past events.
On the other hand, in the case of contingent liability, either outflow of resources to settle the obligation is
not probable or the amount expected to be paid to settle the liability cannot be measured with sufficient
reliability.

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75 ACCOUNTING PROCESS 1.75

UNIT – 6 ACCOUNTING POLICIES

LEARNING OUTCOMES
After studying this unit, you will be able to:
 Understand the meaning of ‘Accounting Policies’.
 Familiarize with the situations under which selection from different accounting policies is
required.
 Grasp the conditions where change in accounting policy can be made and the consequences
arising from such change.

UNIT OVERVIEW

Selection of Accounting Policies

Based
on

Substance over
Prudence Materiality
Form

6.1 MEANING OF ACCOUNTING POLICIES

Accounting Policies refer to specific accounting principles and methods of applying these principles adopted by the
enterprise in the preparation and presentation of financial statements. Policies are based on various accounting
concepts, principles and conventions that have already been explained in Unit 2 of Chapter 1. There is no single
list of accounting policies, which are applicable to all enterprises in all circumstances. Enterprises operate in
diverse and complex environmental situations and so they have to adopt various policies. The c hoice of specific
accounting policy appropriate to the specific circumstances in which the enterprise is operating, calls for
considerate judgement by the management. ICAI has been trying to reduce the number of acceptable accounting
policies through Guidance Notes and Accounting Standards in its combined efforts with the government, other
regulatory agencies and progressive managements. Already it has achieved some progress in this respect.
The areas wherein different accounting policies are frequently encountered can be given as follows:
(1) Valuation of Inventories;
(2) Valuation of Investments.
This list should not be taken as exhaustive but is only illustrative. As the course will progress, students will see
the intricacies of the various accounting policies.

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1.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

Supposeanenterpriseholdssomeinvestmentsintheformofsharesofacompanyattheendofanaccounting period. For

valuation of shares, the enterprise may adopt FIFO, average method etc. The method selected by that enterprise
for valuation is called an accounting policy. Different enterprises may adopt different accounting policies.
Likewise, different methods of providing depreciation on fixed assets, i.e. Straight line, written down, etc. are
available to the business enterprises which will lead to different depreciation amounts.

6.2 SELECTION OF ACCOUNTING POLICIES

Choice of accounting policy is an important policy decision which affects the performance measurement as well
as financial position of the business entity. Selection of inappropriate accounting policy may lead to understatement
or overstatement of performance and financial position. Thus, accounting policy should be selected with due care
after considering its effect on the financial performance of the business enterprise from the angle of various users
of accounts.
It is believed that no unified and exhaustive list of accounting policies can be suggested which has universal
application. Three major characteristics which should be considered for the purpose of selection an d application
of accounting policies. viz.,Prudence, Substance over form, and Materiality. The financial statements should be
prepared on the basis of such accounting policies, which exhibit true and fair view of state of affairs of Balance
Sheet and the Profit & Loss Account.
Examples wherein selection from a set of accounting policies is made, can be given as follows: –
1. Inventories are valued at cost except for finished goods and by-products. Finished goods are valued at
lower of cost or market value and by-products are valued at net realizable value.
2. Investments (long term) are valued at their acquisition cost. Provision for permanent diminution in value
has been made wherever necessary.
Sometimes a wrong or inappropriate treatment is adopted for items in Balance Sheet, or Profit & Loss Account,
or other statement. Disclosure of the treatment adopted is necessary in any case, but disclosure cannot rectify a
wrong or inappropriate treatment.

6.3 CHANGE IN ACCOUNTING POLICIES

A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.
Change in accounting policy may have a material effect on the items of financial statements. For example, if cost
formula used for inventory valuation is changed from weighted average to FIFO, or if interest is capitalized which
was earlier not in practice, or if proportionate amount of interest is changed to inventory which was earlier not
the practice, all these may increase or decrease the net profit. Unless the effect of such chan ge in accounting
policy is quantified, the financial statements may not help the users of accounts. Therefore, it is necessary to
quantify the effect of change on financial statement items like assets, liabilities, profit/loss.
For Example, Omega Enterprises revised its accounting policy relating to valuation of inventories to include
applicable production overheads.

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77 ACCOUNTING PROCESS 1.77

SUMMARY
 Accounting Policies refer to specific accounting principles and methods of applying these principles
adopted by the enterprise in the preparation and presentation of financial statements. Policies are based
on various accounting concepts, principles and conventions.
 Three major characteristics which should be considered for the purpose of selection and application of
accounting policies. viz., Prudence, Substance over form, and Materiality.
 A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.

TEST YOUR KNOWLEDGE

True and False
1. There is a single list of accounting policies, which are applicable to all enterprises in all circumstances.
2. Selection of accounting policy doesn’t impact financial performance and financial position of the business
3. A change in accounting policies should be made as and when business like to show result as per their choice.
4. Choosing FIFO or weighted average method for inventory valuation is selection of accounting policy.
5. Selection of an inappropriate accounting policy decision will overstate the performance and financial
position of a business entity every time.

Multiple Choice Questions

1. A change in accounting policy is justified
(a) To comply with accounting standard and law.
(b) To ensure more appropriate presentation of the financial statement of the enterprise.
(c) Both (a) and (b).
2. Accounting policy for inventories of Xeta Enterprises states that inventories are valued at the lower of
cost determined on weighted average basis or net realizable value. Which accounting principle is
followed in adopting the above policy?
(a) Materiality. (b) Prudence.
(c) Substance over form.
3. The areas wherein different accounting policies can be adopted are
(a) Providing depreciation. (b) Valuation of inventories.
(c) Both the option.
4. Selection of an inappropriate accounting policy decision may
(a) Overstate the performance and financial position of a business entity.

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1.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) Understate/overstate the performance and financial position of a business entity.

(c) Overstate the performance of a business entity.
5. Accounting policies refer to specific accounting
(a) Principles. (b) Methods of applying those principles.
(c) Both (a) and (b).

Theoretical Questions
1. Define Accounting Policies in brief. Identify few areas wherein different accounting policies are frequently
encountered.
2. “Change in accounting policy may have a material effect on the items of financial statements.” Explain the
statement with the help of an example.

ANSWERS/HINTS
True and False
1. False: There cannot be single list of accounting policies, which are applicable to all enterprises in all
circumstances. There would always be different policies chosen by different industries under different
circumstances.
2. False: Accounting policy has big impact on value of items goes under financial statements, hence it
impacts financial performance and financial position of the business.
3. False: A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.
4. True: An enterprise may adopt FIFO or weighted average method for inventory valuation and the method
selected for valuation is called an accounting policy.
5. False: It could understate/overstate the performance and financial position of a business entity.

Multiple Choice Questions

(1) (c), (2) (b), (3) (c), (4) (b), (5) (c)

Theoretical Questions
1. Accounting Policies refer to specific accounting principles and methods of applying these principles
adopted by the enterprise in the preparation and presentation of financial statements. For details, refer
para 6.1.
2. Change in accounting policy may have a material effect on the items of financial statements. For
example, if cost formula used for inventory valuation is changed from weighted average to FIFO. Unless
the effect of such change in accounting policy is quantified, the financial statements may not help the users
of accounts.

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79 ACCOUNTING PROCESS 1.79

UNIT – 7 ACCOUNTING AS A MEASUREMENT DISCIPLINE –

VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Understand the meaning of measurement and its basic elements.
♦ Know how far accounting is a measurement discipline if considered from the standpoint of the basic
elements of measurement.
♦ Distinguish measurement from valuation.
♦ Learn the different measurement bases namely historical cost, realizable value and present value.
♦ Understand the measurement bases which can give objective valuation to transactions and events.
♦ Understand that the traditional accounting system mostly uses historical cost as measurement base
although in some cases other measurement bases are also used.

UNIT OVERVIEW

Elements of Measurement

Evaluation of Dimension of
Identification of Objects and Selection of Standards or
Measurement Standards or
Events Scale
Scale

Valuation Principles

Historical Cost Current Cost Relizable Value Present Value

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1.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

7.1 MEANING OF MEASUREMENT

Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of money.
Any measurement discipline deals with three basic elements of measurement viz., identification of objects and
events to be measured, selection of standard or scale to be used, and evaluation of dimension of measurement
standards or scale.
Prof. R. J. Chambers defined ‘measurement’ as “assignment of numbers to objects and events according to rules
specifying the property to be measured, the scale to be used and the dimension of the unit”. (R.J. Chambers,
Accounting Evaluation and Economic Behaviour, Prentice Hall, Englewood Cliffs, N.J. 1966, P.10).
Kohler defined measurement as the assignment of a system of ordinal or cardinal numbers to the results of a
scheme of inquiry or apparatus of observations in accordance with logical or mathematical rules – [A Dictionary
of Accountant].
Ordinal numbers, or ordinals, are numbers used to denote the position in an ordered sequence: first, second, third,
fourth, etc., whereas a cardinal number says ‘how many there are’: one, two, three, four, etc.
Chambers’ definition has been widely used to judge how far accounting can be treated as a measurement
discipline.
According to this definition, the three elements of measurement are:
(1) Identification of objects and events to be measured;
(2) Selection of standard or scale to be used;
(3) Evaluation of dimension of measurement standard or scale.

7.2 OBJECTS OR EVENTS TO BE MEASURED

We have earlier defined Accounting as the process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by the users of the information. So accounting
essentially includes measurement of ‘information’.
Decision makers need past, present and future information. For external users, generally the past information is
communicated.
There is no uniform set of events and transactions in accounting which are required for decision making. For example, in
cash management, various cash receipts and expenses are the necessary objects and events. Obviously, the decision
makers need past cash receipts and expenses data along with projected receipts and expenses. For giving loan to a
business one needs information regarding the repayment ability (popularly called debt servicing) of principal and interest.
This also includes past information, current state of affairs as well as future projections. It may be mentioned that past
and present objects and events can be measured with some degree of accuracy but future events and objects are only
predicted, not measured. Prediction is an essential part of accounting information. Decision makers have to take decisions
about the unseen future for which they need suitable information.

7.3 STANDARD OR SCALE OF MEASUREMENT

In accounting, money is the scale of measurement (see money measurement concept), although now-a- days
quantitative information is also communicated along with monetary information.

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Money as a measurement scale has no universal denomination. It takes the shape of currency ruling in a country.
For example, in India the scale of measurement is Rupee, in the U.K. Pound-Sterling (£), in Germany Deutschmark
(DM), in the United States Dollar ($) and so on. Also there is no constant exchange relationship among the
currencies.
If one businessman in India took loan $5,000 from a businessman of the U.S.A., he would enter the transaction in his
books in terms of ` Suppose at the time of loan agreement exchange rate was US $ = ` 50. Then loan amounted
to ` 2,50,000. Afterwards the exchange rate has been changed to $ 1 = ` 55. At the changed exchange rate the
loan amount becomes` 2,75,000. So money as a unit of measurement lacks universal applicability across the
boundary of a country unless a common currency is in vogue. Since the rate of exchange fluctuates between two
currencies over the time, money as a measurement scale also becomes volatile.

7.4 DIMENSION OF MEASUREMENT SCALE

An ideal measurement scale should be stable over time. For example, if one buys 1 kg. cabbage today, the quantity
he receives will be the same if he will buy 1 kg. cabbage one year later. Similarly the length of 1 metre cloth will
not change if it is bought a few days later. That is to say a measurement scale should be stable in dimension.
Money as a scale of measurement is not stable. There occurs continuous change in the input output prices. The
same quantity of money may not have the ability to buy same quantity of identical goods at different dates. Thus
information of one year measured in money terms may not be comparable with that of another year. Suppose
production and sales of a company in two different years are as follows:
Year 1 Year 2
Qty. ` Qty. `
5,000 pcs 5,00,000 4,500 pcs 5,40,000
Looking at the monetary figures one may be glad for 8% sales growth. In fact there was 10% production and sales
decline. The growth envisaged through monetary figures is only due to price change. Let us suppose further that
the cost of production for the above mentioned two years is as follows:
Year 1 Year 2
Qty. ` Qty. `
5,000 pcs 4,00,000 4,500 pcs 4,50,000
Take Gross profit = Sales – Cost of Production. Then in the first year profit was ` 1,00,000 while in the second year
the profit was ` 90,000. There was 10% decline in gross profit.
So, money as a unit of measurement is not stable in the dimension.
Thus, Accounting measures information mostly in money terms which is not a stable scale having universal
applicability and also not stable in dimension for comparison over the time. So it is not an exact measurement
discipline.

7.5 ACCOUNTING AS A MEASUREMENT DISCIPLINE

How do you measure a transaction or an event? Unless the measurement base is settled we cannot progress to
the record keeping function of book-keeping. It has been explained that accounting is meant for generating
information suitable for users’ judgments and decisions. But generation of such information is preceded by

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1.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

recording, classifying and summarising data. By that process it measures performance of the business entity by
way of profit or loss and shows its financial position. Thus, measurement is an important part of accounting
discipline. But a set of theorems governs the whole measurement sub- system. These theorems should be
carefully understood to know how the cogs of the ‘accounting-wheel’ work. Now-a-days accounting profession
earmarked three theorems namely going concern, consistency and accrual as fundamental accounting
assumptions, i.e. these assumptions are taken for granted. Also while measuring, classifying, summarising and
also presenting, various policies are adopted. Recording, classifying summarising and communication of
information are also important part of accounting, which do not fall within the purview of measurement discipline.
Therefore, we cannot simply say that accounting is a measurement discipline.
But in accounting money is the unit of measurement. So, let us take one thing for granted that all transactions and
events are to be recorded in terms of money only. Quantitative information is also required in many cases but
such information is only supplementary to monetary information.

7.6 VALUATION PRINCIPLES

There are four generally accepted measurement bases or valuation principles. These are:
(i) Historical Cost;
(ii) Current Cost;
(iii) Realizable Value;
(iv) Present Value.
Let us discuss these principles in detail.
(i) Historical Cost: It means acquisition price. For example, the businessman paid ` 7,00,000 to purchase
the machine and spend `1,00,000 on its installation, its acquisition price including installation charges
is ` 8,00,000. The historical cost of machine would be ` 8,00,000.
According to this base, assets are recorded at an amount of cash or cash equivalent paid at the time of
acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation. In
some circumstances a liability is recorded at the amount of cash or cash equivalent expected to be paid
to satisfy it in the normal course of business.
When a businessman, takes ` 5,00,000 loan from a bank @ 10% interest p.a., it is to be recorded at the
amount of proceeds received in exchange for the obligation. Here the obligation is the repayment of loan as
well as payment of interest at an agreed rate i.e. 10%. Proceeds received are ` 5,00,000 - it is historical
cost of the transactions. Take another case regarding payment of income tax liability. You know every
individual has to pay income tax on his income if it exceeds certain minimum limit. But the income tax
liability is not settled immediately when one earns his income. The income tax authority settles it some
time later, which is technically called assessment year. Then how does he record this liability? As per
historical cost base it is to be recorded at an amount expected to be paid to discharge the liability.
(ii) Current Cost: Take that Mr. X purchased a machine on 1st January, 2011 at ` 7,00,000. As per historical
cost base he has to record it at ` 7,00,000 i.e. the acquisition price. As on 1.1.2020, Mr. X found that it
would cost ` 25,00,000 to purchase that machine. Take also that Mr. X took loan from a bank as on
1.1.2011 ` 5,00,000 @ 18% p.a repayable at the end of 15th year together with interest. As on 1.1.2020

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the bank announces 1% prepayment penalty on the loan amount if it is paid within 15 days starting from
that day. As per historical cost the liability is recorded at ` 5,00,000 at the amount or proceeds received
in exchange for obligation and asset is recorded at ` 7,00,000.
Current cost gives an alternative measurement base. Assets are carried out at the amount of cash or
cash equivalent that would have to be paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to
settle the obligation currently.
So as per current cost base, the machine value is ` 25,00,000 while the value of bank loan is ` 5,05,000.
(iii) Realisable Value: Suppose Mr. X found that he can get ` 20,00,000 if he would sell the machine purchased,
on 1.1.2011 paying ` 7,00,000 and which would cost ` 25,00,000 in case he would buy it currently. Take
also that Mr. X found that he had no money to pay off the bank loan of ` 5,00,000 currently.
As per realisable value, assets are carried at the amount of cash or cash equivalents that could currently
be obtained by selling the assets in an orderly disposal. Haphazard disposal may yield something less.
Liabilities are carried at their settlement values; i.e. the undiscounted amount of cash or cash equivalents
expressed to be paid to satisfy the liabilities in the normal course of business.
So, the machine should be recorded at ` 20,00,000 the realisable value in an orderly sale while the bank
loan should be recorded at ` 5,00,000 the settlement value in the normal course of business.
(iv) Present Value: Suppose we are talking as on 1.1.2020 - take it as time for reference. Now think the machine
purchased by Mr. X can work for another 10 years and is supposed to generate cash @ ` 1,00,000 p.a.
Also take that bank loan of ` 5,00,000 taken by Mr. X is to be repaid as on 31.12.2026. Annual interest is
` 90,000.
As per present value, an asset is carried at the present discounted value of the future net cash inflows
that the item is expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business.
The term ‘discount’, ‘cash inflow’ and ‘cash outflow’ need a little elaboration. ` 100 in hand as on 1.1.2020 is
not equivalent to ` 100 in hand as on 31.12.2020. There is a time gap of one year. If Mr. X had ` 100 as
on 1.1.2020 he could use it at that time. If he received it only on 31.12.2020, he had to sacrifice his use for
a year. The value of this sacrifice is called ‘time value of money’. Mr. X would sacrifice i.e. he would agree
to take money on 31.12.2020 if he had been compensated for the sacrifice. So a rational man will never
exchange ` 100 as on 1.1.2020 with ` 100 to be received on 31.12.2020. Then ` 100 of 1.1.2020 is not
equivalent to ` 100 of 31.12.2020. To make the money receivable at a future date equal with the money of
the present date it is to be devalued. Such devaluation is called discounting of future money.
Perhaps you know the compound interest rule: A = P (1+ i)n
A = Amount
P = Principal
i = interest / 100
n = Time

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1.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

This equation gives the relationship between present money, principal and the future money amount. If
A, i and n are given, to find out P, the equation is to be changed slightly.
A
P=
(1 + I)n

Using the equation one can find out the present value if he knows the values of A, i and n.
Suppose i = 20%, now what is the present value of ` 1,00,000 to be received as on 31.12.2020 (Take
1.1.2020 as the time of reference).
1,00,000
P= = ` 83,333
(1 + 20)1

Similarly,
Time of Receipt Money Value Present Value
` `
31.12.2021 1,00,000 69,444
31.12.2022 1,00,000 57,870
31.12.2023 1,00,000 48,225
31.12.2024 1,00,000 40,188
31.12.2025 1,00,000 33,490
31.12.2026 1,00,000 27,908
31.12.2027 1,00,000 23,257
31.12.2028 1,00,000 19,381
31.12.2029 1,00,000 16,150

Total of all these present values is ` 4,19,246. Since the machine purchased by Mr. X will produce cash
equivalent to ` 4,19,246 in terms of present value, it is to be valued at such amount as per present value
measurement basis.
Here, Mr. X will receive ` 1,00,000 at different points of time-these are cash inflows. In the other example,
he has to pay interest and principal of bank loan-these are cash outflows.
Perhaps you also know the annuity rule:
Present value of an Annuity or Re. A for n periods is
A = Annuity
i = interest
t = time 1, 2, 3, ..........n.
A 1 
1 − 
i  (1 + i)n 

Applying this rule one can derive the present value of ` 1,00,000 for 10 years @ 20% p.a.

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85 ACCOUNTING PROCESS 1.85

1,00,000  1 
1 − 10  = ` 4,19,246
0.20  (1 + 0.20) 

Similarly, the present value of bank loan is

90,000  1  5,00,000
1 − 5
+
0.20  (1 + 0.20)  (1 + 0.20)5

= ` 2,69,155 + ` 2,00,939= ` 4,70,094

Thus, we get the four measurements as on 1.1.2020:
Historical cost Current cost Realisable value Present value
` ` ` `
Asset: Machine 7,00,000 25,00,000 20,00,000 4,19,246
Liability: Bank Loan 5,00,000 5,05,000 5,00,000 4,70,094
The accounting system which we shall discuss in the remaining chapters is also called historical cost
accounting. However, this need not mean that one shall follow only historical cost basis of accounting.
In the later stages of the CA course, we shall see that the accounting system uses all types of
measurement bases although under the traditional system most of the transactions and events are
measured in terms of historical cost.

7.7 MEASUREMENT AND VALUATION

Value relates to the benefits to be derived from objects, abilities or ideas. To the economist, value is the utility
(i.e.; satisfaction) of an economic resource to the person contemplating or enjoying its use. In accounting, to
mean value of an object, abilities or ideas, a monetary surrogate is used. That is to say, value is measured in
terms of money. Suppose, an individual purchased a car paying ` 2,50,000. Its value lies in the satisfaction to
be derived by that individual using the car in future. Economists often use ordinal scale to indicate the level of
satisfaction. But accountants use only cardinal scales. If the value of car is taken as ` 2,50,000 it is only one
type of value called acquisition cost or historical cost. So value is indicated by measurement. In accounting the
value is always measured in terms of money.

7.8 ACCOUNTING ESTIMATES

Earlier in this unit we have learned how to measure a transaction, which had already taken place and for which
either some value/money has been paid or some valuation principles are to be adopted for their measurement.
But there are certain items, which have not occurred therefore cannot be measured using valuation principles
still they are necessary to record in the books of account, for example, provision for doubtful debts. For such
items, we need some value. In such a situation reasonable estimates based on the existing situation and past
experiences are made.
The measurement of certain assets and liabilities is based on estimates of uncertain future events. As a result of the
uncertainties inherent in business activities, many financial statement items cannot be measured with precision but
can only be estimated. Therefore, the management makes various estimates and assumptions of assets, liabilities,
incomes and expenses as on the date of preparation of financial statements. Such estimates are made in
connection with the computation of depreciation, amortisation and impairment losses as well as, accruals,

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1.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

provisions and employee benefit obligations. Also estimates may be required in determining the bad debts, useful
life and residual value of an item of plant and machinery and inventory obsolescence. The process of estimation
involves judgements based on the latest information available.
An estimate may require revision if changes occur regarding circumstances on which the estimate was based, or as
a result of new information, more experience or subsequent developments. Change in accounting estimate means
difference arises between certain parameters estimated earlier and re-estimated during the current period or actual
result achieved during the current period.
Few examples of situations wherein accounting estimates are needed can be given as follows:
1. A company incurs expenditure of ` 10,00,000 on development of patent. Now the company has to
estimate that for how many years the patent would benefit the company. This estimation should be based
on the latest information and logical judgement.
2. A company dealing in long-term construction contracts, uses percentage of completion method for
recognizing the revenue at the end of the accounting year. Under this method the company has to make
adequate provisions for unseen contingencies, which can take place while executing the remaining
portion of the contract. Since provisioning for unseen contingencies requires estimation, there may be
excess or short provisioning, which is to be adjusted in the period when it is recognised.
3. Company has to provide for taxes which is also based on estimation as there can be some interpretational
differences on account of which tax authorities may either accept the expenditure or refuse it. This will
ultimately lead to different tax liability.

SUMMARY
♦ Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of
money.
♦ There are three elements of measurement:
(i) Identification of objects and events to be measured;
(ii) Selection of standard or scale to be used;
(iii) Evaluation of dimension of measurement standard or scale.
♦ There are four generally accepted measurement bases or valuation principles. These are:
(i) Historical Cost; (ii) Current Cost;
(iii) Realizable Value; (iv) Present Value.

TEST YOUR KNOWLEDGE

True and False
1. There are four generally accepted measurement bases.
(i) Historical Cost; (ii) Current Cost;
(iii) Realizable Value; (iv) Future Value.

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87 ACCOUNTING PROCESS 1.87

2. Historical Cost means price paid at time acquisition.

3. As per future value, assets are carried at the amount of cash or cash equivalents that could currently be
obtained by selling the assets in an orderly disposal.
4. At Present value, liabilities are carried at the value of future net cash outflows that are expected to be
required to settle the liabilities in the normal course of business.
5. ABC purchased a machinery amounting ` 10,00,000 on 1st April, 2001. On 31st March, 2020, similar
machinery could be purchased for ` 20,00,000. Historical cost of machine is 20,00,000
6. ABC purchased a machinery amounting ` 10,00,000 on 1st April, 2001. On 31st March, 2020, similar
machinery could be purchased for ` 20,00,000. Current cost of machine is ` 20,00,000

Multiple Choice Questions

1. (i) Measurement discipline deals with
(a) Identification of objects and events. (b) Selection of scale.
(c) Both (a) and (b)
(ii) All of the following are valuation principles except
(a) Historical cost. (b) Present value.
(c) Future value.
(iii) Book value of machinery on 31st March, 2019 ` 10,00,000
Market value as on 31st March, 2019 if sold ` 11,00,000
As on 31st March, 2019, if the company values the machinery at ` 11,00,000, which of the
following valuation principle is being followed?
(a) Historical Cost. (b) Present Value.
(c) Realisable Value.
2. Mohan purchased a machinery amounting ` 10,00,000 on 1st April, 2001. On 31st March, 2019, similar
machinery could be purchased for ` 20,00,000 but the realizable value of the machinery (purchased on
1.4.2001) was estimated at ` 15,00,000. The present discounted value of the future net cash inflows
that the machinery was expected to generate in the normal course of business, was calculated as
` 12,00,000.
(i) The current cost of the machinery is
(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.
(ii) The present value of machinery is
(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 12,00,000.

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1.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iii) The historical cost of machinery is

(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.
(iv) The realizable value of machinery is
(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.

Theoretical Questions
1. Define Measurement in brief. Explain the significant elements of measurement.
2. Describe in brief, the alternative measurement bases, for determining the value at which an element can
be recognized in the balance sheet or statement of profit and loss.

ANSWER/HINTS
True and False
1. False: There are four generally accepted measurement bases .
(i) Historical Cost; (ii) Current Cost;
(iii) Realizable Value; (iv) Present Value.
2. True: Historical cost means the acquisition price.
3. False: At Realisable value, assets are carried at the amount of cash or cash equivalents that could
currently be obtained by selling the assets in an orderly disposal.
4. False: Liabilities are carried at the present discounted value of future net cash outflows that are expected to
be required to settle the liabilities in the normal course of business.
5. False: Historical cost is `10,00,000.
6. True: Since similar machine is purchased at 20,00,000, the current cost of machine is ` 20,00,000

Multiple Choice Questions

1.(i) (c) (ii) (c) (iii) (c) 2.(i) (b) (ii) (c) (iii) (a)
(iv) (c)

Theoretical Questions
1. Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of
money. Three elements of measurement are: (1) Identification of objects and events to be measured;
(2) Selection of standard or scale to be used;(3)Evaluation of dimension of measurement standard or
scale.
2. Alternative measurement bases are: (i) Historical Cost; (ii) Current cost (iii) Realizables (Settlement)
Value and (iv) Present Value. Refer para 7.6 for details.

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UNIT – 8 ACCOUNTING STANDARDS

LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Understand the significance of issuance of Accounting Standards.
♦ Grasp the objectives, benefits and limitations of Accounting Standards.
♦ Learn the process of formulation of Accounting Standards by the Council of the Institute of Chartered
Accountants of India.
♦ Familiarize with the list of applicable Accounting Standards in India.

UNIT OVERVIEW

Accounting Stadards deal with the issues of

Recognition of Measurement of Presentation of Disclosure

events and transactions and transactions and requirements
transactions events events

Formulation of Accounting Standards

Identification of area

Constitution of study group

Preparation of draft and its circulation

Ascertainment of views of different bodies on draft

Finalisation of exposure draft (E.D)

Comments received on exposure draft (E.D)

Modification of the draft

Issue of AS

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1.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

8.1 INTRODUCTION OF ACCOUNTING STANDARDS

Accounting as a ‘language of business’ communicates the financial results of an enterprise to various
stakeholders by means of financial statements. If the financial accounting process is not properly regulated, there
is possibility of financial statements being misleading, tendentious and providing a distorted picture of the
business, rather than the true. To ensure transparency, consistency, comparability, adequacy and reliability of
financial reporting, it is essential to standardize the accounting principles and policies. Accounting Standards
(ASs) provide framework and standard accounting policies for treatment of transactions and events so that the
financial statements of different enterprises become comparable.
Accounting standards are written policy documents issued by the expert accounting body or by the government
or other regulatory body covering the aspects of recognition, measurement, presentation and disclosure of
accounting transactions and events in the financial statements. The ostensible purpose of the standard setting
bodies is to promote the dissemination of timely and useful financial information to investors and certain other
parties having an interest in the company’s economic performance. The accounting standards deal with the issues
of -
(i) recognition of events and transactions in the financial statements;
(ii) measurement of these transactions and events;
(iii) presentation of these transactions and events in the financial statements in a manner that is meaningful and
understandable to the reader; and
(iv) the disclosure requirements which should be there to enable the public at large and the stakeholders
and the potential investors in particular, to get an insight into what these financial statements are trying to
reflect and thereby facilitating them to take prudent and informed business decisions.

8.2 OBJECTIVES OF ACCOUNTING STANDARDS

The whole idea of accounting standards is centered around harmonisation of accounting policies and practices
followed by different business entities so that the diverse accounting practices adopted for various aspects of
accounting can be standardised. Accounting Standards standardise diverse accounting policies with a view to:
(i) eliminate the non-comparability of financial statements and thereby improving the reliability of financial
statements; and
(ii) provide a set of standard accounting policies, valuation norms and disclosure requirements.
Accounting standards reduce the accounting alternatives in the preparation of financial statements within the
bounds of rationality, thereby ensuring comparability of financial statements of different enterprises.

8.3 BENEFITS AND LIMITATIONS OF ACCOUNTING STANDARDS

Accounting standards seek to describe the accounting principles, the valuation techniques and the methods of
applying the accounting principles in the preparation and presentation of financial statements so that they may
give a true and fair view. By setting the accounting standards, the accountant has following benefits:

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91 ACCOUNTING PROCESS 1.91

(i) Standards reduce to a reasonable extent or eliminate altogether confusing variations in the accounting
treatments used to prepare financial statements.
(ii) There are certain areas where important information are not statutorily required to be disclosed.
Standards may call for disclosure beyond that required by law.
(iii) The application of accounting standards would, to a limited extent, facilitate comparison of financial
statements of companies situated in different parts of the world and also of different companies situated in
the same country. However, it should be noted in this respect that differences in the institutions, traditions
and legal systems from one country to another give rise to differences in accounting standards adopted in
different countries.

Standardisation
of Alternative
accounting
treatments

Benefits of
Accounting
Standards

Comparability Requirements
of financial for additional
statements disclosures

However, there are some limitations of accounting standards:

(i) Difficulties in making choice between different treatments: Alternative solutions to certain accounting
problems may each have arguments to recommend them. Therefore, the choice between different
alternative accounting treatments may become difficult.
(ii) Restricted scope: Accounting standards cannot override the statute. The standards are required to be
framed within the ambit of prevailing statutes.

Difficulties in
Limitations of
making choice
accounting Restricted scope
between different
standards
treatments

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1.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

8.4 PROCESS OF FORMULATION OF ACCOUNTING STANDARDS IN

INDIA
The Institute of Chartered Accountants of India (ICAI), being a premier accounting body in the country, took upon
itself the leadership role by constituting the Accounting Standards Board (ASB) in 1977. The ICAI has taken
significant initiatives in the setting and issuing procedure of Accounting Standards to ensure that the standard-
setting process is fully consultative and transparent. The ASB considers International Financial Reporting
Standards (IFRSs) while framing Indian Accounting Standards (ASs) in India and try to integrate them, in the
light of the applicable laws, customs, usages and business environment in the country. The composition of ASB
includes, representatives of industries (namely, ASSOCHAM, CII, FICCI), regulators, academicians, government
departments etc. Although ASB is a body constituted by the Council of the ICAI, it (ASB) is independent in the
formulation of accounting standards and Council of the ICAI is not empowered to make any modifications in the
draft accounting standards formulated by ASB without consulting with the ASB.
The standard-setting procedure of Accounting Standards Board (ASB) can be briefly outlined as follows:
♦ Identification of broad areas by ASB for formulation of AS.
♦ Constitution of study groups by ASB to consider specific projects and to prepare preliminary drafts of
the proposed accounting standards. The draft normally includes objective and scope of the standard,
definitions of the terms used in the standard, recognition and measurement principles wherever
applicable and presentation and disclosure requirements.
♦ Consideration of the preliminary draft prepared by the study group of ASB and revision, if any, of the
draft on the basis of deliberations.
♦ Circulation of draft of accounting standard (after revision by ASB) to the Council members of the ICAI
and specified outside bodies such as Department of Company Affairs (DCA), Securities and Exchange
Board of India (SEBI), Comptroller and Auditor General of India (C&AG), Central Board of Direct Taxes
(CBDT), Standing Conference of Public Enterprises (SCOPE), etc. for comments.
♦ Meeting with the representatives of the specified outside bodies to ascertain their views on the draft of
the proposed accounting standard.
♦ Finalisation of the exposure draft of the proposed accounting standard and its issuance inviting public
comments.
♦ Consideration of comments received on the exposure draft and finalisation of the draft accounting
standard by the ASB for submission to the Council of the ICAI for its consideration and approval for
issuance.
♦ Consideration of the final draft of the proposed standard and by the Council of the ICAI, and if found
necessary, modification of the draft in consultation with the ASB is done.
♦ The accounting standard on the relevant subject (for non-corporate entities) is then issued by the ICAI.
For corporate entities the accounting standards are issued by The Central Government of India.

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8.5 LIST OF ACCOUNTING STANDARDS IN INDIA

The ‘Accounting Standards’ issued by the Accounting Standards Board establish standards which have to be
complied by the business entities so that the financial statements are prepared in accordance with generally
accepted accounting principles.
Following is the list of applicable Accounting Standards:
List* of Accounting Standards

Sl. Number of the Title of the Accounting Standard

No. Accounting Standard
(AS)
1. AS 1 Disclosure of Accounting Policies
2. AS 2 (Revised) Valuation of Inventories
3. AS 3 (Revised) Cash Flow Statements
4. AS 4 (Revised) Contingencies and Events Occurring after the Balance Sheet Date
5. AS 5 (Revised) Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies
4. AS 6 (withdrawn pursuant to Depreciation Accounting
issuance of AS 10 on
Property, Plant and
Equipment, 2016)
7. AS 7 (Revised) Accounting for Construction Contracts
8. AS 8 (withdrawn pursuant to Accounting for Research and Development
AS 26 becoming
mandatory)
9. AS 9 Revenue Recognition
10. AS 10 Property, Plant and Equipment
11. AS 11 (Revised) The Effects of Changes in Foreign Exchange Rates
12. AS 12 Accounting for Government Grants
13. AS 13 Accounting for Investments
14. AS 14 Accounting for Amalgamations
15. AS 15 (Revised) Employee Benefits
14. AS 16 Borrowing Costs
17. AS 17 Segment Reporting
18. AS 18 Related Party Disclosures

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1.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

19. AS 19 Leases
20. AS 20 Earnings Per Share
21. AS 21 Consolidated Financial Statements
22. AS 22 Accounting for Taxes on Income
23. AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
24. AS 24 Discontinuing Operations
25. AS 25 Interim Financial Reporting
24. AS 26 Intangible Assets
27. AS 27 Financial Reporting of Interests in Joint Ventures
28. AS 28 Impairment of Assets
29. AS 29 Provisions, Contingent Liabilities & Contingent Assets

* Note: The list of accounting standards given above does not form part of syllabus. It has been given
here for the knowledge of students only.

SUMMARY
♦ Accounting Standards (ASs) provide framework and standard accounting policies for treatment of
transactions and events so that the financial statements of different enterprises become comparable.
Accounting Standards standardise diverse accounting policies with a view to:
(i) eliminate the non-comparability of financial statements
(ii) provide a set of standard accounting policies, valuation norms and disclosure requirements
♦ By setting the accounting standards, the accountant has following benefits:
(i) Comparability of financial statements
(ii) Requirements of additional disclosures
♦ Following are the limitations of accounting standards
(i) Difficulties in making choice between different treatments.
(ii) Accounting standards cannot override the statute

TEST YOUR KNOWLEDGE

True and False
1. Accounting standards are written policy documents issued by the expert accounting body or by the
government or other regulatory body covering the aspects of recognition, measurement, presentation and
disclosure of accounting transactions and events in the financial statements.

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95 ACCOUNTING PROCESS 1.95

2. Accounting standards can override the statute.

3. Difficulties in making choice between different treatments is one of the benefits of accounting standards.
4. Requirements for additional disclosures is limitation of accounting standards.
5. ASB stands for Accounting standardisation benchmarking.
6. There are no limitation to accounting standards.

Multiple Choice Questions

1. Accounting Standards for Non-Corporate entities in India are issued by
(a) Central Govt. (b) State Govt.
(c) Institute of Chartered Accountants of India. (d) Reserve Bank of India.
2. Accounting Standards
(a) Harmonise accounting policies.
(b) Eliminate the non-comparability of financial statements.
(c) Improve the reliability of financial statements.
(d) All the three.
3. It is essential to standardize the accounting principles and policies in order to ensure
(a) Transparency. (b) Consistency.
(c) Comparability. (d) All the three.

Theoretical Questions
1. Explain the objective of “Accounting Standards” in brief.
2. State the advantages of setting Accounting Standards.

ANSWERS/HINTS
True and False
1. True: Accounting standards are documents covering recognition, measurement, presentation and
disclosure of accounting transactions and events in the financial statements.
2. False: Accounting standards can never override the statute. The standards are required to be framed
within the ambit of prevailing statutes.
3. False: Difficulties in making choice between different treatments is one of the limitation of accounting standard.
4. False: Benefits of accounting standards are:
• Standardisation of alternative accounting treatments
• Comparability of financial statements
• Requirements for additional disclosures.

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1.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. False: ASB stands for Accounting standard Board.

6. False: limitations of accounting standards
• Difficulties in making choice between different treatments
• Restricted scope

Multiple Choice Questions

1. (c), 2. (d), 3. (d),

Theoretical Questions
1. Accounting Standards are selected set of accounting policies or broad guidelines regarding the principles
and methods to be chosen out of several alternatives. The main objective of Accounting Standards is to
establish standards which have to be complied with, to ensure that financial statements are prepared in
accordance with generally accepted accounting principles. Accounting Standards seek to suggest rules
and criteria of accounting measurements. These standards harmonize the diverse accounting policies
and practices at present in use in India.
2. The main advantage of setting accounting standards is that the adoption and application of accounting
standards ensure uniformity, comparability and qualitative improvement in the preparation and
presentation of financial statements. The other advantages are: Reduction in variations; Disclosures
beyond that required by law and Facilitates comparison.

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97 ACCOUNTING PROCESS 1.97

UNIT – 9 INDIAN ACCOUNTING STANDARDS

LEARNING OUTCOMES
After studying this unit, you will be able to:
♦ Understand the significance of issuance of Indian Accounting Standards.
♦ Learn the need of issuance of Indian Accounting Standards.

UNIT OVERVIEW

Indian Accounting Standards

Convergence Transparency of Comparability of Enhanced

towards Global financial financial Disclosure
Standards statements statements requirements

9.1 NEED FOR CONVERGENCE TOWARDS GLOBAL STANDARDS

The last decade has witnessed a sea change in the global economic scenario. The emergence of transnational
corporations in search of money, not only for fueling growth, but to sustain on going activities has necessitated
raising of capital from all parts of the world, cutting across frontiers.
Each country has its own set of rules and regulations for accounting and financial reporting. Therefore, when an
enterprise decides to raise capital from the markets other than the country in which it is located, the rules and
regulations of that other country will apply and this in turn will require that the enterprise is in a position to
understand the differences between the rules governing financial reporting in the foreign country as compared to
its own country of origin. Therefore translation and re-instatements are of utmost importance in a world that is
rapidly globalising in all ways. In themselves also, the accounting standards and principle need to be robust so
that the larger society develops degree of confidence in the financial statements, which are put forward by
organizations.
International analysts and investors would like to compare financial statements based on similar accounting
standards, and this has led to the growing support for an internationally accepted set of accounting standards for

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1.98 PRINCIPLES AND PRACTICE OF ACCOUNTING

cross-border filings. The harmonization of financial reporting around the world will help to raise confidence of
investors generally in the information they are using to make their decisions and assess their risks.
Also a strong need was felt by legislation to bring about uniformity, rationalization, comparability, transparency
and adaptability in financial statements. Having a multiplicity of accounting standards around the world is against
the public interest. If accounting for the same events and information produces different reported numbers,
depending on the system of standards that are being used, then it is self-evident that accounting will be
increasingly discredited in the eyes of those using the numbers. It creates confusion, encourages error and
facilitates fraud. The cure for these ills is to have a single set of global standards, of the highest quality, set in the
interest of public. Global Standards facilitate cross border flow of money, global listing in different bourses and
comparability of financial statements.
The convergence of financial reporting and accounting standards is a valuable process that contributes to the
free flow of global investment and achieves substantial benefits for all capital market stakeholders. It improves
the ability of investors to compare investments on a global basis and thus lowers their risk of errors of judgment. It
facilitates accounting and reporting for companies with global operations and eliminates some costly
requirements say reinstatement of financial statements. It has the potential to create a new standard of
accountability and greater transparency, which are values of great significance to all market participants including
regulators. It reduces operational challenges for accounting firms and focuses their value and expertise around
an increasingly unified set of standards. It creates an unprecedented opportunity for standard setters and other
stakeholders to improve the reporting model. For the companies with joint listings in both domestic and foreign
country, the convergence is very much significant.

9.2 INTERNATIONAL FINANCIAL REPORTING STANDARDS AS

GLOBAL STANDARDS
With a view of achieving convergence towards global reporting, the London based group namely the International
Accounting Standards Committee (IASC), responsible for developing International Accounting Standards, was
established in June, 1973. It is presently known as International Accounting Standards Board (IASB), The IASC
comprises the professional accountancy bodies of over 75 countries (including the Institute of Chartered
Accountants of India). Primarily, the IASC was established, in the public interest, to formulate and publish,
International Accounting Standards to be followed in the presentation of audited financial statements.
International Accounting Standards were issued to promote acceptance and observance of International
Accounting Standards worldwide. The members of IASC have undertaken a responsibility to support the
standards promulgated by IASC and to propagate those standards in their respective countries.
Between 1973 and 2001, the International Accounting Standards Committee (IASC) released International
Accounting Standards. Between 1997 and 1999, the IASC restructured their organisation, which resulted in
formation of International Accounting Standards Board (IASB). These changes came into effect on 1st April,
2001. Subsequently, IASB issued statements about current and future standards: IASB publishes its Standards
in a series of pronouncements called International Financial Reporting Standards (IFRS). However, IASB has not
rejected the standards issued by the ISAC. Those pronouncements continue to be designated as “International
Accounting Standards” (IAS).

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The term IFRS comprises IFRS issued by IASB; IAS issued by International Accounting Standards Committee
(IASC); Interpretations issued by the Standard Interpretations Committee (SIC) and the IFRS Interpretations
Committee of the IASB.
International Financial Reporting Standards (IFRSs) are considered a "principles-based" set of standards. In
fact, they establish broad rules rather than dictating specific treatments. Every major nation is moving toward
adopting them to some extent. Large number of authorities requires public companies to use IFRS for stock-
exchange listing purposes, and in addition, banks, insurance companies and stock exchanges may use them for
their statutorily required reports. So over the next few years, thousands of companies will adopt the international
standards. This requirement will affect about 7,000 enterprises, including their subsidiaries, equity investors and
joint venture partners. The increased use of IFRS is not limited to public-company listing requirements or statutory
reporting. Many lenders and regulatory and government bodies are looking to IFRS to fulfil local financial reporting
obligations related to financing or licensing.

9.3 BENEFITS OF CONVERGENCE WITH IFRSS

There are many beneficiaries of convergence with IFRSs such as the economy, investors, industry etc.
The Economy: When the markets expand globally the need for convergence increases since the convergence
benefits the economy by increasing growth of its international business. It facilitates maintenance of orderly and
efficient capital markets and also helps to increase the capital formation and thereby economic growth. It
encourages international investing and thereby leads to more foreign capital flows to the country.
Investors: A strong case for convergence can be made from the viewpoint of the investors who wish to invest outside
their own country. Investors want the information that is more relevant, reliable, timely and comparable across the
jurisdictions. Financial statements prepared using a common set of accounting standards help investors better
understand investment opportunities as opposed to financial statements prepared using a different set of national
accounting standards. Investors’ confidence is strong when accounting standards used are globally accepted.
Convergence with IFRS contributes to investors’ understanding and confidence in high quality financial statements.
The Industry: A major force in the movement towards convergence has been the interest of the industry. The
industry is able to raise capital from foreign markets at lower cost if it can create confidence in the minds of foreign
investors that their financial statements comply with globally accepted accounting standards. With the diversity
in accounting standards from country to country, enterprises which operate in different countries face a multitude
of accounting requirements prevailing in the countries. The burden of financial reporting is lessened with
convergence of accounting standards because it simplifies the process of preparing the individual and group
financial statements and thereby reduces the costs of preparing the financial statements using different sets of
accounting standards.

9.4 DEVELOPMENT IN INDIAN ACCOUNTING STANDARDS (IND AS)

9.4.1 First Step towards IFRSs
The Institute of Chartered Accountants of India (ICAI) being the accounting standards-setting body in India, way
back in 2006, initiated the process of moving towards the International Financial Reporting Standards (IFRSs)

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1.100 PRINCIPLES AND PRACTICE OF ACCOUNTING

issued by the International Accounting Standards Board (IASB) with a view to enhance acceptability and
transparency of the financial information communicated by the Indian corporates through their financial
statements. This move towards IFRS was subsequently accepted by the Government of India.
The Government of India in consultation with the ICAI decided to converge and not to adopt IFRSs issued by the
IASB. The decision of convergence rather than adoption was taken after the detailed analysis of IFRS
requirements and extensive discussion with various stakeholders. Accordingly, while formulating IFRS- converged
Indian Accounting Standards (Ind AS), efforts have been made to keep these Standards, as far as possible, in line
with the corresponding IFRS and departures have been made where considered absolutely essential. These
changes have been made considering various factors, such as, various terminology related changes have been
made to make it consistent with the terminology used in law. Certain changes have been made considering the
economic environment of the country, which is different as compared to the economic environment presumed to
be in existence by IFRS.

9.4.2 What are Indian Accounting Standards (Ind AS)?

Indian Accounting Standards (Ind-AS) are the International Financial Reporting Standards (IFRS) converged
standards issued by the Central Government of India under the supervision and control of Accounting Standards
Board (ASB) of ICAI and in consultation with National Advisory Committee on Accounting Standards (NACAS).
National Advisory Committee on Accounting Standards (NACAS) recommend these standards to the Ministry of
Corporate Affairs (MCA). MCA has to spell out the accounting standards applicable for companies in India.
The Ind AS are named and numbered in the same way as the corresponding International Financial Reporting
Standards (IFRS).

9.4.3 Government of India - Commitment to IFRS Converged Ind AS

Initially Ind AS were expected to be implemented from the year 2011. However, keeping in view the fact that
certain issues including tax issues were still to be addressed, the Ministry of Corporate Affairs decided to
postpone the date of implementation of Ind AS.
In July 2014, the Finance Minister of India at that time, Shri Arun Jaitely ji, in his Budget Speech, announced an
urgency to converge the existing accounting standards with the International Financial Reporting Standards (IFRS)
through adoption of the new Indian Accounting Standards (Ind AS) by the Indian companies.
Pursuant to the above announcement, various steps have been taken to facilitate the implementation of IFRS-
converged Indian Accounting Standards (Ind AS). Moving in this direction, the Ministry of Corporate Affairs (MCA)
has issued the Companies (Indian Accounting Standards) Rules, 2015 vide Notification dated February 16, 2015
covering the revised roadmap of implementation of Ind AS for companies other than Banking companies,
Insurance Companies and NBFCs and Indian Accounting Standards (Ind AS). As per the Notification, Indian
Accounting Standards (Ind AS) converged with International Financial Reporting Standards (IFRS) shall be
implemented on voluntary basis from 1st April, 2015 and mandatory from 1st April, 2016. Later on, in 2016 MCA
notified roadmap for NBFC announcing implementation date for Ind AS. Similarly, Banking and Insurance
regulatory authority have issued separate roadmaps for implementation of Ind AS for Banking and Insurance
companies respectively.

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101 ACCOUNTING PROCESS 1.101

9.5 LIST OF IND AS

Ind AS Title of Ind AS
101 First -Time Adoption of Indian Accounting Standards
102 Share- Based Payment
103 Business Combinations
104* Insurance Contracts
105 Non-current Assets Held for Sale and Discontinued Operations
106 Exploration for and Evaluation of Mineral Resources
107 Financial Instruments: Disclosures
108 Operating Segments
109 Financial Instruments
110 Consolidated Financial Statements
111 Joint Arrangements
112 Disclosure of Interests in Other Entities
113 Fair Value Measurement
114 Regulatory Deferral Accounts
115 Revenue from Contracts with Customers
116 Leases
1 Presentation of Financial Statements
2 Inventories
7 Statement of Cash Flows
8 Accounting Policies, Changes in Accounting Estimates and Errors
10 Events after the Reporting Period
12 Income Taxes
16 Property, Plant and Equipment
19 Employee Benefits
20 Accounting for Government Grants and Disclosure of Government Assistance
21 The Effects of Changes in Foreign Exchange Rates
23 Borrowing Costs
24 Related Party Disclosures
27 Separate Financial Statements
28 Investment in Associates and Joint Ventures

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1.102 PRINCIPLES AND PRACTICE OF ACCOUNTING

Ind AS Title of Ind AS

29 Financial Reporting in Hyperinflationary Economies
32 Financial Instruments: Presentation
33 Earnings per Share
34 Interim Financial Reporting
36 Impairment of Assets
37 Provisions, Contingent Liabilities and Contingent Assets
38 Intangible Assets
40 Investment Property
41 Agriculture
*Ind AS 117 Insurance Contracts is under formulation and it will replace this.
Note: The list of Ind AS given above does not form part of syllabus. It has been given here for the
knowledge of students only.

SUMMARY
 The convergence of financial reporting and accounting standards improves the ability of investors to
compare investments on a global basis and thus lowers their risk of errors of judgment. The major
beneficiaries of convergence with IFRSs are the economy, investors, industry etc.

 Indian Accounting Standards (Ind-AS) are the International Financial Reporting Standards (IFRS)
converged standards issued by the Central Government of India under the supervision and control of
Accounting Standards Board (ASB) of ICAI

TEST YOUR KNOWLEDGE

True and False
1. The Government of India in consultation with the ICAI decided to adopt IFRSs issued by the IASB.
2. There are many benefits of convergence with IFRSs to the economy, investors, industry etc.
3. There was no need to converge to global accounting standards.
4. International Financial Reporting Standards (IFRSs) are considered a “rules-based” set of standards.
5. Govt of India has taken IASB support to develop Ind AS standards.
6. IASC stands for International Accounting Standards Council.

Multiple Choice Questions

1. Global Standards facilitate
(a) Cross border flow of money. (b) Global listing in different bourses.

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103 ACCOUNTING PROCESS 1.103

(c) Comparability of financial statements. (d) All the three.

2. The Government of India in consultation with the ICAI decided to
(a) Adapt with IFRS. (b) Converge with IFRS.
(c) apply IFRS in India. (d) notify IFRS in India.
3. Convergence with IFRSs
(a) Simplifies the process of preparing the financial statements.
(b) Reduces the costs of preparing the financial statements.
(c) Both (a) and (b).
(d) Facilitates global investors’ understanding and confidence in high quality financial statements.

Theoretical Questions
1. Explain the need of convergence rather adoption of IFRS as Global Standards.
2. What is the significance of issue of Indian Accounting Standards? Explain in brief.

ANSWERS/HINTS
True and False
1. False: The Government of India in consultation with the ICAI decided to converge and not to adopt IFRSs
issued by the IASB.

2. True: Major benefits of convergence with IFRS’s to economy, investors and industry.

3. False: Since India is going global, there was huge demand of global standards for better comparison.

4. False: International Financial Reporting Standards (IFRSs) are considered a “principles-based” set of
standards.

5. False: Govt. of India has taken ASB support to develop Ind AS standards.

6. False: IASC stands for International Accounting Standards Committee.

Multiple Choice Questions

1. (d); 2. (b); 3. (d)

Theoretical Questions
1. The Government of India in consultation with the ICAI decided to converge and not to adopt IFRSs
issued by the IASB. The decision of convergence rather than adoption was taken after the detailed
analysis of IFRSs requirements and extensive discussion with various stakeholders. Accordingly, while
formulating IFRS-converged Indian Accounting Standards (Ind AS), efforts have been made to keep

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1.104 PRINCIPLES AND PRACTICE OF ACCOUNTING

these Standards, as far as possible, in line with the corresponding IAS/IFRS and departures have been
made where considered absolutely essential.
2. Global Standards facilitate cross border flow of money, global listing in different bourses and
comparability of financial statements. The convergence of financial reporting and accounting standards
is a valuable process that contributes to the free flow of global investment and achieves substantial
benefits for all capital market stakeholders. It improves the ability of investors to compare investments
on a global basis and thus lowers their risk of errors of judgment. It facilitates accounting and reporting
for companies with global operations and eliminates some costly requirements say reinstatement of
financial statements.

© The Institute of Chartered Accountants of India

CHAPTER
2
ACCOUNTING PROCESS
UNIT -1 BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES
LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand meaning and significance of Double Entry System.
 Familiarize with the term ‘account’ and understand the classification of accounts into personal,
real and nominal.
 Note the utility of such classification and sub-classifications.
 Understand how debits and credits are determined from transactions and events.
 Observe the points to be taken care of while recording a transaction in the journal.

UNIT OVERVIEW

• All documents in books which contain financial records and act as evidence of
Source Documents transactions.

• Purchase day book, Cash book, Sales day book and Purchases return book
Books of original entry
• Accounts where information relating to a particular asset/liability, capital,
and Ledger Accounts income and expnses are recorded.

• It contains the totals from various ledger accounts and act as preliminary
Trial Balance check on accounts before producing final accounts.

Accounts

Personal Impersonal
Accounts Accounts

Artificial Real Nominal

Natural Representative
(Legal) Accounts Accounts

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2.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.1 DOUBLE ENTRY SYSTEM

Double entry system of accounting is more than 500 years old. “Luca Pacioli” an Italian friar & mathematician
published Summa de Arithmetica, Geometria, Proportioni, et Proportionalita (“Everything about
Arithemetic Geometry and proportions”). The first book that described a double entry accounting system. Double
entry system of book-keeping has emerged in the process of evolution of various accounting techniques. It is the
only scientific system of accounting. According to it, every transaction has two-fold aspects–debit and credit and
both the aspects are to be recorded in the books of accounts. Therefore, in every transaction at least two accounts
are effected.
For example, on purchase of furniture either the cash balance will be reduced or a liability to the supplier will
arise. and new asset furniture is acquired . This has been made clear already, the Double Entry System records
both the aspects. It may be defined as the system which recognises and records both the aspects of transactions.
This system has proved to be systematic and has been found of great use for recording the financial affairs for
all institutions requiring use of money.

1.2 ADVANTAGES OF DOUBLE ENTRY SYSTEM

This system affords the under mentioned advantages:
(i) By the use of this system the accuracy of the accounting work can be established, through the device of
the trial balance.
(ii) The profit earned or loss suffered during a period can be ascertained together with details.
(iii) The financial position of the firm or the institution concerned can be ascertained at the end of each
period, through preparation of the balance sheet.
(iv) The system permits accounts to be kept in as much details as necessary and, therefore affords
significant information for the purposes of control etc.
(v) Result of one year may be compared with those of previous years and reasons for the change may be
ascertained.
It is because of these advantages that the system has been used extensively in all countries.

1.3 ACCOUNT
We have seen how the accounting equation becomes true in all cases. A person starts his business with say,
` 10,00,000; capital and cash are both ` 10,00,000. Transactions entered into by the firm will alter the cash
balance in two ways, one will increase the cash balance and other will reduce it. Payment for goods purchased,
for salaries and rent, etc., will reduce it; sales of goods for cash and collection from customers will increase it.
We can change the cash balance with every transaction but this will be cumbersome. Instead it would be better
if all the transactions that lead to an increase are recorded in one column and those that reduce the cash balance
in another column; then the net result can be ascertained. If we add all increases to the opening balance of cash
and then deduct the total of all decreases we shall know the closing balance. In this manner, significant
information will be available relating to cash.

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3 ACCOUNTING PROCESS 2.3

The two columns which we referred above are put usually in the form of an account, called the ‘T’ form. This is
illustrated below by taking imaginary figures:
CASH
Increase Decrease
(Receipt) (Payment)
` `
Opening Balance (1) 10,00,000 (7) 1,00,000
(2) 2,50,000 (8) 3,00,000
(3) 2,00,000 (9) 2,00,000
(4) 5,00,000 (10) 5,00,000
(5) 1,35,000
(6) 4,00,000 (11) 12,00,000
New or Closing Balance 1,85,000
24,85,000 24,85,000

Since, each T-account shows only amounts and not transaction descriptions, we key each transaction in some
way, such as by numbering used in this illustration. However, one can use date also for this purpose.
What we have done is to put the increase of cash on the left hand side and the decrease on the right hand side;
the closing balance has been ascertained by deducting the total of payments, ` 23,00,000 from the total of the
left - hand side. Such a treatment of receipts and payments of cash is very convenient.
Here we talked about only one account namely cash, now let us see how to make T-accounts when asset as well
as liabilities are effected from a particular transaction.
Now, let us take some more examples:-
Transaction 1:
Initial investment by owners ` 25,00,000 in cash.
This will effect two accounts namely cash and capital. The asset cash increases and the stock holders’ equity
paid up capital also increases.
CASH
Increase Decrease
(1) 25,00,000

CAPITAL
Decrease Increase
(1) 25,00,000

Transaction 2:
Paid cash to the creditors ` 14,00,000
This will effect cash account which will decrease and creditors account which is a liability will also decrease.

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2.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

CASH
Increase Decrease
(2) 14,00,000
CREDITORS
Decrease Increase
(2) 14,00,000

The proper form of an account is as follows:

Account
Date Particulars Ref. Amount Date Particulars Ref. Amount
`

The columns are self-explanatory except that the column for reference (Ref.) is meant to indicate the sources
where information about the entry is available.

1.4 DEBIT AND CREDIT

We have seen that in T-accounts increase and decrease entries are made on the left and right side of the
accounts for assets respectively and vice-versa for liabilities. But, formally accountants use the term Debit (Dr.)
to denote an entry on the left side of any account and Credit (Cr.) to denote an entry on the right side of any
account.
We know that by deducting the total of liabilities from the total of assets the amount of capital is ascertained, as
is indicated by the accounting equation.
Assets = Liabilities + Capital
or
Assets – Liabilities = Capital
To understand the equation better, let us expand it:-
Assets = Liabilities + stockholders’ Equity

Assets = Liabilities + ( contributed capital + beginning retained earnings + revenue - expense - dividends)
Here,
Contributed capital = the original capital introduced by the owner.
Beginning retained earnings = previous earnings not distributed to the shareholders.
Revenue = generated from the ongoing activities of the business

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5 ACCOUNTING PROCESS 2.5

Expenses = cost incurred for the operations of the company.

Dividends = earnings distributed to the shareholders of the company
We have also seen that if there is any change on one side of the equation, there is bound to be similar change
on the other side of the equation or amongst items covered by it or an opposite change on the same side of the
equation. This is illustrated below:
Transactions Total = Liabilities + Owner’s
Assets ` Capital
` `
(1) Started business with cash ` 10,00,000 10,00,000 10,00,000
(2) Borrowed ` 5,00,000 + 5,00,000 + 5,00,000
(3) Withdrew cash from business ` 2,00,000 - 2,00,000 - 2,00,000
(4) Loan repaid to the extent of ` 1,00,000 - 1,00,000 - 1,00,000
(5) Bought furniture worth ` 3,00,000 with +3,00,000
Cash - 3,00,000
Balance 12,00,000 = 4,00,000 + 8,00,000

As has been seen previously, what has been given above is suitable only if the number of transactions is small.
But if the number is large, a different procedure of putting increases and decreases in different columns will be
useful and this will also yield significant information. The transactions given above are being shown below
according to this method.
Total Assets = Liabilities + Owner’s Capital
Decrease Decrease Increase Decrease Increase
` ` ` ` `

(1) 10,00,000 10,00,000

(2) 5,00,000 5,00,000
(3) 2,00,000 2,00,000
(4) 1,00,000 1,00,000
Total 15,00,000 3,00,000 1,00,000 5,00,000 2,00,000 10,00,000
Balance 12,00,000 4,00,000 + 8,00,000

It is a tradition that:
(i) increases in assets are recorded on the left-hand side and decreases in them on the right-hand side; and
(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and decreases on the
left-hand side.
When two sides are put together in T form, the left-hand side is called the ‘debit side’ and the right hand
side is ‘credit side’. When in an account a record is made on the debit or left-hand side, one says that
one has debited that account; similarly to record an amount on the right-hand side is to credit it.

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2.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

From the above, the following rules can be obtained:

(i) When there is an increase in the amount of an asset, its account is debited; the account will be credited
if there is a reduction in the amount of the asset concerned: Suppose a firm purchases furniture for
` 8,00,000 the furniture account will be debited by ` 8,00,000 since the asset has increased by this
amount. Suppose later the firm sells furniture to the extent of ` 3,00,000 the reduction will be recorded
by crediting the furniture account by ` 3,00,000.
FURNITURE
Increase Decrease
(1) 8,00,000 (2) 3,00,000
Balance 5,00,000

(ii) If the amount of a liability increases, the increase will be entered on the credit side of the liability account,
i.e. the account will be credited: similarly, a liability account will be debited if there is a reduction in the
amount of the liability. Suppose a firm borrows ` 5,00,000 from Mohan; Mohan’s account will be credited
since ` 5,00,000 is now owing to him. If, later, the loan is repaid, Mohan’s account will be debited since
the liability no longer exists.
MOHAN
Decrease Increase
(2) 5,00,000 (1) 5,00,000

(iii) An increase in the owner’s capital is recorded by crediting the capital account: Suppose the proprietor
introduces additional capital, the capital account will be credited. If the owner withdraws some money,
i.e., makes a drawing, the capital account will be debited.
(iv) Profit leads to an increase in the capital and a loss to reduction: According to the rule mentioned in (iii)
above, profit & incomes may be directly credited to the capital account and losses & expenses may be
similarly debited.
However, it is more useful to record all incomes, gains, expenses and losses separately. By doing so,
very useful information will be available regarding the factors which have contributed to the year’s profits
and losses. Later the net result of all these is ascertained and adjusted in the capital account.
(v) Expenses are debited and Incomes are credited: Since incomes and gains increase capital, the rule is
to credit all gains and incomes in the accounts concerned and since expenses and losses decrease
capital, the rule is to debit all expenses and losses. Of course, if there is a reduction in any income or
gain, the account concerned will be debited; similarly, for any reduction in an expenses or loss the
concerned account will be credited.
The rules given above are summarised below:
(i) Increases in assets are debits; decreases are credits;
(ii) Increases in liabilities are credits; decreases are debits;
(iii) Increases in owner’s capital are credits; decreases are debits;

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7 ACCOUNTING PROCESS 2.7

(iv) Increases in expenses are debits; decreases are credits; and

(v) Increases in revenue or incomes are credits; decreases are debits.
The terms debit and credit should not be taken to mean, respectively, favourable and unfavourable things. They
merely describe the two sides of accounts.

ILLUSTRATION 1

Following are the transactions entered into by R after he started his business. Show how various accounts will
be affected by these transactions:

2020 April (` in 000)

1. R started business with 5,000
2. He purchased furniture for 1,200
3. Paid salary to his clerk 1,100
4. Paid rent 1,150
5. Received interest 2,000

SOLUTION

2020 Explanation Accounts Nature of How Debit Credit

April Involved Accounts affected (` in 000) (` in 000)
1. ` 5,000 cash Bank and R’s Asset Increased 5,000
invested in business Capital Capital Increased 5,000
2. Purchased furniture Furniture and Asset Increased 1,200
for ` 1,200 Bank Asset Decreased 1,200
3. Paid ` 1,100 to Salary & Bank Expense Increased 1,100
employee for salary Asset Decreased 1,100
4. Paid Rent ` 1,150 Rent & Bank Expense Increased 1,150
Asset Decreased 1,150
5. Received interest Cash & Interest Asset Increased 2,000
` 2,000 Income Increased 2,000

1.5 TRANSACTIONS
In the system of book-keeping, students can notice that transactions are recorded in the books of accounts. A
transaction is a type of event, which is generally external in nature and can be determined in terms of money. In
an accounting period, every business has huge number of transactions which are analysed in financial terms and
then recorded individually, followed by classification and summarisation process, to know their impact on the
financial statements. A transaction is a two way process in which value is transferred from one party to another.
In it either a party receives a value in terms of goods etc. and passes the value in terms of money or vice versa.
Therefore, one can easily make out that in a transaction, a party receives as well as passes the value to other

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2.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

party. For recording transaction it is very important that they are supported by a substantial document like
purchasing invoices, bills, pay-slips, cash-memos, passbook etc.
Transactions analysed in terms of money and supported by proper documents are recorded in the books of
accounts under double entry system. To analyse the dual aspect of each transaction, two approaches can be
followed:
(1) Accounting Equation Approach.
(2) Traditional Approach.

1.6 ACCOUNTING EQUATION APPROACH

The relationship of assets with that of liabilities and owners’ equity in the equation form is known as ‘Accounting
Equation’. Basic accounting equation comes into picture when sum total of capital and liabilities equalises assets,
where assets are what the business owns and capital and liabilities are what the business owes. Under double
entry system, every business transaction has two-fold effect on the business enterprise where each transaction
affects changes in assets, liabilities or capital in such a way that an accounting equation is completed and
equated. This accounting equation holds good at all points of time and for any number of transactions and events
except when there are errors in accounting process.
Let us suppose that an individual started business by contributing ` 50,00,000 and taking loan of `10,00,000
from a bank to be repayable, after 5 years. He purchased furniture costing ` 10,00,000, and merchandise worth
` 50,00,000. For purchasing the merchandise he paid ` 40,00,000 to the suppliers and agreed to pay balance
after 3 months. Assume that all these transactions and events occurred at to, base point of time.
The contribution by the owner is termed as capital; the borrowings are termed as loans or liabilities. Whenever
the loan is repayable in the short-run, say within one year, it is called short-term loan or liability. On the other
hand, if the loan is repayable within say 4 or 5 years or more, it would be termed as long term loan or liability.
Some other short-term liabilities relating to credit purchase of merchandise are popularly called as trade
payables, and for other purchases and services received on credit as expense payables. These short-term
liabilities are also termed as current liabilities.
On the other hand, money raised has been invested in two types of assets–fixed assets and current assets.
Furniture is a fixed asset, if it lasts long, say more than one year, and has utility to the business, while inventory
and cash balance will not remain fixed for long as soon as the business starts to roll-these are current assets.
Often the owner’s claim or fund in the business is called equity. Owner’s claim implies capital invested plus any
profit earned minus any loss sustained.
Now at to we have an equation:
Equity + Liabilities = Assets
or, Equity + Long-Term Liabilities = Fixed Assets + Current Assets - Current Liabilities

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9 ACCOUNTING PROCESS 2.9

Check : L.H.S. (` in ‘000)

Equity ` 5,000
Long–term Liabilities ` 1,000
Current Liabilities ` 1,000
` 7,000
R.H.S.
Fixed Assets:
Furniture ` 1,000
Current Assets:
Inventory ` 5,000
Cash ` 1,000
` 7,000

Cash = Capital + Loan - Furniture - Payment to Trade payables (`’ 000 )

= ` 5,000 + ` 1,000 - ` 1,000 - ` 4,000 = ` 1,000
Let us use E0, L0 and A0 to mean Equity, Liabilities and Assets respectively at t0. Thus the basic accounting
equation becomes
E0 + L0 = A0
or E0 = A0 - L0 ...(Eq. 1)
(`’ 000 )
Now, let us suppose that at the end of period inventory valuing ` 2,500 is in hand, cash
` 2,000; trade payables ` 500; bank loan ` 1,000 (interest was properly paid); furniture ` 800
(` 200 is taken as loss of value due to use). So at t1 -

Assets: (`’ 000)

Fixed assets/ Furniture ` 800
Current assets/ inventory ` 2,500
Cash ` 2,000
(A1) ` 5,300
Liabilities:
Long-term Liabilities ` 1,000
Current Liabilities ` 500
(L1) ` 1,500
Equity (A1 - L1) ` 3,800

© The Institute of Chartered Accountants of India

2.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

Equity = Assets - Liabilities

i.e., E1 = A1 - L1
or E1 + L1 = A1 ...(Eq. 2)
Let us compare E1 with E0. Equity is reduced by ` 12,00,000 (50,00,000 - 38,00,000). Reduction in equity is
termed as loss.
Since the business sustained loss during the period, E1 becomes less than E0.
E1< E0 implies loss during t01
Similarly, E2< E1 implies loss during t12 and so on.
On the other hand, E1> E0 implies profit earned by business during t01, E2> E1 implies profit earned during t12 and
so on.
So if En> En-1, in general terms, equity has increased, while En< En-1 implies that equity has declined. Increase
in equity is termed as profit while decrease in equity is termed as loss.

ILLUSTRATION 2

Develop the accounting equation from following information available at the beginning of accounting period:
Particulars (` in ‘000)
Capital 51,000
Loan 11,500
Trade payables 5,700
Fixed Assets 12,800
Inventory 22,600
Trade receivables 17,500
Cash and Bank 15,300

At the end of the accounting period the balances appear as follows:

`
Capital ?
Loan 11,500
Trade payables 5,800
Fixed Assets 12,720
Inventory 22,900
Trade receivables 17,500
Cash at Bank 15,600

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11 ACCOUNTING PROCESS 2.11

(a) Reset the equation and find out profit.

(b) Prepare Balance Sheet at the end of the accounting period.
(All the figures in solution are in ‘000)

SOLUTION

(a) Accounting equation is given by

Equity + Liabilities = Assets
Let us use E0, L0 and A0 to mean equity, liabilities and assets respectively at the beginning of the
accounting period.
E0 = ` 51,000
L0 = Loan + Trade payables
= ` 11,500 + ` 5,700
= ` 17,200
A0 = Fixed Assets + Inventories + Trade receivables + Cash at Bank
= ` 12,800 + ` 22,600 + ` 17,500 + ` 15,300
= ` 68,200
So, at the beginning of accounting period
E0 + L 0 = A0
i.e., ` 51,000 + ` 17,200 = ` 68,200
Let us use E1, L1, A1 to mean equity, liabilities and assets respectively at the end of the accounting
period.
L1 = Loan + Trade payables
= ` 11,500 + ` 5,800
= ` 17,300
A1 = Fixed Assets + Inventories + Trade receivables + Cash at Bank
= ` 12,720 + ` 22,900 + ` 17,500 + ` 15,600
= ` 68,720
E1 = A1 - L1 = ` 68,720 - ` 17,300 = ` 51,420
Profit = E1 - E0 = ` 51,420 - ` 51,000 = ` 420
(b) Balance Sheet
Liabilities ` ` Assets `
Capital Fixed Assets 12,720

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2.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

Balance 51,000 Inventories 22,900

Add: Profit 420 51,420 Trade receivables 17,500
Loan 11,500 Cash at Bank 15,600
Trade payables 5,800
68,720 68,720

ILLUSTRATION 3

Mr. Dravid. has provided following details related to his financials. Find out the missing figures:

Particulars (` in’000)
Profits carved during the year 5,000
Assets at the beginning of year A
Liabilities at the beginning of year 12,000
Assets at the end of the year B
Liabilities at the end of the year C
Closing capital 35,000
Total liabilities including capital at the end of the year 50,000

SOLUTION

Computing opening capital: (All figure in `’ 000 )

Closing capital - profits earned during the year
= 35,000 - 5,000
= 30,000
We also know:
Assets = liabilities + capital
Therefore, opening assets (A) = 12,000 + 30,000
= 42,000
Computation of liabilities at the end of the year:
Total liabilities including capital = 50,000
Less: closing capital = (35,000)
Liabilities at the end of the year (C) = 15,000
Also assets at the end of the year (B) = closing capital + liabilities at the end of the year
= 35,000 + 15,000 = 50,000

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13 ACCOUNTING PROCESS 2.13

1.7 TRADITIONAL APPROACH

Under traditional approach of recording transactions one should first understand the term debit and credit and
their rules. The term debit and credit have already been explained in para 1.4 of this Unit.
Transactions in the journal are recorded on the basis of the rules of debit and credit only. For the purpose of
recording, these transactions are classified in three groups:
(i) Personal transactions.
(ii) Transactions related to assets and properties.
(iii) Transactions related to expenses, losses, income and gains.

1.7.1 Classification of Accounts

(i) Personal Accounts: Personal accounts relate to persons, trade receivables or trade payables. Example
would be the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a supplier of
goods. The capital account is the account of the proprietor and, therefore, it is also personal but
adjustment on account of profits and losses are made in it. This account is further classified into three
categories:
(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.
(b) Artificial (legal) personal accounts: For business purpose, business entities are treated to have
separate entity. They are recognised as persons in the eye of law for dealing with other persons.
For example: Government, Companies (private or limited), Clubs, Co-operative societies etc.
(c) Representative personal accounts: These are not in the name of any person or organisation but
are represented as personal accounts. For example: outstanding liability account or prepaid
account, capital account, drawings account.
(ii) Impersonal Accounts: Accounts which are not personal such as machinery account, cash account, rent
account etc. These can be further sub-divided as follows:
(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example, accounts
regarding land, building, investment, fixed deposits etc., are real accounts. Cash in hand and
Cash at the bank accounts are also real.
(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc. like salary
account, interest paid account, commission received account. The net result of all the nominal
accounts is reflected as profit or loss which is transferred to the capital account. Nominal
accounts are, therefore, temporary.

1.7.2 Golden Rules of Accounting

All the above classified accounts have two rules each, one related to Debit and one related to Credit for recording
the transactions which are termed as golden rules of accounting, as transactions are recorded on the basis of
double entry system.

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2.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

Types of Account Account to be Debited Account to be Credited

Personal Account Receiver Giver
Real Account What comes in What goes out
Nominal Account Expense and losses Income and gains

Example:-
From the following information, state the nature of account and state which account will be debited and which will
be credited.
1. Started business with a capital of ` 50,00,000.
2. Wages and salaries paid ` 50,000
3. Rent received ` 2,00,000
4. Purchased goods on credit ` 9,00,000
5. Sold goods for ` 8,16,000 and received payment in cheque.

SOLUTION

Transaction ACCOUNTS NATURE DEBIT OR CREDIT Journal Entry

INVOLVED
Started business Bank account Personal Debit (Receiver) Bank A/c Dr.
with capital of Capital account Personal Credit (giver) To Capital A/c
` 50,00,000
Wages and Wages/salaries Nominal Debit (expense) Wages/ Salaries Dr.
salaries paid Bank Personal Credit (giver) To Bank A/c
Rent received Bank Personal Debit (Receiver) Bank A/c Dr.
Rent Nominal Credit (income) To Rent A/c
Purchases made Purchases Nominal Debit (expense) Purchases A/c Dr.
on credit Creditor Personal Credit (giver) To Creditor A/c
Goods sold and Bank Personal Debit (Receiver) Bank A/c Dr.
payment received Sales Nominal Credit (gains) To Sales A/c
in cheque

1.8 MODERN CLASSIFICATION OF ACCOUNTS

Real, nominal and personal accounts is the traditional classification of accounts. Now, let us see the modern and
more acceptable classification of accounts:-

Types of account Normal balance of Account to be debited Account to be credited

account when there is: when there is:
Asset account Debit Increase Decrease

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15 ACCOUNTING PROCESS 2.15

Liabilities account Credit Decrease Increase

Capital account Credit Decrease Increase
Revenue account Credit Decrease Increase
Expenditure account Debit Increase Decrease
Withdraw account Debit Increase Decrease

Let us solve the same example with the modern approach now:-
Accounts involved Nature Debit/Credit Reason
Cash Asset Debit Increase
Capital Liability Credit Increase
Wages/salaries Expense Debit Increase
Cash Asset Credit Decrease
Cash Asset Debit Credit
Rent Revenue Credit Increase
Purchase Expense Debit Increase
Creditor Liability Credit Debit
Cash Asset Debit Increase
Sales Revenue Credit Increase

1.9 JOURNAL
Transactions are first entered in this book to show which accounts should be debited and which credited. Journal
is also called subsidiary book. Recording of transactions in journal is termed as journalizing the entries. It is the
book of original entry in which transactions are entered on a daily basis in a chronological order.

1.9.1 Journalising Process

All transactions may be first recorded in the journal as and when they occur; the record is chronological; otherwise
it would be difficult to maintain the records in an orderly manner. Debits and credits are listed along with the
appropriate explanations. There are basically two types of journals:-
1. General journal
2. Specialized journal
The latter is used when there are many repetitive transactions of the same nature. The form of the journal
is given below:

© The Institute of Chartered Accountants of India

2.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

JOURNAL

Dr. Cr.
Date Particulars L.F. Amount Amount
` ` ` `
(1) (2) (3) (4) (5)

The columns have been numbered only to make clear the following but otherwise they are not numbered. The
following points should be noted:
(i) In the first column the date of the transaction is entered-the year is written at the top, then the month
and in the narrow part of the column the particular date is entered.
(ii) In the second column, the names of the accounts involved are written; first the account to be debited,
with the word “Dr” written towards the end of the column. In the next line, after leaving a little space, the
name of the account to be credited is written preceded by the word “To” (the modern practice shows
inclination towards omitting “Dr.” and “To”). Then in the next line the explanation for the entry together
with necessary details is given-this is called narration.
(iii) In the third column the number of the page in the ledger on which the account is written up is entered.
(iv) In the fourth column the amounts to be debited to the various accounts concerned are entered.
(v) In the fifth column, the amount to be credited to various accounts is entered.

1.9.2 Points to be taken into care while recording a Transaction in the Journal
1. Journal entries can be single entry (i.e. one debit and one credit) or compound entry (i.e. one debit and
two or more credits or two or more debits and one credit or two or more debits and credits). In such
cases, it is important to check that the total of both debits and credits are equal.
2. If journal entries are recorded in several pages then both the amount column of each page should be
totalled and the balance should be written at the end of that page and also that the same total should be
carried forward at the beginning of the next page.
An entry in the journal may appear as follows:
` `
May 5 Bank Account Dr. 14,50,000
To Mohan 14,50,000
(Being the amount received from Mohan
in payment of the amount due from him)

We will now consider some individual transactions.

(i) Mohan commences business with ` 50,00,000 in his bank account. This means that the firm has
` 50,00,000 in bank. According to the rules given above, the increase in an asset has to be debited to
it. The firm also now owes ` 50,00,000 to the proprietor, Mohan as capital. The rule given above also
shows that the increase in capital should be credited to it. Therefore, the journal entry will be:

© The Institute of Chartered Accountants of India

17 ACCOUNTING PROCESS 2.17

Bank Account Dr. ` 50,00,000

To Capital Account ` 50,00,000
(Being capital introduced by Shri Mohan)

(ii) Out of the above, ` 25,000 is withdrawn from the bank. By this transaction the bank balance is reduced
by ` 25,000 and another asset, cash account, comes into existence. Since increase in assets is debited
and decrease is credited, the journal entry will be:

Cash Account Dr. ` 25,000

To Bank Account ` 25,000
(Being cash deposited in Bank)
(iii) Furniture is purchased for ` 12,00,000. Applying the same reasoning as above the entry will be:

Furniture Account Dr. ` 12,00,000

To Bank Account ` 12,00,000
(Being Furniture purchased vide CM No....)
(iv) Purchased goods for cash ` 4,00,000. The student can see that the required entry is:

Purchases Account Dr. ` 4,00,000

To Bank Account ` 4,00,000
(Being goods purchased vide CM No....)

(v) Purchased goods for ` 10,00,000 on credit from M/s Ram Narain Bros. Purchase of merchandise is an
expense item so it is to be debited. ` 10,00,000 is now owing to the supplier; his account should therefore
be credited, since the amount of liabilities has increased. The entry will be:

Purchases Account Dr. ` 10,00,000

To M/s Ram Narain Bros. ` 10,00,000
(Being goods purchased vide Bill No.....)

(vi) Sold goods to M/s Ram & Co. for ` 6,00,000. Amount is received in cheque. The amount of bank
increases and therefore, the bank amount should be debited; sale of merchandise is revenue item so it
is to be credited. The entry will be:

Bank Account Dr. ` 6,00,000

To Sales Account ` 6,00,000
(Being goods sold vide CM No....)

(vii) Sold goods to Ramesh on credit for ` 13,00,000. The Inventories of goods has decreased and therefore,
the goods account has to be credited. Ramesh now owes ` 13,00,000; that is an asset and therefore,
Ramesh should be debited. The entry is:

© The Institute of Chartered Accountants of India

2.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

Ramesh Dr. ` 13,00,000

To Sales Account ` 13,00,000
(Being goods sold vide Bill No....)
Note: There are two views on classification of “Purchase Account” and “Sales Account”. One view is
that they represents “flow of goods”, so they should be classified as ‘Real A/c’. However, others are of
the opinion that only nominal a/cs are closed by transferring to ‘Trading or Profit and Loss A/c’. Therefore,
purchases and sales shall be classified as Nominal A/cs. However, in both the views, there will be debit
balance of Purchase A/c and credit balance of Sales A/c.
(viii) Received cheque from Ramesh ` 13,00,000. The amount of bank increased therefore the bank account
has to be debited. Ramesh’s liability towards firm has decreased infact in this case he no longer owes
any amount to the firm, i.e., this particular form of assets has disappeared; therefore, the account of
Ramesh should be credited. The entry is:

Bank Account Dr. ` 13,00,000

To Ramesh ` 13,00,000
(Being cash received against Bill No....)
(x) Paid rent ` 1,00,000. The bank balance has decreased and therefore, the bank account should be
credited. No asset has come into existence because the payment is for services enjoyed and is an
expense. Expenses are debited. Therefore, the entry should be:

Rent Account Dr. ` 1,00,000

To Bank Account ` 1,00,000
(Being rent paid for the month of .......)
(xi) Paid ` 22,000 to the clerk as salary. Applying the reasons given in (x) above, the required entry is:
Salary Account Dr. ` 22,000
To Bank Account ` 22,000
(Being salary paid to Mr..... for the month of ...........)
(xii) Received ` 2,20,000 interest. The bank account should be debited since there is an increase in the bank
balance. There is no increase in any liability; since the amount is not returnable to any one, the amount
is an income, incomes are credited. The entry is :

Bank Account Dr. ` 2,20,000

To Interest Account ` 2,20,000
(Being interest received from………for the period ............)

When transactions of similar nature take place on the same date, they may be combined while they are
journalised. For example, entries (x) and (xi) may be combined as follows:

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19 ACCOUNTING PROCESS 2.19

Rent Account Dr. ` 1,00,000

Salary Account Dr. ` 22,000
To Bank Account ` 1,22,000
(Being expenses done as per detail attached)

When journal entry for two or more transactions are combined, it is called composite journal entry.
Usually, the transactions in a firm are so numerous that to record the transactions for a month will require
many pages in the journal. At the bottom of one page the totals of the two columns are written together
with the words “Carried forward” in the particulars column. The next page is started with the respective
totals in the two columns with the words “Brought forward” in the particulars column.

ILLUSTRATION 4

Analyse transactions of M/s Sahil & Co. for the month of March, 2020 on the basis of double entry system by
adopting the following approaches:
(A) Accounting Equation Approach.
(B) Traditional Approach.
Transactions for the month of March, 2020 were as follows (figures are in ‘000):
1. Sahil introduced capital through bank of ` 4,000.
2. Cash withdrawn from the City Bank ` 200.
3. Loan of ` 500 taken from Mr. Y.
4. Salaries paid for the month of March, 2020, ` 300 and ` 100 is still payable for the month of
March, 2020.
5. Furniture purchased ` 500.
Required
What conclusions one can draw from the above analysis?

SOLUTION

(A) Analysis of Business Transaction: Accounting Equation Approach

The accounting equation is
Assets = Liabilities + Capital
(` in ‘000)

ASSETS = CAPITAL + LIABILITIES

CASH + BANK + FURNITURE = CAPITAL + LIABILITIES
(a) - + 4,000 + - = 4,000 + -
(b) +200 + -200 + - = - + -

© The Institute of Chartered Accountants of India

2.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

(c) - + 500 + - = - + 500

(d) - + -300 + - = -400 + 100
(e) - + -500 + 500 = - + -
Balance 200 + 3,500 + 500 = 3,600 + 600
4,200 4,200

(B) Analysis of Business Transactions: Traditional Approach

Transaction Analysis Account Rule Entry
Affected
and Nature of
Account
Introduction of Bank has received Bank–Personal Debit the receiver Debit Bank
` 4,000 through the money; Owner Capital–Personal Credit the giver Credit Capital
bank by the has given Bank
proprietor balance
Cash Withdrawn Cash comes into Cash–Real Debit what Debit Cash
from Bank Rs. business; Bank Bank–Personal comes in Credit Credit Bank
200 gives out cash the giver
Loan from Y Bank receives the Bank–Personal Debit the receiver Debit Bank
` 500 amount :Y pays Y’s Loan– Credit the giver Credit Y’s Loan
through bank Personal
Salary paid Cost of services Salary Nominal Debit all Debit Salary
` 300 and still used ` 400; Bank Bank–Personal expenses (` 400)
payable gives out `300; Salary Credit the giver Credit Bank
` 100 Still payable or Outstanding- Credit the giver (`3,00)
outstanding for Personal Credit Salary
services received outstanding
` 100 (` 100)
Furniture Furniture is Furniture Real Debit what Debit Furniture
purchased purchased; Bank–Personal comes in Credit Credit Bank
` 500 Bank gives out the giver
money

Conclusion:
It is evident from above analysis that procedure for analysis of transactions, classification of accounts and rules
for recording business transactions under accounting equation approach and traditional approach are different.
But the accounts affected and entries in affected accounts remain same under both approaches. Thus, the
recording of transactions in affected accounts on the basis of double entry system is independent of the method
of analysis followed by a business enterprise. In other words, accounts to be debited and credited to record the
dual aspect remain same under both the approaches.

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21 ACCOUNTING PROCESS 2.21

ILLUSTRATION 5

Journalise the following transactions. Also state the nature of each account involved in the Journal entry.
Following figures are given in (‘00)
1. December 1, 2020, Ajit started business with capital ` 4,00,000
2. December 3, he withdrew cash for business from the Bank ` 2,000.
3. December 5, he purchased goods making payment through bank` 15,000.
4. December 8, he sold goods` 16,000 and received payment through bank.
5. December 10, he purchased furniture and paid by cheque ` 2,500.
6. December 12, he sold goods to Arvind ` 2,400.
7. December 14, he purchased goods from Amrit ` 10,000.
8. December 15, he returned goods to Amrit ` 500.
9. December 16, he received from Arvind ` 2,300 in full settlement.
10. December 18, he withdrew goods for personal use ` 1,000.
11. December 20, he withdrew cash from business for personal use ` 2,000.
12. December 24, he paid telephone charges ` 110.
13. December 26, amount paid to Amrit in full settlement ` 9,450.
14. December 31, paid for stationery ` 200, rent `5,000 and salaries to staff ` 2,000.
15. December 31, goods distributed by way of free samples ` 2,000.

SOLUTION

JOURNAL (` in ‘00)
Dr. Cr.
Sl. Date Particulars Nature of L.F. Debit Credit
No Account (`) (`)
1. Dec. 1 Bank Account Dr. Personal A/c 4,00,000
To Capital Account Personal A/c 4,00,000
(Being commencement of
business)
2. Dec. 3 Cash Account Dr. Real A/c 2,000
To Bank Account Personal A/c 2,000
(Being cash withdrawn from
the Bank)
3. Dec. 5 Purchases Account Dr. Real A/c 15,000

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2.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

To Bank Account Personal A/c 15,000

(Being purchase of goods
for cash)
4. Dec. 8 Bank Account Dr. Personal A/c 16,000
To Sales Account Real A/c 16,000
(Being goods sold for cash)
5. Dec. 10 Furniture Account Dr. Real A/c 2,500
To Bank Account Personal A/c 2,500
(Being purchase of
furniture, paid by cheque)
6. Dec. 12 Arvind Dr. Personal A/c 2,400
To Sales Account Real A/c 2,400
(Being sale of goods)
7. Dec. 14 Purchases Account Dr. Real A/c 10,000
To Amrit Personal A/c 10,000
(Being purchase of goods
from Amrit)
8. Dec. 15 Amrit Dr. Personal A/c 500
To Purchases Returns Real A/c 500
Account
(Being goods returned to
Amrit)
9. Dec. 16 Bank Account Dr. Personal A/c 2,300
Discount Account Dr. Nominal A/c 100
To Arvind Personal A/c 2,400
(Being cash received from
Arvind in full settlement and
allowed him ` 100 as
discount)
10. Dec. 18 Drawings Account Dr. Personal A/c 1,000
To Purchases Account Real A/c 1,000
(Being withdrawal of goods
for personal use)
11. Dec. 20 Drawings Account Dr. Personal A/c 2,000
To Cash Account Real A/c 2,000
(Being cash withdrawal
from the business for
personal use)

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23 ACCOUNTING PROCESS 2.23

12. Dec. 24 Telephone Expenses Dr. Nominal A/c 110

Account
To Bank Account Personal A/c 110
(Being telephone expenses
paid)
13. Dec 26 Amrit Dr. Personal A/c 9,500
To Bank Account Personal A/c 9,450
To Discount Account Nominal A/c 50
(Being cash paid to Amrit
and he allowed ` 50 as
discount)
14. Dec. 31 Stationery Expenses Dr. Nominal A/c 200
Rent Account Dr. Nominal A/c 5,000
Salaries Account Dr. Nominal A/c 2,000
To Bank Account Personal A/c 7,200
(Being expenses paid)
15. Dec. 31 Advertisement Expenses Dr. Nominal A/c 2,000
Account
To Purchases Account Real A/c 2,000
(Being distribution of goods
by way of free samples)

ILLUSTRATION 6

Show the classification of the following Accounts under traditional and accounting equation approach:
(a) Building; (b) Purchases; (c) Sales; (d) Bank Fixed Deposit; (e) Rent; (f) Rent Outstanding; (g) Cash; (h)
Adjusted Purchases; (i) Closing Inventory; (j) Investments; (k) Trade receivables; (l) Sales Tax Payable, (m)
Discount Allowed; (n) Bad Debts; (o) Capital; (p) Drawings; (q) Interest Receivable account; (r) Rent received in
advance account; (s) Prepaid salary account; (t) Bad debts recovered account; (u) Depreciation account, (v)
Personal income-tax account.

SOLUTION

Nature of Account
Sl. Title of Account Traditional Approach Accounting Equation Approach
No.
(a) Building Real Asset
(b) Purchases Real* Asset
(c) Sales Real* Revenue
(d) Bank Fixed Deposit Personal Asset
(e) Rent Nominal (Expense) Expense

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2.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

(f) Rent Outstanding Personal Liability

(g) Cash Real Asset
(h) Adjusted Purchases Nominal (Expense) Expense
(i) Closing Inventory Real Asset
(j) Investment Real Asset
(k) Trade receivables Personal Asset
(l) Sales Tax Payable Personal Liability
(m) Discount Allowed Nominal (Expense) Temporary Capital (Expense)
(n) Bad Debts Nominal (Expense) Temporary Capital (Expense)
(o) Capital Personal Capital
(p) Drawings Personal Temporary Capital (Drawings)
(q) Interest receivable Personal Asset
(r) Rent received in advance Personal Liability
(s) Prepaid salary Personal Asset
(t) Bad debts recovered Nominal (Gain) Temporary Capital (Gain)
(u) Depreciation Nominal (Expense) Temporary Capital (Expense)
(v) Personal Income Tax Personal (Drawing) Temporary Capital (Drawings)

* In present senerio, purchases and sales are considered as nominal accounts.

ILLUSTRATION 7

Transactions of Ramesh for April are given below. Journalise them.

2020 `
April 1 Ramesh started business with 10,00,000
“ 3 Bought goods for cash 50,000
“ 5 Drew cash from bank 10,000
“ 13 Sold to Krishna- goods on credit 1,50,000
“ 20 Bought from Shyam goods on credit 2,25,000
“ 24 Received from Krishna 1,45,000
“ Allowed him discount 5,000
“ 28 Paid Shyam cash 2,15,000
“ Discount allowed 10,000
“ 30 Cash sales for the month 8,00,000
Paid Rent 50,000
Paid Salary 1,00,000

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25 ACCOUNTING PROCESS 2.25

SOLUTION

JOURNAL
Date Particulars L.F. Amount Amount
2020 (Dr.) (Cr.)
April 1 Bank Account Dr. 1 10,00,000
To Capital Account 4 10,00,000
(Being the amount invested by Ramesh in
the business as capital)
“3 Purchases Account Dr. 7 50,000
To Bank Account 1 50,000
(Being goods purchased for cash)
“5 Cash Account Dr. 5 10,000
To Bank Account 1 10,000
(Being cash withdrawn from bank)
“ 13 Krishna Dr. 9 1,50,000
To Sales Account 11 1,50,000
(Being goods sold to Krishna on credit)
“ 20 Purchases Account Dr. 7 2,25,000
To Shyam 10 2,25,000
(Being goods bought from Shyam on credit)
“ 24 Bank Account Dr. 1 1,45,000
Discount Account Dr. 12 5,000
To Krishna 9 1,50,000
(Being cash received from Krishna and
discount allowed to him)
“ 28 Shyam Dr. 10 2,25,000
To Bank Account 1 2,15,000
To Discount Account 12 10,000
(Being cash paid to Shyam and discount
allowed by him)
“ 30 Bank Account Dr. 1 8,00,000
To Sales Account 11 8,00,000
(Being goods sold for cash)

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2.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

“ 30 Rent Account Dr. 15 50,000

Salaries Account Dr. 14 1,00,000
To Bank Account 1 1,50,000
(Being the amount paid for rent and salary)
Total 27,60,000 27,60,000
(Ledger Folio imaginary)

1.10 ADVANTAGES OF JOURNAL

In journal, transactions recorded on the basis of double entry system, fetch following advantages:
1. As transactions are recorded on chronological order, one can get complete information about the
business transactions on time basis.
2. Entries recorded in the journal are supported by a note termed as narration, which is a precise
explanation of the transaction for the proper understanding of the entry. One can know the correctness
of the entry through these narrations.
3. Journal forms the basis for posting the entries in the ledger. This eases the accountant in their work and
reduces the chances of error.

SUMMARY
♦ The accounting process starts with the recording of transactions in the form of journal entries.
♦ The recording is based on double entry system. This book or register called journal is the book of first
or original entry.
♦ Next step is to post the entries in the ledger covered in the next unit.

TEST YOUR KNOWLEDGE

True and False
1. In accounting equation approach, equity + Long-term liabilities = fixed asset + current assets – current
liabilities.
2. In the traditional approach a debtor becomes receiver.
3. The rule of nominal account states that all expenses & losses are recorded on credit side.
4. Journal proper is also called a subsidiary book.
5. Capital account has a debit balance.
6. Purchase account is a nominal account.
7. All the personal & real account are recorded in P&L A/c.
8. Asset side of balance sheet contains all the personal & nominal accounts.

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27 ACCOUNTING PROCESS 2.27

9. Capital account is a personal account.

10. Journal is also known as the book of original entry.

Multiple Choice Question

1. The rent paid to landlord is credited to
(a) Landlord’s account.
(b) Rent account.
(c) Cash account.
2. In case of a debt becoming bad, the amount should be credited to
(a) Trade receivables account.
(b) Bad debts account.
(c) Cash account.
3. A Ltd. has a ` 35,000 account receivable from Mohan. On January 20, Mohan makes a partial payment
of ` 21,000 to A Ltd. The journal entry made on January 20 by A Ltd. to record this transaction includes:
(a) A credit to the cash received account of ` 21,000.
(b) A credit to the Accounts receivable account of ` 21,000.
(c) A debit to the cash account of ` 14,000.
4. Which financial statement represents the accounting equation -
Assets = Liabilities + Owner’s equity:
(a) Income Statement
(b) Statement of Cash flows
(c) Balance Sheet.
5. Which account is the odd one out?
(a) Office furniture & Equipment.
(b) Freehold land and Buildings.
(c) Inventory of materials.
6. The debts written off as bad, if recovered subsequently are
(a) Credited to Bad Debts Recovered Account
(b) Credited to Trade receivables Account.
(c) Debited to Profit and Loss Account.
7. In Double Entry System of Book-keeping every business transaction affects:
(a) Two accounts

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2.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) Two sides of the same account.

(c) The same account on two different dates.
8. A sale of goods to Ram for cash should be debited to:
(a) Ram
(b) Cash
(c) Sales

Theory Questions
1. Write short note on classification of accounts.
2. Distinguish between Real account and nominal account.

Practical Questions
1. Show the classification of the following Accounts under traditional and accounting equation approach:
a Rent outstanding g Capital
b Closing Inventory h Sales Tax Payable
c Sales i Trade receivables
d Bank Fixed Deposit j Depreciation
e Cash k Drawings
f Bad Debts

2. Pass Journal Entries for the following transactions in the books of Gamma Bros.
(i) Employees had taken inventory worth ` 1,00,000 (Cost price ` 75,000) on the eve of Deepawali
and the same was deducted from their salaries in the subsequent month.
(ii) Wages paid for erection of Machinery ` 18,000.
(iii) Income tax liability of proprietor ` 1,17000 was paid out of petty cash.
(iv) Purchase of goods from Naveen of the list price of ` 2,00,000. He allowed 10% trade discount,
` 5,000 cash discount was also allowed for quick payment.
3. Calculate the missing amount for the following.
Assets Liabilities Capital
(a) 15,00,000 2,50,000 ?
(b) ? 1,50,000 75,000
(c) 14,50,000 ? 13,75,000
(d) 57,00,000 - 2,80,000 ?

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29 ACCOUNTING PROCESS 2.29

4. Show the effect of increase = (+), decrease = (-) and no change=(0) on the assets of the following
transactions:
a. Purchased office furniture, payment to be made next month.
b. Collected cash for repair services
c. Goods sold on credit.
d. Withdrawal of cash by the owner for personal use.
e. Hired an employee as sales manager of the north wing.
f. Returned goods worth ` 50,000.
g. One of our debtor agreed to pay his dues to Mr. C who is a creditor of the company with the
same amount being due to him.
h. Entered into an agreement with Mehta & Co. to purchase all raw materials from their company
from next year.
Also give reasons for your answers.
5. Following is the information provided by Mr. Gopi pertaining to year ended 31st March 2019. Find the
unknowns, showing computation to support your answer:
Particulars ` Particulars `
Machinery 12,00,000 Trade Receivables B
Accounts Payable 1,00,000 Loans C
Inventory 60,000 Closing Capital D
Total Liabilities including capital 14,15,000 Opening Capital 10,00,000
Cash A Loss incurred during the year 35,000
Bank 80,000 Capital Introduced during the year 1,00,000
Additional Information: During the year sales of ` 15,55,000 was made of which ` 15,00,000 have
been received.

ANSWERS/HINTS
True and False
1. True: As per the modern accounting equation approach- it is the basic formula in the accounting process
2. False: In the traditional approach a debtor becomes giver.
3. False: The rule of nominal account states that all expenses & losses are recorded on debit side.
4. True: It is one of the book where in the transactions not entered in the other books are entered in this
book.

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2.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. False: Capital account has a credit balance.

6. True: As it is considered as an expense.
7. False: All the personal & real account are recorded in balance sheet.
8. False: Asset side of balance sheet contains all the personal & real accounts.
9. True: As it is in the name of the proprietor who is bringing in the capital to the business.
10. True: As the transactions are entered first in this book as a first hand record.

Multiple Choice Questions

1. (c) 2. (a) 3. (b) 4. (c) 5. (c) 6. (a) 7. (a) 8. (b)

Theoretical Questions
1 a. Accounts are broadly classified into assets, liabilities and capital. The basic accounting equation
specifies broad categories, which are as follows:
(i) Assets: These are resources controlled by the enterprise as a result of past events
and from which future economic benefits are expected to flow to the enterprise,
namely cash, stock of goods, land, buildings, machinery etc.
(ii) Liabilities: These are financial obligations of an enterprise other than owner’s equity
namely long term loans, creditors, outstanding expenses etc.
(iii) Capital: It generally refer to the amounts invested in an enterprise by its owner(s),
the accretion to it or a reduction in it. Since capital is affected by expenses and
incomes of revenue nature, there are two more categories of accounts, namely
expenses and incomes. The difference between incomes and expenses are taken
into capital account.
 Expenses: These represents those accounts which show the amount spent
or even lost in carrying on operations.
 Incomes: These represent those accounts which show the revenue amounts
earned by the enterprise.
However, traditionally accounts are classified as follows:
(i) Personal Accounts: These accounts relate to persons, institutions, debtors or
creditors.
(ii) Impersonal Accounts: These represent accounts which are not personal. These can
be further sub-divided as follows:
 Real Accounts: These accounts relate to assets of the firm but not debt e.g.
accounts relating to land, buildings, cash in hand etc.
 Nominal accounts: These accounts relate to expenses, losses, gains,
revenues etc.

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31 ACCOUNTING PROCESS 2.31

2. A real account is an account relating to properties and assets, other than personal accounts of the firm.
Examples are land, buildings, machinery, cash, investments etc. Nominal accounts relate to expenses
or losses, incomes and gains. Examples are: wages, salaries, rent, depreciation etc. The net result of
all the nominal accounts is reflected as profit or loss which is transferred to the capital account. Nominal
accounts are therefore, temporary. The real accounts are shown in the balance sheet along with personal
accounts.

Practical Problems
Answer 1
Nature of Account

Sl. No. Title of Account Traditional Approach Accounting Equation Approach

a Rent Outstanding Personal Liability
b Closing Inventory Real Asset
c Sales Nominal Revenue
d Bank Fixed Deposit Personal Asset
e Cash Real Asset
f Bad Debts Nominal (Expense) Temporary Capital (Expense)
g Capital Personal Capital
h Sales Tax Payable Personal Liability
i Trade receivables Personal Asset
j Depreciation Nominal (Expense) Temporary Capital (Expense)
k Drawings Personal Temporary Capital (Drawings)

Answer 2
Journal Entries in the books of Gamma Bros.
Particulars Dr. Cr.
Amount Amount
` `
(i) Salaries A/c Dr. 75,000
To Purchase A/c 75,000
(Being entry made for inventory taken by employees)
(ii) Machinery A/c Dr. 18,000
To Bank/Cash A/c 18,000
(Being wages paid for erection of machinery)
(iii) Drawings A/c Dr. 1,17,000

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2.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

To Petty Cash A/c 1,17,000

(Being the income tax of proprietor paid out of
business money)
(iv) Purchase A/c Dr. 1,80,000
To Naveen A/c 1,80,000
(Being goods purchased from Naveen)
Naveen A/c Dr. 1,80,000
To Cash 1,75,000
To Discount Received A/c 5,000
(Being cash received from the goods purchased from
Naveen for ` 2,00,000. 10% trade discount and cash
discount of ` 5,000 allowed to him)
Note:
i. Here wages paid on erection of machinery have been capitalised therefore machinery account has been
debited directly instead of wages being recorded as an expenditure.
ii. The students may also note that trade discount is allowed on the list price of goods. It is deducted to find
out the invoice amount of the goods to be recorded in the books. Cash discount is a discount allowed in
case of early payments to the seller. The entry is made in the books of accounts for cash discount.
Answer 3
(a) 12,50,000
(b) 2,25,000
(c) 75,000
(d) 59,80,000
These have been solved using the Accounting Equation:
Assets = Capital + Liabilities
Answer 4
S.No. Increase (+) / Reasons
Decrease (-) /
No Change (0)
in Assets
(a) Furniture has been purchased making it an increase in assets and also it being
+ purchased on credit it increases liability and there is no outflow of assets like
cash or bank.
(b) + Cash has flowed in for services provided making it an increase in assets.
(c) + Here with goods sold there is a decrease in inventory (assets) but given there
is an increase in debtors there will be a net increase in assets.

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33 ACCOUNTING PROCESS 2.33

Though if goods are sold at cost it will result in no change whereas sale at
below cost will result in decrease in assets.
(d) - Here cash has been withdrawn from business resulting in decrease in assets
and capital.
(e) 0 Only hiring of employee has been done resulting in no change in assets.
(f) - Outflow of goods has resulted in decrease in assets while money owed to
creditors reduce on the liability side.
(g) - Here both assets and liabilities reduce by same amounts meaning a decrease
in assets.
(h) 0 Only a purchase agreement has been entered into with no transaction taking
place yet.
Answer 5
Trade Receivable Balance (B) = Sales- Amount received during the year
= ` (15,55,000 - 15,00,000)
= ` 55,000.
Since, we know Assets = Capital + Liabilities
Therefore, balance of assets is also ` 14,15,000
So, total assets:

Particulars `
Total Assets 14,15,000
Less: Machinery (12,00,000)
Less: Inventory (60,000)
Less: Bank (80,000)
Less: Receivables (55,000)
Cash (A) 20,000

Computation of Closing Capital (D):

Particulars `
Opening Capital 10,00,000
Add: Introduced during the year 1,00,000
Less: Loss incurred during the year (35,000)
Closing Capital 10,65,000

So, Loan amount (C) = Total Liabilities and capital - Closing Capital - Trade Payables
= ` (14,15,000 - 10,65,000 - 1,00,000)
= ` 2,50,000

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2.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 2 : LEDGERS

LEARNING OUTCOMES

After studying this unit, you would be able to:

 Understand the concept of Ledgers.
 Learn the technique of ledger posting and how to balance an account.
 Learn the technique of opening accounts each year taking closing balances of the
previous year. Note also the use of ‘balance c/d’ and ‘balance b/d’

UNIT OVERVIEW

2.1 INTRODUCTION
After recording the transactions in the journal, recorded entries are classified and grouped into by preparation of
accounts. The book which contains all set of accounts (viz. personal, real and nominal accounts), is known as
Ledger. It is known as principal books of account in which account-wise balance of each account is determined.

2.2 SPECIMEN OF LEDGER ACCOUNTS

A ledger account has two sides-debit (left part of the account) and credit (right part of the account). Each of the
debit and credit side has four columns. (i) Date (ii) Particulars (iii) Journal folio i.e. page from where the entries
are taken for posting and (iv) Amount.

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35 ACCOUNTING PROCESS 2.35

Dr. Account Cr.

Date Particulars J.F. Amount (`) Date Particulars J.F. Amount(`)

2.3 POSTING
The process of transferring the debit and credit items from journal to classified accounts in the ledger is known
as posting.

2.3.1 RULES REGARDING POSTING OF ENTRIES IN THE LEDGER

1. Separate account is opened in ledger book for each account and entries from ledger posted to respective
account accordingly.
2. It is a practice to use words ‘To’ and ‘By’ while posting transactions in the ledg er. The word ‘To’ is used
in the particular column with the accounts written on the debit side while ‘By’ is used with the accounts
written in the particular column of the credit side. These ‘To’ and ‘By’ do not have any meanings but are
used to the account debited and credited.
3. The concerned account debited in the journal should also be debited in the ledger but reference should
be of the respective credit account.

2.4 BALANCING AN ACCOUNT

At the end of the each month or year or any particular day it may be necessary to ascertain the balance in an
account. This is not a too difficult thing to do; suppose a person has bought goods worth `1,000 and has paid
only ` 850; he owes `150 and that is balance in his account. To ascertain the balance in any a ccount, what is
done is to total the sides and ascertain the difference; the difference is the balance. If the credit side is bigger
than the debit side, it is a credit balance. In the other case it is a debit balance. The credit balance is written on
the debit side as, “To Balance c/d”; c/d means “carried down”. By doing this, two sides will be equal. The totals
are written on the two sides opposite one another.
Then the credit balance is written on the credit side as “By balance b/d (i.e., brought down)”. This is the opening
balance for the new period. The debit balance similarly is written on the credit side as “By Balance c/d”, the totals
then are written on the two sides as shown above as then the debit balance written on the debit side as, “To
Balance b/d”, as the opening balance of the new period.
It should be noted that nominal accounts are not balanced; the balance in the end are transferred to the profit
and loss account. Only personal and real accounts ultimately show balances. In the illustrations given, you will
have notice that the capital account, the purchases account, sales account, the discount account, the rent account

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2.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

and the salary account have not been balanced. The capital account will have to be adjusted for profit or loss
and that is why it has not been balanced yet.

ILLUSTRATION 1

Prepare the Stationery Account of a firm for the year ended 31.12.2020 duly balanced off, from the following
details:
2020 `
Jan. 1 Inventory of stationery 480
April 5 Purchase of stationery by cheque 800
Nov. 15 Purchase of stationery on credit from Five Star Stationery Mart 1,280

SOLUTION

Dr. Stationery Account Cr.

Date Particulars ` Date Particulars `
1.1.2020 To Balance b/d 480 31.12.2020 By Balance c/d 2,560
5.4.2020 To Bank A/c 800
15.11.2020 To Five Star Stationery
Mart A/c 1,280
2,560 2,560
1.1.2021 To Balance b/d 2,560

ILLUSTRATION 2

Prepare the ledger accounts on the basis of following transactions in the books of a trader.
Debit Balances on January 1, 2020:
Cash in Hand ` 8,000, Cash at Bank ` 25,000, inventory of Goods ` 20,000, Building ` 10,000. Trade
receivables: Vijay ` 2,000 and Madhu ` 2,000.
Credit Balances on January 1, 2020:
Trade payables: Anand ` 5,000, Capital ` 55,000
Following were further transactions in the month of January, 2020:
Jan. 1 Purchased goods worth ` 5,000 (payable at later date) for cash less 20% trade discount and 5% cash
discount.
Jan. 4 Received ` 1,980 from Vijay and allowed him ` 20 as discount.
Jan. 8 Purchased plant from Mukesh for `5,000 and paid `100 as cartage for bringing the plant to the factory
and another `200 as installation charges.

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37 ACCOUNTING PROCESS 2.37

Jan. 12 Sold goods to Rahim on credit `600.

Jan. 15 Rahim became insolvent and could pay only 50 paise in a rupee.
Jan. 18 Sold goods to Ram for cash `1,000.

SOLUTION

Dr. Cash Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
2020 2020
Jan. 1 To Balance b/d 8,000 Jan. 1 By Purchases A/c 3,800
Jan. 4 To Vijay 1,980 Jan. 8 By Plant A/c 300
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 7,180
Jan. 18 To Sales A/c 1,000
11,280 11,280
Feb. 1 To Balance b/d 7,180

Dr. Bank Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 25,000 Jan. 31 By Balance c/d 25,000
25,000 25,000
Feb. 1 To Balance b/d 25,000

Dr. Inventory Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 20,000 Jan. 31 By Balance c/d 20,000
20,000 20,000
Feb. 1 To Balance b/d 20,000
Dr. Building Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 10,000 Jan. 31 By Balance c/d 10,000
10,000 10,000
Feb. 1 To Balance b/d 10,000

Dr. Vijay Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 2,000 Jan. 4 By Cash A/c 1,980
By Discount A/c 20
2,000 2,000

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2.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

Dr. Madhu Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000
Dr. Anand Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 5,000 Jan. 1 By Balance b/d 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000
Dr. Capital Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 55,000 Jan. 1 By Balance b/d 55,000
55,000 55,000
Feb. 1 By Balance b/d 55,000
Dr. Purchases Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Cash 3,800
Jan. 1 To Cash Discount 200 Jan. 31 By Balance c/d 4,000
4,000 4,000
Feb. 1 To Balance b/d 4,000
Dr. Discount Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 4 To Vijay 20 Jan. 1 By Purchases A/c 200
Jan.31 To Balance c/d 180
200 200
Feb. 1 By Balance b/d 180
Dr. Plant Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 8 To Mukesh 5,000 Jan. 31 By Balance c/d 5,300
Jan. 8 To Cash A/c 300
5,300 5,300
Feb. 1 To Balance b/d 5,300

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39 ACCOUNTING PROCESS 2.39

Dr. Mukesh Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 5,000 Jan. 8 By Plant A/c 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000
Dr. Sales Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 1,600 Jan. 12 By Rahim 600
Jan. 18 By Cash A/c 1,000
1,600 1,600
Feb. 1 By Balance b/d 1,600
Dr. Rahim Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 12 To Sales A/c 600 Jan. 15 By Cash A/c 300
Jan. 15 By Bad Debts A/c 300
600 600
Dr. Bad Debts Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 300
300 300
Feb. 1 To Balance b/d 300

ILLUSTRATION 3

The following data is given by Mr. S, the owner, with a request to compile only the two personal accounts of
Mr. H and Mr. R, in his ledger, for the month of April, 2020.
1 Mr. S owes Mr. R ` 15,000; Mr. H owes Mr. S ` 20,000.
4 Mr. R sold goods worth ` 60,000 @ 10% trade discount to Mr. S.
5 Mr. S sold to Mr. H goods prices at ` 30,000.
17 Record a purchase of ` 25,000 net from R, which were sold to H at a profit of `15,000.
18 Mr. S rejected 10% of Mr. R’s goods of 4th April.
19 Mr. S issued a cash memo for `10,000 to Mr. H who came personally for this consignment of goods,
urgently needed by him.
22 Mr. H cleared half his total dues to Mr. S, enjoying a ½% cash discount (of the payment received,
` 20,000 was by cheque).

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2.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

26 R’s total dues (less `10,000 held back) were cleared by cheque, enjoying a cash discount of `1,000 on
the payment made.
29 Close H’s Account to record the fact that all but ` 5,000 was cleared by him, by a cheque, because he
was declared bankrupt.
30 Balance R’s Account.

SOLUTION

In the books of Mr. S

Dr. Mr. H Account Cr.
Date Particulars ` Date Particulars `
1.4.2020 To Balance b/d 20,000 22.4.2020 By Bank A/c 20,000
5.4.2020 To Sales A/c 30,000 22.4.2020 By Cash A/c (Note 2) 24,775
17.4.2020 To Sales A/c 40,000 29.4.2020 By Discount Allowed A/c 225
29.4.2020 By Bank A/c 40,000
29.4.2020 By Bad Debts A/c 5,000
90,000 90,000
Dr. Mr. R Account Cr.

Date Particulars ` Date Particulars `

18.4.2020 To Purchase 5,400 1.4.2020 By Balance b/d 15,000
To Returns A/c 4.4.2020 By Purchases A/c 54,000
26.4.2020 To Bank A/c 77,600 17.4.2020 By Purchases A/c 25,000
26.4.2020 To Discount
Received A/c 1,000
30.4.2020 To Balance c/d 10,000
94,000 94,000
1.5.2020 By Balance b/d 10,000

Working Notes:
(1) Sale of `10,000 on 19th April is a cash sales, therefore, it will not be recorded in the Personal Account
of Mr. H; and (2) On 22nd April, Mr. H owes Mr. S ` 90,000, amount paid by Mr. H ½ of ` 90,000 less
½% discount i.e., ` 45,000– ` 225 = ` 44,775. Out of this amount, ` 20,000 paid by cheque and the
balance of ` 24,775 in cash.
Note: The balance of all nominal accounts are transferred to Profit and Loss account at the time of preparation
of financial statements as the nominal Accounts are in the nature of revenue/incomes/gains or expenses/losses.
Thus, the net result of all nominal accounts are reflected in profit and loss Account for an accounting period which
is transferred to Capital Account. The balance of all the accounts relating to assets and liabilities (personal or

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41 ACCOUNTING PROCESS 2.41

impersonal) are reflected in the Balance Sheet at the end of accounting period.

SUMMARY
 Process of transferring journal entries in the accounts opened in Ledger is called posting.
 Ledger is known as principal books of accounts and it provides full information regarding all the
transactions pertaining to any individual account.
 The difference between the totals of debits and credit sides is found out as the balance. Some of these
balances are transferred to the profit and loss account and some are carried forward to the next year
i.e., shown in the balance sheet, depending upon the nature of the account.

TEST YOUR KNOWLEDGE

True and False
1. A ledger is also known as the principal book of accounts.
2. Cash account has a debit balance.
3. Posting is the process of transferring the accounts from ledger to journal.
4. At the end of the accounting year, all the nominal accounts of the ledger book are balanced.
5. Ledger records the transactions in a chronological order.
6. If the total debit side is greater than the total of credit side, we get a credit balance.
7. Ledger accounts of assets will always be debited when they are increased.

Multiple Choice Questions

1. The process of transferring the debit and credit items from a Journal to their respective accounts in the
ledger is termed as
(a) Posting
(b) Purchase
(c) Balancing of an account
2. The technique of finding the net balance of an account after considering the totals of both debits and
credits appearing in the account is known as
(a) Posting
(b) Purchase
(c) Balancing of an account
3. Journal and ledger records transactions in
(a) A chronological order and analytical order respectively.

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2.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) An analytical order and chronological order respectively.

(c) A chronological order only

4. Ledger book is popularly known as

(a) Secondary book of accounts
(b) Principal book of accounts
(c) Subsidiary book of accounts
5. At the end of the accounting year all the nominal accounts of the ledger book are
(a) Balanced but not transferred to profit and loss account
(b) Not balanced and also the balance is not transferred to the profit and loss account
(c) Not balanced and their balance is transferred to the profit and loss account.

Theory Questions
1 What do you mean by principal books of accounts?
2 What are the rules of posting of journal entries into the Ledger?

Practical Questions
1. Journalize the following transactions, post them in the Ledger and balance the accounts on
31st December.
1. X started business with a capital of ` 20,000
2. He purchased goods from Y on credit ` 4,000
3. He paid cash to Y ` 2,000
4. He sold goods to Z ` 4,000
5. He received cash from Z ` 6,000
6. He further purchased goods from Y ` 4,000
7. He paid cash to Y ` 2,000
8. He further sold goods to Z ` 4,000
9 He received cash form Z ` 2,000

ANSWERS/HINTS
True and False
1. True: Since it classifies all the amounts related to a particular account and then it is used as the base
for preparing the Trial balance, a ledger is also known as principal books of accounts.
2. True: Being an asset under the modern equation approach, cash account has a debit balance.

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43 ACCOUNTING PROCESS 2.43

3. False: Posting is the process of transferring the balances from journal to ledger.
4. False: At the end of the accounting year, all the nominal accounts of the ledger book are totaled and
transferred to P&L A/c.
5. False: Ledger records the transactions in analytical order. But journal records the transactions in a
chronological order.
6. False: If the total of debit side is greater than the total of credit side, we get a debit balance as the
opening balance.
7. True: The increase to an asset shall be debited since the original balance is also debit.

Multiple Choice Questions

1. (a) 2. (c) 3. (a) 4. (b) 5. (c)

Theoretical Questions
1. Ledger is known as principal books of accounts and it provides full information regarding all the
transactions pertaining to any individual account. Ledger contains all set of accounts (viz. personal, real
and nominal accounts).
2. Rules regarding posting of entries in the ledger:
a. Separate account is opened in ledger book for each account and entries from ledger posted to
respective account accordingly.
b. It is a practice to use words ‘To’ and ‘By’ while posting transactions in the ledger. The word ‘To’
is used in the particular column with the accounts written on the debit side while ‘By’ i s used
with the accounts written in the particular column of the credit side. These ‘To’ and ‘By’ do not
have any meanings but are used to the account debited and credited.
c. The concerned account debited in the journal should also be debited in the led ger but reference
should be of the respective credit account.

Practical Questions
Answer 1
Journal
Particulars L.F. Debit ` Credit `
Cash Account Dr. 20,000
To Capital Account 20,000
(Being commencement of business)
Purchase Account Dr. 4,000
To Y 4,000
(Being purchase of goods on credit)
Y Dr. 2,000
To Cash 2,000

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2.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

(Being payment of cash to Y)

Z Dr. 4,000
To Sales 4,000
(Being goods sold to Z)
Cash Account Dr. 6,000
To Z 6,000
(Being cash received form Z)
Purchase Account Dr. 4,000
To Y 4,000
(Being payment of goods from Y)
Y Dr. 2,000
To Cash Account 2,000
(Being payment of cash to Y)
Z Dr. 4,000
To Sales Account 4,000
(Being goods sold to Z)
Cash Account Dr. 2,000
To Z 2,000
(Being cash received from Z)
TOTAL 48,000 48,000

Dr. Cash Account Cr.

Date Particulars ` Date Particulars `

To Capital A/c 20,000 By Y 2,000
To Z 6,000 By Y 2,000
To Z 2,000 By Balance c/d 24,000
28,000 28,000
Feb. 1 To Balance b/d 24,000

Dr. Capital Account Cr.

Date Particulars ` Date Particulars `

Jan. 31 To Balance c/d 20,000 By Cash A/c 20,000
20,000 20,000
Feb. 1 By Balance b/d 20,000

Dr. Purchase Account Cr.

Date Particulars ` Date Particulars `
To Y 4,000 Jan 31. By Balance c/d 8,000
To Y 4,000

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45 ACCOUNTING PROCESS 2.45

8,000 8,000
Feb.1 To Balance b/d 8,000

Dr. Y’s Account Cr.

Date Particulars ` Date Particulars `
To Cash 2,000 By Purchases 4,000
To Cash 2,000 By Purchases 4,000
Jan. 31 To Balance c/d 4,000
8,000 8,000
By Balance b/d 4,000

Dr. Z’s Account Cr.

Date Particulars ` Date Particulars `
To Sales 4,000 By Cash A/c 6,000
To Sales 4,000 By Cash A/c 2,000
8,000 8,000

Dr. Sales Account Cr.

Date Particulars ` Date Particulars `
Jan. 31 To Balance c/d 8,000 By Z 4,000
By Z 4,000
8,000 8,000
Feb. 1 By Balance b/d 8,000

© The Institute of Chartered Accountants of India

2.46 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 3 : TRIAL BALANCE

LEARNING OUTCOMES

After studying this unit, you will be able to:

♦ Learn the technique of taking balances from ledger accounts to prepare trial balance.
♦ Understand what is trial balance and what purposes it can serve.

UNIT OVERVIEW

Trial balance contains various ledger balances on a particular date. It forms the basis for preparing final statement
i.e. profit and loss statement and balance sheet. If it tallies, it means that the accounts are arithmetically accurate
but certain errors may still remain undetected. Therefore, it is very important to carefully journalise and post the
entries, following the rules of accounting.

3.1 INTRODUCTION
Preparation of trial balance is the third phase in the accounting process. After posting the accounts in the ledger,
a statement is prepared to show separately the debit and credit balances. Such a statement is known as the trial
balance. It may also be prepared by listing each and every account and entering in separate columns the totals
of the debit and credit sides. Whichever way it is prepared, the totals of the two columns should agree. An
agreement indicates reasonable accuracy of the accounting work; if the two sides do not agree, then there is
simply an arithmetic error(s).

© The Institute of Chartered Accountants of India

47 ACCOUNTING PROCESS 2.47

This follows from the fact that under the Double Entry System, the amount written on the debit sides of various
accounts is always equal to the amounts entered on the credit sides of other accounts and vice versa. Hence the
totals of the debit sides must be equal to the totals of the credit sides. Also total of the debit balances will be
equal to the total of the credit balances. Once this agreement is established, there is reasonable confidence that
the accounting work is free from clerical errors, though it is not proof of cent per cent accuracy, because some
errors of principle and compensating errors may still remain. Generally, to check the arithmetic accuracy of
accounts, trial balance is prepared at monthly intervals. But because double entry system is followed, one can
prepare a trial balance any time. Though a trial balance can be prepared any time but it is preferable to prepare
it at the end of the accounting year to ensure the arithmetic accuracy of all the accounts before the preparation
of the financial statements. It may be noted that trial balance is a statement and not an account.

3.2. OBJECTIVES OF PREPARING THE TRIAL BALANCE

The preparation of trial balance has the following objectives:
(i) Trial balance enables one to establish whether the posting and other accounting processes have been
carried out without committing arithmetical errors. In other words, the trial balance helps to establish
arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basis of agreed trial balance; otherwise the work may
be cumbersome. Preparation of financial statements, therefore, is the second objective.
(iii) The trial balance serves as a summary of what is contained in the ledger; the ledger may have to be
seen only when details are required in respect of an account.
The form of the trial balance is simple as shown below:
Trial Balance
as at.......................

S.No Ledger Accounts L.F. Dr. Amount Cr. Amount

(Total or Balance) (Total or Balance)
` `

The under mentioned points may be noted:

(i) A trial balance is prepared as on a particular date which should be mentioned at the top.
(ii) In the second column the name of the account is written.
(iii) In the fourth column the total of the debit side of the account concerned or the debit balance, if any is
entered.
(iv) In the next column, the total of the credit side or the credit balance is written.
(v) The two columns are totalled at the end.
(vi) The first and third column needs no explanation.

© The Institute of Chartered Accountants of India

2.48 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.3 LIMITATIONS OF TRIAL BALANCE

One should note that the agreement of Trial Balance is not a conclusive proof of accuracy. In other words, in
spite of the agreement of the trial balance some errors may remain. These may be of the following types:
(i) Transaction has not been entered at all in the journal.
(ii) A wrong amount has been written in both columns of the journal.
(iii) A wrong account has been mentioned in the journal.
(iv) An entry has not at all been posted in the ledger.
(v) Entry is posted twice in the ledger.
Still, the preparation of the trial balance is very useful; without it, the preparation of financial statement, the profit
and loss account and the balance sheet, would be difficult.

3.4 METHODS OF PREPARATION OF TRIAL BALANCE

1. TOTAL METHOD
Under this method, every ledger account is totalled and that total amount (both of debit side and credit side) is
transferred to trial balance. In this method, trial balance can be prepared as soon as ledger account is totalled.
Time taken to balance the ledger accounts is saved under this method as balance can be found out in the trial
balance itself. The difference of totals of each ledger account is the balance of that particular account. This
method is not commonly used as it cannot help in the preparation of the financial statements.

ILLUSTRATION 1

Given below is a ledger extract relating to the business of X and Co. as on March, 31, 2020. You are required to
prepare the Trial Balance by the Total Amount Method.
Dr. Cash Account Cr.
Particulars ` Particulars `
To Capital A/c 10,000 By Furniture A/c 3,000
To Ram’s A/c 25,000 By Salaries A/c 2,500
To Cash Sales 500 By Shyam’s A/c 21,000
By Cash Purchases 1,000
By Capital A/c 500
By Balance c/d 7,500
35,500 35,500

Dr. Furniture Account Cr.

Particulars ` Particulars `
To Cash A/c 3,000 By Balance c/d 3,000
3,000 3,000

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49 ACCOUNTING PROCESS 2.49

Dr. Salaries Account Cr.

Particulars ` Particulars `
To Cash A/c 2,500 By Balance c/d 2,500
2,500 2,500

Dr. Shyam’s Account Cr.

Particulars ` Particulars `
To Cash A/c 21,000 By Purchases A/c 25,000
To Purchase Returns A/c 500 (Credit Purchases)
To Balance c/d 3,500 –
25,000 25,000

Dr. Purchases Account Cr.

Particulars ` Particulars `
To Cash A/c (Cash Purchases) 1,000 By Balance c/d 26,000
To Sundries as per Purchases Book
(Credit Purchases) 25,000 –
26,000 26,000

Dr. Purchases Returns Account Cr.

Particulars ` Particulars `
To Balance c/d 500 By Sundries as per Purchases 500
Return Book
500 500

Dr. Ram’s Account Cr.

Particulars ` Particulars `
To Sales A/c (Credit Sales) 30,000 By Sales Returns A/c 100
By Cash A/c 25,000
By Balance c/d 4,900
30,000 30,000

Dr. Sales Account Cr.

Particulars ` Particulars `
To Balance c/d 30,500 By Cash A/c (Cash Sales) 500
By Sundries as per Sales Book
(Credit sales) 30,000
30,500 30,500

© The Institute of Chartered Accountants of India

2.50 PRINCIPLES AND PRACTICE OF ACCOUNTING

Dr. Sales Returns Account Cr.

Particulars ` Particulars `
To Sundries as per Sales
Returns Book 100 By Balance c/d 100
100 100

Dr. Capital Account Cr.

Particulars ` Particulars `
To Cash A/c 500 By Cash A/c 10,000
To Balance c/d 9,500
10,000 10,000

SOLUTION

Trial Balance of X and Co. as at 31.03.2020

Sl. No. Name of Account Total Debit Total
Items Credit Items
` `
1. Cash A/c 35,500 28,000
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam’s A/c 21,500 25,000
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram’s A/c 30,000 25,100
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c 500 10,000
1,19,100 1,19,100

2. BALANCE METHOD
Under this method, every ledger account is balanced and those balances only are carried forward to the trial
balance. This method is used commonly by the accountants and helps in the preparation of the financial
statements. Financial statements are prepared on the basis of the balances of the ledger accounts.

ILLUSTRATION 2

Taking the same information as given in Illustration 1, prepare the Trial Balance by Balance Method.

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51 ACCOUNTING PROCESS 2.51

SOLUTION

Trial Balance of X and Co. as at 31.03.2020

Sl. Name of Account Debit Credit
No. Balance Balance
` `
1. Cash A/c 7,500
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam’s A/c 3,500
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram’s A/c 4,900
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c 9,500
44,000 44,000

3. TOTAL AND BALANCE METHOD

Under this method, the above two explained methods are combined. Under this method statement of trial balance
contains seven columns instead of five columns. This has been explained with the help of the following example:
Trial Balance of X as at 31.03.2020
Sl. Heads of Account L.F. Debit Credit Debit Credit
No. Balance Balance Total Total
(`) (`) (`) (`)
1. Cash Account 7,500 35,500 28,000
2. Furniture Account 3,000 3,000
3. Salaries Account 2,500 2,500
4. Shyam’s Account 3,500 21,500 25,000
5. Purchases Account 26,000 26,000
6. Purchase Returns Account 500 500
7. Ram’s Account 4,900 30,000 25,100
8. Sales Account 30,500 30,500
9. Sale Returns Account 100 100
10. Capital Account 9,500 500 10,000
Total 44,000 44,000 1,19,100 1,19,100

© The Institute of Chartered Accountants of India

2.52 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.5 ADJUSTED TRIAL BALANCE (THROUGH SUSPENSE ACCOUNT)

If the trial balance does not agree after transferring the balance of all ledger accounts including cash and bank
balance and also errors are not located timely, then the trial balance is tallied by transferring the difference of
debit and credit side to an account known as suspense account. This is a temporary account opened to proceed
further and to prepare the financial statements timely.

3.6 RULES OF PREPARING THE TRIAL BALANCE

While preparing the trial balance from the given list of ledger balances, following rules should be taken into care:
1. The balances of all (i) assets accounts (ii) expenses accounts (iii) losses (iv) drawings (v) cash and bank
balances are placed in the debit column of the trial balance.
2. The balances of all (i) liabilities accounts (ii) income accounts (iii) profits (iv) capital are placed in the
credit column of the trial balance.

ILLUSTRATION 3

From the following ledger balances, prepare a trial balance of Anuradha Traders as on 31st March, 2020:
Account Head `
Capital 1,00,000
Sales 1,66,000
Purchases 1,50,000
Sales return 1,000
Discount allowed 2,000
Expenses 10,000
Trade receivables 75,000
Trade payables 25,000
Investments 15,000
Cash at bank and in hand 37,000
Interest received on investments 1,500
Insurance paid 2,500

SOLUTION

Trial Balance of Anuradha Traders as on 31.03.2020

Dr. balance ` Cr. balance `
Purchases 1,50,000 Capital 1,00,000
Sales return 1,000 Sales 1,66,000
Discount allowed 2,000 Trade payables 25,000
Expenses 10,000 Interest received on investments 1,500

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53 ACCOUNTING PROCESS 2.53

Trade receivables 75,000

Investments 15,000
Cash at bank and in hand 37,000
Insurance paid 2,500
Total 2,92,500 2,92,500

ILLUSTRATION 4

One of your clients, Mr. Singhania has asked you to finalise his accounts for the year ended 31st March, 2020.
Till date, he himself has recorded the transactions in books of accounts. As a basis for audit, Mr. Singhania
furnished you with the following statement.
Dr. Balance (`) Cr. Balance (`)
Singhania’s Capital 1,556
Singhania’s Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases return 264
Loan from bank 256
Trade payables 528
Trade expenses 700
Cash at bank 226
Bills payable 100
Salaries and wages 600
Inventories (1.4.2019) 264
Rent and rates 463
Sales return 98
5,454 5,454

The closing inventory on 31st March, 2020 was valued at ` 574. Mr. Singhania claims that he has recorded every
transaction correctly as the trial balance is tallied. Check the accuracy of the above trial balance.

© The Institute of Chartered Accountants of India

2.54 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

Corrected Trial Balance of Mr. Singhania as on 31st March, 2020

Particulars Dr. Amount ` Cr.Amount `
Singhania’s Capital 1,556
Singhania’s Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases returns 264
Loan from Bank 256
Creditor/Suppliers 528
Trade expenses 700
Cash at Bank 226
Bills payable 100
Salaries and Wages 600
Inventory (1.4.2019) 264
Rent and rates 463
Sales return 98
5,454 5,454
Reasons:
1. Due from customers is an asset, so its balance will be a debit balance.
2. Purchases return account always shows a credit balance because assets go out.
3. Balance in Creditors Account is a liability, so its balance will be a credit balance.
4. Bills payable is a liability, so its balance will be a credit balance.
5. Inventory (opening) represents assets, so it will have a debit balance.
6. Sales return account always shows a debit balance because assets come.

SUMMARY
♦ Trial balance contains various ledger balances on a particular date.
♦ It forms the basis for preparing final statement i.e. profit and loss statement and balance sheet.
♦ If it tallies, it means that the accounts are arithmetically accurate but certain errors may still remain
undetected.
♦ It is very important to carefully journalize and post the entries, following the rules of accounting.

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55 ACCOUNTING PROCESS 2.55

TEST YOUR KNOWLEDGE

True and False
1. Preparing trial balance is the third phase of accounting process.
2. Trial balance froms a base for the preparation of Financial statement.
3. Agreement of Trial balance is a conclusive proof of accuracy.
4. A trial balance will tally in case of compensating errors.
5. A Trial balance can find the missing entry from the journal.
6. Suspense account opened in a trial balance is a permanent account.
7. The balance of purchase returns account has a credit balance.

Multiple Choice Questions

1. A trial balance will not balance if _____________________________
(a) Correct journal entry is posted twice.
(b) The purchase on credit basis is debited to purchases and credited to cash.
(c) ` 500 cash payment to creditor is debited to Trade payables for ` 50 and credited to cash as
` 500.
2. ` 1, 500 received from sub-tenant for rent and entered correctly in the cash book is posted to the debit
of the rent account. In the trial balance _____________________________
(a) The debit total will be greater by ` 3,000 than the credit total.
(b) The debit total will be greater by ` 1,500 than the credit total.
(c) Subject to other entries being correct the total will agree.
3. After the preparation of ledgers, the next step is the preparation of _____________________________
(a) Trading accounts
(b) Trial balance
(c) Profit and loss account
4. After preparing the trial balance the accountant finds that the total of debit side is short by ` 1,500. This
difference will be _____________________________
(a) Credited to suspense account
(b) Debited to suspense account
(c) Adjusted to any of the debit balance account
5. S.No. Account heads Debit (`) Credit (`)
1. Sales 15,000
2. Purchases 10,000

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2.56 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. Miscellaneous expenses 2,500

4. Salaries 2,500
Total 12,500 17,500
The difference in trial balance is due to _____________________________
(a) Wrong placing of sales account
(b) Wrong placing of salaries account
(c) Wrong placing of miscellaneous expenses account

Theory Questions
1. What is the trial balance? And how it is prepared?
2. Explain objectives of preparation of trial balance.
3. Even if the trial balance agrees, some errors may remain. Do you agree? Explain.

Practical Question
1. An inexperienced bookkeeper has drawn up a Trial Balance for the year ended 30th June, 2020.
Debit (`) Credit (` )
Provision for Doubtful Debts 200 –
Bank Overdraft 1,654 –
Capital – 4,591
Trade payables – 1,637
Trade receivables 2,983 –
Discount Received 252 –
Discount Allowed – 733
Drawings 1,200 –
Office Furniture 2,155 –
General Expenses – 829
Purchases 10,923 –
Returns Inward – 330
Rent & Rates 314 –
Salaries 2,520 –
Sales – 16,882
Inventory 2,418 –
Provision for Depreciation on Furniture 364 –
Total 24,983 25,002

Required:
Draw up a ‘Corrected’ Trial Balance, debiting or crediting any residual errors to a Suspense Account.

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57 ACCOUNTING PROCESS 2.57

ANSWERS/HINTS
True and False
1. True: Preparing trial balance is the third phase of accounting process which forms the base for the
preparation of the final accounts.
2. True: Based on trial balance only, we can prepare financial statement.
3. False: Agreement of Trial balance gives only arithmetical accuracy, there can still be errors in preparing
the trail balance.
4. True: Since compensating errors cancel out due to their compensating nature of the amounts, hence the
Trial balance tallies.
5. False: A Trial balance cannot find the missing entry from the journal.
6. False: Suspense account opened in a trial balance is a temporary account
7. True: As purchases is debited, any returns shall be credited (treated in opposite way).

Multiple Choice Questions

1. (c) 2. (a) 3. (b) 4. (b) 5. (b)

Theoretical Questions
1. Preparation of trial balance is the third phase in the accounting process. After posting the accounts in
the ledger, a statement is prepared to show separately the debit and credit balances. Such a statement
is known as the trial balance.
Trial balance contains various ledger balances on a particular date. It forms the basis for preparing final
statement i.e. profit and loss statement and balance sheet. It is tallies, it means that the accounts are
arithmetically accurate but certain errors may still remain undetected. Therefore, it is very important to
carefully journalise and post the entries, following are rules of accounting.
2. The preparation of trial balance has the following objectives:
(i) Trial balance enables one to establish whether the posting and other accounting processes
have been carried out without committing arithmetical errors. In other words, the trial balance
helps to establish arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basis of agreed trial balance; otherwise the
work may be cumbersome. Preparation of financial statements, therefore, is the second
objective.
(iii) The trial balance serves as a summary of what is contained in the ledger; the ledger may have
to be seen only when details are required in respect of an account.
3. In spite of the agreement of the trial balance some errors may remain. These may be of the following
types:
(i) Transaction has not been entered at all in the journal.

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2.58 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) A wrong amount has been written in both columns of the journal.
(iii) A wrong account has been mentioned in the journal.
(iv) An entry has not at all been posted in the ledger.
(v) Entry is posted twice in the ledger.

Practical Question
Answer 1
Trial Balance as on 30th June, 2020
Heads of Accounts Debit ` Credit `
Provision for Doubtful Debts – 200
Bank overdraft – 1,654
Capital – 4,591
Trade payables – 1,637
Trade receivables 2,983 –
Discount Received – 252
Discount allowed 733 –
Drawings 1,200 –
Office furniture 2,155 –
General Expenses 829 –
Purchases 10,923 –
Returns Inward 330 –
Rent & Rates 314 –
Salaries 2,520 –
Inventory 2,418 –
Provision for Depreciation on Furniture – 364
Sales – 16,882
Suspense Account (Balancing figure) 1,175 –
Total 25,580 25,580

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59 ACCOUNTING PROCESS 2.59

UNIT – 4 SUBSIDIARY BOOKS

LEARNING OUTCOMES
After studying this unit, you would be able to:
♦ Understand the techniques of recording transactions in Purchase Book, Sales Book; Returns
Inward Book and Returns Outward Book; Bills Receivable and Bills Payable Book.
♦ Learn the technique of posting from Subsidiary Books to Ledger.
♦ Understand that even if subsidiary books are maintained, journalisation is required for many
other transactions and events.
♦ Learn the difference between the subsidiary books and principal books.

• Ledger
Principle books
• Cash books

UNIT OVERVIEW

• Purchases and Sales book, Purchase

and Sales return books
Subsidiary books • Bill payable and Bills receivable books
• Journal Proper

4.1 INTRODUCTION
In a business, most of the transactions generally relate to receipts and payments of cash, sale of goods and their
purchase. It is convenient to keep a separate register for each such class of transactions one for receipts and
payments of cash, one for purchase of goods and one for sale of goods. A register of this type is called a book
of original entry or of prime entry. For transactions recorded in such books there will be no journal entry. The
system by which transactions of a class are first recorded in the book, specially meant for it and on the basis of
which ledger accounts are then prepared is known as the Practical System of Book keeping or even the English
System. It should be noted that in this system, there is no departure from the rules of the double entry system.
These books of original or prime entry are also called subsidiary books since ledger accounts are prepared on
their basis and, without the further process of ledger posting, a trial balance cannot be taken out. Normally, the
following subsidiary books are used in a business:

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2.60 PRINCIPLES AND PRACTICE OF ACCOUNTING

(i) Cash book to record receipts and payments of cash, including receipts into and payments out of the
bank.
(ii) Purchases book to record credit purchases of goods dealt in or of the materials and stores required in
the factory.
(iii) Purchase Returns Books to record the returns of goods and materials previously purchased.
(iv) Sales Book to record the sales of the goods dealt in by the firm.
(v) Sale Returns Book to record the returns made by the customers.
(vi) Bills Receivable Books to record the receipts of promissory notes or hundies from various parties.
(vii) Bills Payable Book to record the issue of the promissory notes or hundies to other parties.
(viii) Journal (proper) to record the transactions which cannot be recorded in any of the seven books
mentioned above.
It may be noted that in all the above cases the word “Journal” may be used for the word “book”
Advantages of Subsidiary Books
The use of subsidiary books affords the undermentioned advantages:
(i) Division of work: Since in the place of one journal there will be so many subsidiary books, the
accounting work may be divided amongst a number of clerks.
(ii) Specialization and efficiency: When the same work is allotted to a particular person over a period of
time, he acquires full knowledge of it and becomes efficient in handling it. Thus the accounting work will
be done efficiently.
(iii) Saving of the time: Various accounting processes can be undertaken simultaneously because of the
use of a number of books. This will lead to the work being completed quickly.
(iv) Availability of information: Since a separate register or book is kept for each class of transactions, the
information relating to each transactions will be available at one place.
(v) Facility in checking: When the trial balance does not agree, the location of the error or errors is
facilitated by the existence of separate books. Even the commission of errors and frauds will be checked
by the use of various subsidiary books.

4.2 DISTINCTION BETWEEN SUBSIDIARY BOOKS AND PRINCIPAL

BOOKS
The books in which transactions are first recorded to enable processing are called subsidiary books. The ledger
and the cash book are the principle books since they furnish information for preparation of the trial balance and
financial statements. The following table will help you in understanding the difference between Subsidiary Books
and Principal Books.

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61 ACCOUNTING PROCESS 2.61

Principal Books
Ledger

Simple Cash Book

Cash books with

Cash
Discount. Column
Books

Cash books with

Bank & Disc
Financial Discount. Column
Books
Petty Cash Book

For Credit
Purchase Book
Purchase
For Credit
Sales Book
Sales

For Credit Purchase Return

Purchase Book
Returns
For Credit

Sales Returns Sales Return Book

Subsidiary
For Bills
Books Bill Receivable Book
Receivable
Received

For Bills
Bill Payable Book
Accepted

For record of
Journal Paper
transactions
not recorded
elsewhere

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2.62 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.3 PURCHASES BOOK

To record the credit purchases of goods dealt in or materials and stores used in the factory, a separate register
called the Purchases Book or the Purchases Journal, is usually maintained by firms. The ruling is given below:
Date Particulars L.F. Details Amount
` `

It should be remembered that :

(i) Cash purchases are not entered in this book since these will be entered in the cash book; and
(ii) Credit purchases of things other than goods or materials, such as office furniture or typewriters are
journalised - they also are not entered in the Purchases Book.
The particulars column is meant to record the name of the supplier and name of the articles purchased and the
respective quantities. The amount in respect of each article is entered in the details column. After totaling the
various amounts included in a single purchase, the amount for packing, or other charges is added and the amount
for trade discount is deducted. The net amount is entered in the extreme right-hand column. The total in this
column shows the total purchase made in a period.

ILLUSTRATION 1

The Rough Book of M/s. Narain & Co. contains the following :
2020
Feb. 1. Purchased from Brown & Co. on credit :
5 gross pencils @ `100 per gross,
1 gross register @ ` 240 per doz.
Less : Trade Discount @ 10%
2. Purchased for cash from the Stationery Mart;
10 gross exercise books @ ` 300 per doz.
3. Purchased computer for office use from M/s. office
Goods Co. on credit for ` 30,000.
4. Purchased on credit from The Paper Co.
5 reams of white paper @ `100 per ream.
10 reams of ruled paper @ `150 per ream.
Less : Trade Discount @ 10%
5. Purchased one dozen gel pens @ `15 each from
M/s. Verma Bros. on credit.
Make out the Purchase Book of M/s. Narain & Co.

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63 ACCOUNTING PROCESS 2.63

SOLUTION

Purchases Book
Date Particulars L.F. Amount
2020 ` `
Feb. 1 M/s. Brown & Co.
5 gross pencils @ ` 100 per gross 500.00
1 gross register @ ` 240 per doz. 2880.00
3380.00
Less : 10% trade discount (338) 3,042
“4 The Paper Co.
5 reams white paper @ ` 100 per ream 500.00
10 reams ruled paper @ ` 150 per ream 1500.00
2,000.00
Less : 10% trade discount (200.00) 1,800
5 M/s. Verma Bros.
1 doz. gel pens @ ` 15 each 180 180
Total 5022

Note : Purchases of cash and purchase of computer cannot be entered in the Purchase Book.

ILLUSTRATION 2

Enter the following transactions in Purchase Book and post them into ledger.
2020
April 4 Purchased from Ajay Enterprises, Delhi
100 Doz. Rexona Hawai Chappal @ ` 120 per doz.
200 Doz. Palki Leather Chappal @ ` 300 per Doz.
Less : Trade discount @ 10%
Freight charged ` 150.
April 15 Purchased from Balaji Traders, Delhi
50 doz. Max Shoes @ ` 400 per doz.
100 pair Sports Shoes @ ` 140 per pair.
Less : Trade discount @ 10%.
Freight charged ` 200.

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2.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

April 28 Purchased from Tripti Industries, Bahadurgarh

40 pair leather shoes @ ` 400 per pair
100 doz. Rosy Hawai Chappal @ ` 180 per doz.
Less : Trade discount @ 10%.
Freight charged ` 100.

SOLUTION

Purchase Book
Date Particulars Gross Trade Net Freight Total
2020 Amount Discount Price Amount
April 4 Ajay Enterprises
100 doz chappal @ ` 120 per doz -
` 12,000
200 doz Palki Leather Chappal
@ ` 300 per doz - ` 60,000
Less: trade discount @ 10% 72,000 7,200 64,800 150 64,950
April 15 Balaji Traders, Delhi
50 doz max Shoes @ ` 400 per doz
- ` 20,000
100 pair Sports shoes @ ` 140 per
pair - ` 14,000
Less: Trade discount @ 10% 34,000 3,400 30,600 200 30,800
April 28 Tripti Industries, Bahadurgarh
40 pair Leather shoes @ ` 400 per
pair - ` 16,000
100 doz Rosy Hawai Chappal:
@ ` 180 per doz - ` 18,000
Less: Trade discount @ 10% 34,000 3,400 30,600 100 30,700
1,40,000 14,000 1,26,000 450 1,26,450

Ledgers
Dr. Purchases A/c Cr.

2020 ` 2020 `

April 30 To amount as per purchase book 1,26,000

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65 ACCOUNTING PROCESS 2.65

Dr. Freight A/c Cr.

2020 ` 2020 `
April 30 To amount as per purchase book 450
Dr. Ajay Enterprises Cr.
2020 ` 2020 `
April 4 By Purchase A/c 64,800
By Freight A/c 150

Dr. Balaji Traders Cr.

2020 ` 2020 `
April 15 By Purchase A/c 30,600
By Freight A/c 200

Dr. Tripati Industries Cr.

2020 ` 2020 `
April 28 By Purchase A/c 30,600
By Freight A/c 100

POSTING THE PURCHASES BOOK

The Purchases Book shows the names of the parties from whom goods have been purchased on credit. These
parties are now trade payables. Their accounts have to be credited for the respective amounts shown in the
purchase book. The total of the amounts column shows the total purchases made in a period. The amount is
debited to the Purchase Account to indicate receipt of goods. In Illustration 1, the Purchases Account is debited
by ` 5,022, M/s. Brown & Co. is credited by ` 3,042, The Paper Company by `1,800 and M/s. Verma Bros. by
`180. The total of the amounts put on the credit side equals the debit. Thus the double entry is completed.

4.4 SALES BOOK

The Sales Book is a register specially kept to record credit sales of goods dealt in by the firm, cash sales are
entered in the Cash Book and not in the Sales Book. Credit sales of things, other than the goods dealt in by the
firm are not entered in the Sales Book; they are journalised. The ruling is the same as for the Purchases Book.
Entries in the Sales Book are also made in the same manner as in the Purchase Book. The particulars column
will record the name of the customers concerned together with particulars and quantities of the goods sold. For
each item, the amount is entered in the details column; after totalling the amounts for one sale, charges for
packing etc; are added and the trade discount, if any is deducted: the net amount is put in the outer column. The
total of this column will show the total credit sales for a period.

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2.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 3

The following are some of the transaction of M/s Kishore & Sons of the year 2020 as per their Waste Book. Make
out their Sales Book.
Sold to M/s. Gupta & Verma on credit:
30 shirts @ ` 800 per shirt.
20 trousers @ `1,000 per trouser.
Less : Trade Discount @ 10%
Sold furniture to M/s. Sehgal & Co. on credit `8,000.
Sold 50 shirts of M/s. Jain & Sons @ `800 per shirt.
Sold 13 shirts to Cheap Stores @ `750 each for cash.
Sold on credit to M/s. Mathur & Jain.
100 shirts @ `750 per shirt
10 overcoats @ `5,000 per overcoat.
Less: Trade Discount @ 10%

SOLUTION

Sales Book
Date Particulars Details L.F. Amount
` `
2020 M/s. Gupta & Verma
30 shirts @ `800 24,000
20 Trousers @ `1,000 20,000
44,000
Less : 10% (4,400)
Sales as per invoice no. dated ..... 39,600
M/s. Jain & Sons 50 shirts @ `800
Sale as per invoice no. dated ...... 40,000
M/s Mathur & Jain
100 shirts @ `750 75,000
10 overcoats @ `5,000 50,000
1,25,000

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67 ACCOUNTING PROCESS 2.67

Less : 10% (12,500)

Sales as per invoice no. dated...... 1,12,500
Total 1,92,100

Note : Cash sale and sale of furniture are not entered in Sales Book.

POSTING THE SALES BOOK

The names appearing in the Sales Book are of those parties which have received the goods. The accounts of the
parties have to be debited with the respective amounts. The total of the Sales Book shows the credit sales made
during the period concerned; the amount is credited to the Sales Account. In the Illustration 3, ` 1,92,100 is
credited to the Sales Account; `39,600 is debited to M/s. Gupta and Verma `40,000 to M/s Jain and Sons and
`1,12,500 to M/s Mathur & Jain. The amount put on the credit side is equal to the total of the amount put on the
debit side. Thus, the double entry principle is followed correctly.

4.5 SALES RETURNS BOOK OR RETURNS INWARD BOOK

If customers frequently return the goods sold to them, it would be convenient to record the returns in a separate
book, which is named as the Sales Returns Book or the Returns Inward Book. The ruling of the book is similar to
the Purchases or the Sales Book and entries are also made in the same manner. The following, assumed figures,
will illustrate this:
Returns Inward Book
Date Particulars Details L.F. Amount
2020 `

June 7 Sunil Bank & Co.

6 Copies-Double Entry

Bookkeeping by T.S. Grewal @ ` 7 42.00

Less : Trade Discount 10% (4.20) 37.80

Kailash & Co.

1 Copy-Business Methods by R.K. Gupta 3.50

Total 41.30

4.6 PURCHASE RETURNS OR RETURNS OUTWARD BOOK

Such a book conveniently records return of goods or material purchased to the suppliers if however, the returns
are not frequent, it may be sufficient to record the transaction in the journal. The ruling of the Purchase Returns
or Returns Outward Book is similar to that of the Purchase Book; entries are also similarly made, as the illustration
given below shows:

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2.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

Returns Outward Book

Date Particulars ` Amount
2020 `
June 2 Premier Electric Co. 175.00
One 36” Usha Ceiling Fan
“ 28 Mohan Electric Co.
Ten Iron Heaters 150.00
Less : Discount (15.00) 135.00
Total 310.00

POSTING OF THE RETURN BOOKS

The Sales Return Book will show the total of the returns made by customers. Really, the total of the returns is in
reduction of the sales. Properly, therefore, the amount may be debited to the Sales Account but, usually, a
separate account called Returns Inward Account is opened and the total of the sales returns is debited to this
accounts. The customers who have returned the goods are credited with the respective amounts.
It should be noted that on goods being received and accepted back from the customers, a credit note is issued
to the customers concerned. This shows the amount to be credited to the customer’s account.
Similarly, when goods are returned to suppliers they will issue the necessary credit note; also the firm returning
the goods will issue a debit note to the supplier, indicating the amount for which the supplier is liable on account
of the return.
The total of Returns Outwards Book shows the total returns made. The amount can be credited to the Purchase
Account, but in practice, is credited to a separate account called Purchase Returns or Returns Outward Account.
The suppliers whose names appear in the Book have received the goods, so their accounts have to be debited.
This is shown in the illustration given below :

ILLUSTRATION 4

Post the following into the ledger

Returns Outward Book
Date Particulars L.F. Details Amount
2020 ` `
Nov. 20 Rajindra Prakash & Sons
One 36” Usha Ceiling Fan 200.00
Less : Trade Discount @ 10% (20.00) 180.00
“ 30 Modern Electric Company 100.00
Total 280.00

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69 ACCOUNTING PROCESS 2.69

SOLUTION

Ledger
Dr. Rajindra Parkash & Sons Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2020
Nov. 20 To Returns Outward A/c 180.00

Dr. Modern Electric Co. Cr.

Date Particulars Folio Amount Date Particulars Folio Amount
2020
Nov. 30 To Returns Outward A/c 100.00
Dr. Returns Outward Account Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2020
Nov. By Sundries as per 280.00
30 Returns Outward
A/c

BILLS RECEIVABLE BOOKS AND BILLS PAYABLE BOOKS

If the firm usually receives a number of promissory notes or hundies, it would be convenient to record the
transaction in a separate book called the Bills Receivable Book. Similarly, if promissory notes or hundies are
frequently issued, the Bills Payable Book will be convenient. This will be discussed later.

4.7 IMPORTANCE OF JOURNAL

Students are now familiar with the journal. They also know that :
(i) Cash transactions are recorded in the cash book;
(ii) Credit purchases of goods or materials are recorded in the purchases book;
(iii) Credit sales of goods are recorded in the sales book;
(iv) Returns from customers are recorded in the sale returns book; and
(v) Returns to suppliers are entered in the purchase returns book.
Bill transactions are entered in the bills receivable books or the bills payable books, if these are maintained. Apart
from the transactions mentioned above, there are some entries also which have to be recorded. For them the
proper place is the journal. In fact, if there is no special book meant to record a transaction, it is recorded in the
journal (proper). The role of the journal is thus restricted to the following types of entries :
(i) Opening entries : When books are started for the new year, the opening balance of assets and liabilities
are journalised.

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2.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) Closing entries : At the end of the year the profit and loss account has to be prepared. For this purpose,
the nominal accounts are transferred to this account. This is done through journal entries called closing
entries.
(iii) Rectification entries : If an error has been committed, it is rectified through a journal entry.
(iv) Transfer entries : If some amount is to be transferred from one account to another, the transfer will be
made through a journal entry.
(v) Adjusting entries : At the end of the year the amount of expenses or income may have to be adjusted
for amounts received in advance or for amounts not yet settled in cash. Such an adjustment is also made
through journal entries. Usually, the entries pertain to the following:
(a) Outstanding expenses, i.e., expenses incurred but not yet paid;
(b) Prepared expenses, i.e., expenses paid in advance for some period in the future;
(c) Interest on capital, i.e., the interest on proprietor’s investment in the business entity investment;
and
(d) Depreciation, i.e., fall in the value of the assets used on account of wear and tear.
For all these, journal entries are necessary.
(vi) Entries on dishonour of Bills : If someone who accepted a promissory note (or bill) is not able to pay
in on the due date, a journal entry will be necessary to record the non-payment or dishonour.
(vii) Miscellaneous entries : The following entries will also require journalising:
(a) Credit purchase of things other than goods dealt in or materials required for production of goods
e.g. credit purchase of furniture or machinery will be journalised.
(b) An allowance to be given to the customers or a charge to be made to them after the issue of
the invoice.
(c) Receipt of promissory notes or issue to them if separate bill books have not been maintained.
(d) On an amount becoming irrecoverable, say, because, of the customer becoming insolvent.
(e) Effects of accidents such as loss of property by fire.
(f) Transfer of net profit to capital account.

ILLUSTRATION 5

From the following transactions, prepare the Purchases Returns Book of Alpha & Co., a saree dealer :

Date Debit Note No. Particulars

04.01.2020 101 Returned to Goyal Mills, Surat - 5 polyester sarees @ ` 1,000.
09.01.2020 Garg Mills, Kota - accepted the return of goods (which were purchased
for cash) from us - 5 Kota sarees @ ` 400.
16.01.2020 102 Returned to Mittal Mills, Bangalore - 5 silk sarees @ `2,600.
30.01.2020 Returned one computer (being defective) @ `35,000 to B & Co.

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71 ACCOUNTING PROCESS 2.71

SOLUTION

Purchase Returns Book

Date Debit Note No. Name of supplier L.F. Amount
2020
Jan. 4 101 Goyal Mills, Surat 5,000
Jan. 16 102 Mittal Mills, Bangalore 13,000
Jan. 31 Purchases Returns Account (Cr.) 18,000

SUMMARY
 Instead of recording all journal entries in one register, it is better to categorize the entries on the basis
of type of transactions.
 Various subsidiary books are maintained so as to record transactions of one type in each register. These
are also called books of original entry or prime entry.
 Example of subsidiary books are purchases book, sales book, purchase returns books, sales returns
book, bills receivable book etc. On the basis of these subsidiary books, the ledger accounts are prepared.

TEST YOUR KNOWLEDGE

True and False
1. Transactions recorded in the purchase book include only purchases of goods on credit transactions.
2. Transactions regarding the purchase of fixed asset are recorded in the purchase book.
3. Cash sales are recorded in the sales book.
4. Subsidiary books are also known as the books of original entry.
5. Bills receivable book is a subsidiary book.
6. Return inward book is also known as purchase return book.
7. Purchase of a second hand machinery will be recorded in purchase book.
8. Total of sales return book is posted to the debit side of sales account.
9. If the sales are on a frequent basis, the transactions are recorded in the sales book.

Multiple Choice Questions

1. In Purchases Book the record is in respect of ___________________________
(a) Cash purchase of goods.
(b) Credit purchase of goods dealt in.
(c) All purchases of goods.

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2.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. The Sales Returns Book records ___________________________

(a) The return of goods purchased.
(b) Return of anything purchased.
(c) Return of goods sold.
3. The Sales Book ___________________________
(a) Is a part of journal.
(b) Is a part of the ledger.
(c) Is a part of the balance sheet.
4. The weekly or monthly total of the Purchase Book is ___________________________
(a) Posted to the debit of the Purchases Account.
(b) Posted to the debit of the Sales Account.
(c) Posted to the credit of the Purchases Account.
5. The total of the Sales Book is posted to ___________________________
(a) Credit of the Sales Account.
(b) Credit of the Purchases Account.
(c) Credit of the Capital Account.
6. In which book of original entry, will you record an allowance of `50 was offered for an early payment of
cash of `1,050 ___________________________.
(a) Sales Book
(b) Cash Book
(c) Journal Proper (General Journal)
7. A second hand motor car was purchased on credit from B Brothers for `10,000 will be recorded in
___________________________.
(a) Journal Proper (General Journal)
(b) Sales Book
(c) Cash Book
(d) Purchase Book
8. In which book of original entry, will you record a bills receivable of `1,000, which was received from a
debtor in full settlement for a claim of `1,100, is dishonoured ____________________.
(a) Purchases Return Book
(b) Bills Receivable Book
(c) Journal Proper (General Journal)

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73 ACCOUNTING PROCESS 2.73

Theory Questions
1 Which subsidiary books are normally used in a business?
2. What are the advantages of subsidiary books?

Practical Questions
1. Enter the following transactions in Sales Book of M/s. Pranat Engineers Ltd., Delhi.
2020
Jan. 2. Sold to M/s. Ajanta Electricals, Delhi 5 pieces of Ovens @ `6,000/- each less Trade discount
@ 10%.
8 Sold to M/s. Ajanta Electricals Plaza, 10 pieces of Tablets @ ` 8,000/- each less trade discount
5%.
15 Sold to M/s. Haryana Traders, 5 pieces of Juicers @ `3,500/- each less trade discount @ 10%.
2. Post into the ledger the entries of Sales Book prepared in Question1.

ANSWERS/HINTS
True and False
1. True: Since cash purchases are taken to the cash book , it is only credit transactions that are recorded
in the purchases book.
2. False: Transactions regarding the purchase of fixed asset are not recorded in the purchase book, only
the credit purchases of goods are recorded in it.
3. False: Credit sales are recorded in the sales book.
4. True: Subsidiary books are maintained as an alternate to the journal.
5. True: Bills receivable is one of the subsidiary book.
6. False: Return inward book is also known as sales return book.
7. False: Purchase of a second hand machinery will not be recorded in purchase book.
8. True: Since sales return is reduction from the total sales value, it is debited in the sales account.
9. True: When there are numerous transactions then there are subsidiary books like the sales book where
there are recorded instead of regular journal entries.

Multiple Choice Questions

1. (b) 2. (c) 3. (a) 4. (a) 5. (a) 6. (b) 7. (a) 8. (c)

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2.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

Theoretical Questions
1. Normally, the following subsidiary books are used in a business:
(i) Cash Book to record receipts and payments of cash, including receipts into and payments out
of the bank.
(ii) Purchases Book to record credit purchases of goods dealt in or of the materials and stores
required in the factory.
(iii) Purchase Returns Books to record the returns of goods and materials previously purchased.
(iv) Sales Book to record the sales of the goods dealt in by the firm.
(v) Sale Returns Book to record the returns made by the customers.
(vi) Bills Receivable Books to record the receipts of promissory notes or hundies from various
parties.
(vii) Bills Payable Book to record the issue of the promissory notes or hundies to other parties.
(viii) Journal (proper) to record the transactions which cannot be recorded in any of the seven books
mentioned above.
2. For advantages of Subsidiary Books, refer para 4.1.

Practical Problems
Answers 1
Sales Book
Date Particulars Gross Amount Trade Discount Net Price
(`) (`) (`)
2020
Jan. 2 Ajanta Electricals 5 pieces of
Ovens @ ` 6,000 each
Less: 10% discount 30,000 3,000 27,000
8 Electronics Plaza 10 pieces of
Tablets @ ` 8,000 each,
less 5% trade discount 80,000 4,000 76,000
15 Haryana Traders 5 pieces of
Juicers @ ` 3,500 each,
less 10% trade discount 17,500 1,750 15,750
1,27,500 8,750 1,18,750

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75 ACCOUNTING PROCESS 2.75

Answers 2
Ledger
Ajanta Electricals
Date Particulars L.F. Amount Date Particulars L.F. Amount
2020 (`) 2020 (` )
Jan. 2 To Sales A/c 27,000

Electronics Plaza
Date Particulars L.F. Amount Date Particulars L.F. Amount
2020 (` ) 2020 (` )
Jan. 8 To Sales A/c 76,000

Haryana Traders
Date Particulars L.F. Amount Date Particulars L.F. Amount
2020 (`)
2020 (`)
Jan. To Sales A/c 15,750
15

Sales Account
Date Particulars L.F Amount Date Particulars L.F. Amount
2020 . (` ) 2020 (`)
Jan. By Sundries (As per 1,18,750
31 Sales Book)

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2.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 5 : CASH BOOK

LEARNING OUTCOMES

After studying this unit, you would be able to:

♦ Understand that a Cash Book is a type of subsidiary book but treated as a principal book.
♦ Be familiar with various kinds of Cash Books, viz., Simple Cash Book, Two-column Cash Book
and Three-column Cash Book.
♦ Learn the technique of preparation of Simple Cash Book and how to balance it.
♦ See how Double-Column Cash Book is a prepared adding discount column alongwith cash
column.
♦ Understand the techniques of preparing Three-column Cash Book.
♦ Understand what is a Petty Cash Book and the Imprest System of Petty Cash.
♦ Note the advantages of the Petty Cash Book.
♦ Learn how to maintain a Petty Cash Book and how to post the entries of the Petty Cash Book in
the ledger.
♦ Understand the accounting of credit/debit sales transactions.

UNIT OVERVIEW

Subsidiary
book as
well as
Principal
book

Simple Cash Three

column
cash book Book cash book

Two
column
cash book

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77 ACCOUNTING PROCESS 2.77

5.1 CASH BOOK - A SUBSIDIARY BOOK AND A PRINCIPAL BOOK

Cash transactions are straightaway recorded in the Cash Book and on the basis of such a record, ledger accounts
are prepared. Therefore, the Cash Book is a subsidiary book. But the Cash Book itself serves as the cash account
and the bank account; the balances are entered in the trial balance directly. The Cash Book, therefore, is part of
the ledger also. Hence, it has also to be treated as the principal book. The Cash Book is thus both a subsidiary
book and a principal book.

5.2 KINDS OF CASH BOOK

The main Cash Book may be of the three types:
(i) Simple Cash Book;
(ii) Two-column Cash Book;
(iii) Three-column Cash Book.
In addition to the main Cash Book, firms also generally maintain a petty cash book but that is purely a subsidiary
book.
SIMPLE CASH BOOK
Such a cash book appears like an ordinary account, with one amount column on each side. The left-hand side
records receipts of cash and the right-hand side the payments.
Balancing of the Cash Book: The cash book is balanced like other accounts. The total of receipts column is
always greater than total of payments column. The difference is written on the credit side as ‘By balance c/d’.
The totals are then entered in the two columns opposite one another and then on the debit side the balance is
written as “To Balance b/d”, to show cash balance in hand in the beginning of next period.

ILLUSTRATION 1

Enter the following transactions in a Simple Cash Book:

2020 `
Jan.1 Cash in hand 1,200
“5 Received from Ram 300
“7 Paid Rent 30
“8 Sold goods for cash 300
“10 Paid to Shyam 700
“27 Purchased Furniture 200
“31 Paid Salaries 100
“31 Rent due, not yet paid, for January 30

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2.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

Dr. Cash Book Cr.

Date Receipts L.F. Amount Date Payments L.F. Amount
2020 ` 2020 `
Jan. 1 To Balance b/d 1,200 Jan. 07 By Rent A/c 30
“5 To Ram A/c 300 “ 10 By Shyam A/c 700
“8 To Sales A/c 300 “ 27 By Furniture A/c 200
“ 31 By Salaries A/c 100
“ 31 By Balance c/d 770
1,800 1,800
2020
Feb. 1 To Balance b/d 770

Note: One can see the following:

(i) In the simple cash book only the cash receipts and cash payments are recorded.
(ii) The total of debit side is always greater than the total of credit side since the payment cannot exceed
the available cash.
(iii) The simple cash book is like an ordinary account.
DOUBLE-COLUMN CASH BOOK
If along with columns for amounts to record cash receipts and cash payments another column is added on each
side to record the cash discount allowed or the discount received, or a column on the debit side showing bank
receipts and another column on the credit side showing payments through bank. It is a double-column cash book.
Cash discount is an allowance which often accompanies cash payments. For example, if a customer owes
` 500 but is promised that 2% will be deducted if payment is made within a certain period, the customer can clear
his account by paying promptly ` 490. Cash received will be ` 490 and ` 10 will be the discount for the firm
receiving the payment discount is a loss; for the person making the payment it is a gain. Since cash discount is
allowed only if cash is paid, it is convenient to add a column for discount allowed on the receipt side of the cash
book and a column for discount received on the payment side of the cash book.
In the cash column on the debit side, actual cash received is entered; the amount of the discount allowed, if any,
to the customer concerned is entered in the discount column. Similarly, actual cash paid is entered in the cash
column on the payments side and discount received in the discount column. Also the bank column on the debit
side records all receipts through bank and the same column on the credit side shows payment through bank.
Balancing: It should be noted that the discount columns are not balanced. They are merely totalled. The total of
the discount column on the receipts side shows total discount allowed to customers and is debited to the Discount
Account. The total of the column on the payments side shows total discount received and is credited to the
Discount Account. The Cash columns are balanced, as already shown. The bank columns are also balanced and
the balancing figure is called bank balance. Thus a double column cash book should have two columns on each
side comprising of either cash and discount transaction or cash and bank transactions.

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79 ACCOUNTING PROCESS 2.79

ILLUSTRATION 2

Ganesh commenced business on 1st April, 2020 with ` 2,000 as capital. He had the following cash transactions
in the month of April 2020:
` `
April 1 Purchased furniture April 7 Paid for petty expenses 15
and paid cash 250 “ 8 Cash purchases 150
“2 Purchased goods 500
“4 Sold goods for cash 950
13 Paid for labour 1,000
“5 Paid cash to Ram Mohan 560
“6 He allowed discount 10 “” Paid Ali & Sons 400
“6 Received cash from They allowed discount 8
Krishna & Co. 600 “”
Allowed discount 20

Make out the two-column Cash Book (Cash and discount column) for the month of April, 2020.

SOLUTION

Cash Book
Dr. Receipts L.F. Discount Amount Date Payments L.F. Discount Cr.
Date ` ` 2020 ` Amount
2020 `
April 1 To Capital A/c 2,000 April 1 By Furniture A/c 250
“4 To Sales A/c 950 “ 2 By Purchases A/c 500
“6 To Krishna A/c 20 600
“5 By Ram Mohan 10 560
“7 By Petty
Expenses A/c 15
“8 By Purchases A/c 150
“ 13 By wages A/c 1,000
“ 13 By Ali & Sons 8 400
“ 30 By Balance c/d 675
20 3,550 18 3,550
May 1 To Balance b/d 675

To summarise:
(i) the discount columns in the cash book are totalled;
(ii) they are not balanced; and
(iii) their totals are entered in the discount received/paid account in the ledger.

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2.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

Note: The person who pays, is credited by both the cash paid by him and the discount allowed to him. Similarly,
the person to whom payment is made, is debited with both the amount paid and the discount allowed by him.
THREE-COLUMN CASH BOOK
A firm normally keeps the bulk of its funds at a bank; money can be deposited and withdrawn at will if it is current
account. Probably payments into and out of the bank are more numerous than strict cash transactions. There is
only a little difference between cash in hand and money at bank. Therefore, it is very convenient if, on each side
in the cash book, another column is added to record cash deposited at bank (on the receipt side of the cash
book) and payments out of the bank (on the payment side of the cash book).
For writing up the three-column cash book the under mentioned points should be noted:
1. While commencing a new business, the amount is written in the cash column if cash is introduced and
in the bank column if it is directly put into the bank with the description “To Capital Account”. If a new
cash book is being started for an existing business, the opening balances are written as : “To Balance
b/d”.
2. All receipts are written on the receipts side, cash in the cash column and cheques in the bank column.
If any discount is allowed to the party paying the amount, the discount is entered in the discount column.
In the particulars column the name of the account in respect of which payment has been received is
written.
3. All payments are written on the payments side, cash payment in the cash column and payments by
cheques in the bank column. If some discount has been received from the party receiving the payment,
it is entered in the discount column.
4. Contra Entries: Often cash is withdrawn from bank for use in the office. In such a case the amount is
entered in the bank column on the payments side and also in the cash column on the receipts side. In
the reverse case of cash being sent to the bank, the amount is recorded in the bank column on the
receipts side and in cash column on payment side. Against such entries, the letter “C” should be written
in the LF. column, to indicate that these are contra transaction and no further posting is required for
them.
Note: If initially cheques received are entered in the cash column and then sent to the bank, the entry is
as if cash has been sent to the bank.
While recording contra entries, the basic but important rules should be followed -
(a) The Receiver Dr.
The Giver Cr.
(b) All what comes in Dr.
All what goes out Cr.
e.g. where a Cash Book with separate columns for Bank Account is maintained.
(a) If cash is deposited in Bank Account, the Bank will be the Receiver, hence it will be Debited and
as the cash is going out, cash will be credited.

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81 ACCOUNTING PROCESS 2.81

(b) If cash is withdrawn from the Bank Account, the Bank will be the Giver, hence it will be Credited
and, as the cash is coming in, cash will be Debited.
5. If some cheque sent to the bank is dishonoured, i.e., the bank is not able to collect the amount, it is
entered in the bank column on the credit side with the name of the related party in the particulars column.
6. If some cheque issued by the firm is not paid on presentation, it is entered in the Bank column on the
debit side with the name of the party to whom the cheque was given.
7. In a rare case, a cheque received may be given to some other party, i.e., endorsed. On receipt, it must
have been entered in the bank column on the debit side; on endorsement the amount will be written in
the bank column on the credit side.
The advantages of such type of Cash Book are that -
(a) the Cash Account and the Bank Account are prepared simultaneously, therefore the double
entry is completed in the Cash Book itself. Thus the contra entries can be easily cross-checked
in Cash column in one side and the Bank column in the other side of the Cash Book. Also the
chances of error are reduced.
(b) the information regarding Cash in Hand and the Bank Balance can be obtained very easily and
quickly as there is no need to prepare Ledger of the Bank Account.
In case of maintaining more than one Bank Account, separate column can be add for each Bank Account.
Transactions between these two or more Bank Accounts can be recorded and tallied with a much less
effort.
Suppose, there are two Bank Accounts namely PNB Current Account and SBI-Cash Credit Account.
Now, if a cheque is deposited from PNB cheque Book to SBI Account, the receiver - i.e., PNB Account
will be debited and the giver i.e. the SBI Account shall be credited.
Balancing: The discount columns are totalled but not balanced. The cash columns are balanced exactly
in the same manner as indicated for the simple cash book. The process is similar for balancing the bank
columns also. It is possible, however, that the bank may allow the firm to withdraw more than the amount
deposited i.e., to have an overdraft, In such a case, the total of the bank column on the credit side is
bigger than the one on the debit side. The difference is written on the debit side as “To Balance c/d.”
Then the totals are written on the two sides opposite one another, the balance is then entered on the
credit side as “By Balance b/d.”
However, the usual case is that payments into the bank will exceed the withdrawals or payments out of
the bank. Then the bank columns are balanced just like the cash columns.

ILLUSTRATION 3

Enter the following transactions in Cash Book with Discount and Bank Columns. Cheques are first treated as
cash receipt.
2020 `
Jan.1 Chandrika commences business with Cash 20,000
“ 3 He paid into Current A/c 19,000

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2.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

“ 4 He received cheque from Kirti & Co. on account 600

“ 7 He pays in bank Kirty & Co.’s cheque 600
“ 10 He pays Rattan & Co. by cheque and is allowed discount ` 20 330
“ 12 Tripathi & Co. pays into his Bank A/c 475
“ 15 He receives cheque from Warshi and allows him discount ` 35 450
“ 20 He receives cash ` 75 and cheque ` 100 for cash sale
“ 25 He pays into Bank, including cheques received on 15th and 20th 1,000
“ 27 He pays for cash purchase 275
“ 30 He pays sundry expenses in cash 50

SOLUTION

Dr. Cash Book Cr.

Date Receipts L.F. Discount Cash Bank Date Payments L.F. Discount Cash Bank

` ` ` ` ` `

2020 2020

Jan. To Capital A/c 20,000 Jan. 3 By Bank A/c C 19,000

1

3 To Cash C 19,000 7 By Bank A/c C 600

4 To Kirti & Co. 600 10 By Ratan & Co. 20 330

7 To Cash C 600 25 By Bank A/c C 1,000

12 To Tripathi & Co. 475 27 By Purchases 275

A/c

15 To Warshi 35 450 30 By S. Exp. A/c 50

20 To Sales A/c 175

25 To Cash C 1,000

31 By Balance c/d 300 20,745

35 21,225 21,075 20 21,225 21,075

Feb. To Balance b/d 300 20,745

1

5.3 POSTING THE CASH BOOK ENTRIES

Students would have seen that the cash columns in the cash book is actually the cash account and the bank
column is actually bank account. Also, the discount columns are memorandum columns, meant only to provide
information about the total discount allowed and total discount received.

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83 ACCOUNTING PROCESS 2.83

The debit side columns for cash and bank indicate receipts. Therefore, the amounts debited in the cash book
should be put to the credit of the account in respect of which cash or cheque has been received. For instance, in
the cash book given above we see that `175 have been received for sale of goods. For posting, the amount is
credited to the Sales Account as “By Cash `175.” We also see M/s. Warsi have paid `450 and also they have
been allowed ` 35 as discount; thus they have discharged a debt of `485. In the account of M/s. Warsi, the
posting is on the credit side as
By Cash ` 450
By Discount ` 35
or as:
By Sundries ` 485
All payments are recorded on the credit side. The particulars columns show on what account payments have
been made. In the ledger accounts concerned the amount is put on the debit side. For example, the cash book
shows that a cheque for ` 330 has been issued to M/s. Ratan & Co. and also that they have allowed a discount
of ` 20; thus an obligation of ` 350 has been met. In the account of M/s. Ratan & Co. the posting is:
To Bank ` 330
To Discount ` 20
Or
To Sundries ` 350
The rule thus develops: From the debit side of the cash book credit the various accounts with their respective
amounts (including any discount that may have been allowed); from the credit side of cash book the posting will
be to the debit of the accounts mentioned in the particular column with their respective amounts (including the
discount which may have been received).
As has been shown already, the total of the discount columns on the debit side is debited to the discount account;
the total of the column on the credit side is credited to the discount account. From the cash book given on the
previous page ` 35 is debited and ` 20 be credited to the discount account.

5.4 PETTY CASH BOOK

In a business house a number of small payments, such as for telegrams, taxi fare, cartage, etc., have to be made.
If all these payments are recorded in the cash book, it will become unnecessarily heavy. Also, the main cashier
will be overburdened with work. Therefore, it is usual for firms to appoint a person as ‘Petty Cashier’ and to
entrust the task of making small payments say below ` 200, to him. Of course he will be reimbursed for the
payments made. Later, on an analysis, the respective account may be debited.
IMPREST SYSTEM OF PETTY CASH
It is convenient to entrust a definite sum of money to the petty cashier in the beginning of a period and to
reimburse him for payments made at the end of the period. Thus, he will have again the fixed amount in the
beginning of the new period. Such a system is known as the imprest system of petty cash.

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2.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

The system is very useful specially if an analytical Petty Cash Book is used. The book has one column to record
receipt of cash (which is only from the main cashier) and other columns to record payments of various types. The
total of the various columns show why payments have been made and then the relevant accounts can be debited.
(i) The amount fixed for petty cash should be sufficient for the likely small payments for a relatively short
period, say for a week or a fortnight.
(ii) The reimbursement should be made only when petty cashier prepares a statement showing total
payments supported by vouchers, i.e., documentary evidence and should be limited to the amount of
actual disbursements.
(iii) The vouchers should be filed in order.
(iv) No payment should be made without proper authorization. Also, payments above a certain specified limit
should be made only by the main cashier.
(v) The petty cashier should not be allowed to receive any cash except for reimbursement.
In the petty cash book the extreme left-hand column records receipts of cash. The money column towards the
right hand shows total payments for various purposes; a column is usually provided for sundries to record
infrequent payments. The sundries column is analysed. At the end of the week or the fortnight the petty cash
book is balanced. The method of balancing is the same as for the simple cash book.

ILLUSTRATION 4

Prepare a Petty Cash Book on the imprest System from the following:
2020 `
Jan. 1 Received `100 for petty cash
“ 2 Paid bus fare .50
“ 2 Paid cartage 2.50
“ 3 Paid for Postage & Telegrams 5.00
“ 3 Paid wages for casual labourers 6.00
“ 4 Paid for stationery 4.00
“ 4 Paid tonga charges 2.00
“ 5 Paid for the repairs to chairs 15.00
“ 5 Bus fare 1.00
“ 5 Cartage 4.00
“ 6 Postage and Telegrams 7.00
“ 6 Tonga charges 3.00
“ 6 Cartage 3.00
“ 6 Stationery 2.00
“ 6 Refreshments to customers 5.00

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85 ACCOUNTING PROCESS 2.85

SOLUTION

Petty Cash Book

Receipts Date V. Particulars Total Con- Cartage Statio- Postage & Wages Sundries
` 2020 No. ` veyance ` nery Telegrams ` `
` ` `
100 Jan.1 To Cash
2 1 By Conveyance .50 .50
2 By Cartage 2.50 2.50
3 3 By Postage and 5.00 5.00
Telegrams
4 By Wages 6.00 6.00
4 5 By Stationery 4.00 4.00
6 By Conveyance 2.00 2.00
5 7 By Repairs to 15.00 15.00
Furniture
8 By Conveyance 1.00 1.00
9 By Cartage 4.00 4.00
6 10 By Postage and 7.00 7.00
Telegrams
“ 11 By Conveyance 3.00 3.00
“ 12 By Cartage 3.00 3.00
“ 13 By Stationery 2.00 2.00
“ 14 By General 5.00 5.00
Expenses
60.00 6.50 9.50 6.00 12.00 6.00 20.00
By Balance c/d 40.00
100 100.00
40.00 To Balance b/d
60.00 8 To Cash

ADVANTAGES OF PETTY CASH BOOK

There are mainly three advantages:
(i) Saving of time of the chief cashier;
(ii) Saving in labour in writing up the cash book and posting into the ledger; and
(iii) Control over small payments.

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2.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

POSTING THE PETTY CASH BOOK

In the ledger, a petty cash account is maintained; when an amount is given to the petty cashier, the petty cash
account is debited. Each week or forthnight, the total of the payments made is credited to this account. The petty
cash account will then show the balance in the hand of the cashier; on demand he should be able to produce it
for counting. At the end of the year, the balance is shown in the balance sheet as part of cash balance.
Of course, the payments must be debited to their respective amounts as shown by the petty cash book. For this
two methods may be used:
(i) From the petty cash book the total of the various columns may be directly debited to the concerned
accounts; or
(ii) A journal entry may first be prepared on the basis of the petty cash book, debiting the accounts shown
by the various analysis columns, and crediting the total of the payment of the petty cash accounts.
For Illustration 4 the journal entry and relevant accounts are as follows:
2020 ` `
Jan. 6 Conveyance Account Dr. 6.50
Cartage account Dr. 9.50
Stationery account Dr. 6.00
Postage and Telegrams account Dr. 12.00
Wages Account Dr. 6.00
Repairs Account Dr. 15.00
General Expenses Account Dr. 5.00
To Petty Cash Account 60.00
(Being the analysis of the Petty Cash Book for the week ending Jan. 6)
Entry for cash handed over to the Petty Cashier
Petty Cash Account Dr. 60
To Cash Account 60
(Being Cash received)

Petty Cash Account

Date Particulars Folio Amount Date Particulars Folio Amount
2020 ` 2020 `
Jan.1 To Cash 100.00 Jan. 6 By Sundries:
“8 To Cash 60.00 Conveyance 6.50
Cartage 9.50
Stationery 6.00
Postage and Telegrams 12.00

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87 ACCOUNTING PROCESS 2.87

Wages 6.00
Repairs 15.00
General Expenses 5.00

5.5 ENTRIES FOR SALE THROUGH CREDIT/DEBIT CARDS

Now-a-days sales through Credit/Debit Cards are issued by almost every Bank in India either directly or with
collaboration of some other agencies. HSBC Card, SBI Card, BOB Card, ICICI Bank Card, HDFC Card and
Andhra Bank Card are some of the popular Cards.
The procedure for issuing Credit/Debit Cards are as follows -
1. A small Plastic Card, called Credit Card is issued by bank to a prospective customer, after verifying his
credibility, which is generally measured by his income sources. Debit Card is issued by bank to a
customer who has an account with the bank, maintaining a minimum balance. Now a days ATM Card
issued by the bank can also be used as Debit Card. This card would contain an embossed 16 digit
number and also the name of the cardholder.
2. Generally Bank charges annual subscription fees from the credit card holder. No fee is charged in case
of Debit Card, though some banks charge a nominal fee on Debit Card.
3. When the Card holder intends to buy some goods or services through Credit or Debit Card, the seller
fills in a form, generally in triplicate, the details of the goods a with the amount of sales and uses the
embossed card with the help of the Credit Card machine to print the data on that form. Also the customer
has to countersign the form. One carbon copy of the form is given to the customer for the record.
4. The seller sums up the different amounts sold like this and submits, generally everyday, to his bank all
the forms. The amount is credited by the bank to the seller’s account and debited to the account of the
Bank or the company issuing the Credit/Debit Card.
5. The bank issuing the Card, charges commission for each such transaction, which varies between 1% to
4% and is immediately debited to seller’s bank account.
6. The bank sends a monthly statement to the card holder. In case of Debit Card the account is immediately
debited to the card holder’s account, whereas in case of Credit Card, card holder has to pay the amount
in full or part. However, if not paid in full, the interest is charged.
ACCOUNTING FOR CREDIT/DEBIT CARD SALE
From the seller’s point of view, this type of sale is equivalent to a cash sale. Commission charged by the bank
will be treated as selling expenses. The following journal entries will be made in the seller’s books of accounts.
1. Bank A/c Dr.
To Sales Account
(Sales made through Credit/Debit Card)
2. Commission Account Dr.
To Bank Account
(Commission charged by bank)

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2.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 5

Enter the following transaction in Cash Bank with Discount and Bank columns. Cheques are first treated as cash
receipts -
2020 `
March 1 Cash in Hand 15,000
Overdraft in Bank 500
2 Cash Sales 3,000
3 Paid to Sushil Bros. by cheque 3,400
Discount received 100
5 Sales through credit card 2,800
6 Received cheque from Srijan 6,200
7 Endorsed Srijan’s cheque in favour of Adit
9 Deposit into Bank 6,800
10 Received cheque from Aviral and deposited the same into Bank by allowing discount 3,600
of ` 50
12 Adit informed that Srijan’s cheque is dishonoured. Now cash is received from Srijan
and amount is paid to Adit through own cheque
15 Sales through Debit Card 3,200
24 Withdrawn from Bank 1,800
28 Paid to Sanchit by cheque 3,000
30 Bank charged 1% commission on sales through
Debit/Credit Cards

SOLUTION

Dr. Cash Book Cr.

Date Particulars L.F. Discount Cash Bank Date Particulars L.F. Discount Cash Bank
` ` ` ` ` `

2020 2020
March 1 To Balance b/d 15,000 March 1 By Balance b/d 500
2 To Sales 3,000 3 By Sushil Bros. 100 3,400
5 To Sales 2,800 7 By Adit 6,200
6 To Srijan 6,200 9 By Bank C 6,800
9 To Cash A/c C 6,800 12 By Adit 6,200
10 To Aviral 50 3,600 24 By Cash A/c C 1,800
12 To Srijan 6,200 28 By Sanchit 3,000

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89 ACCOUNTING PROCESS 2.89

15 To Sales A/c 3,200 30 By Commission 60

24 To Bank A/c C 1,800 31 By Balance c/d 19,200 1,440
50 32,200 16.400 100 32,200 16,400

Note: If the received cheque is endorsed to the other party on the same day, then no entry is required.
However, in the above case posting has been done through cash column as the endorsement is done on next
day.

SUMMARY
 Cash book contains cash transactions and also bank transactions, if it has a separate book column. It is
both a subsidiary book and a principal book.
 Cash book can be prepared adding discount column also.
 For small payments, petty cash book is maintained separately recording the particulars of payment and
its amount. The fixed amount is given to the petty cashier for making small payments in the beginning
of the period. The amount spent is replenished so that he will have again the fixed sum in the beginning
of the next period. This system is known as imprest system of petty cash book.

TEST YOUR KNOWLEDGE

True and False
1. Cash book is a subsidiary book as well as a principal book.
2. Two column cash book consists of two columns cash column & bank column.
3. Discount column of cash book is never balanced.
4. Contra entry is passed in a two column cash book.
5. If the bank column is showing the opening balance on credit side, it is an overdraft.
6. A cash book records cash transactions as well as credit transactions.
7. Discount column of cash book records the trade discount.

Multiple Choice Questions

1. The total of discounts column on the debit side of the cash book, recording cash discount deducted by
customers when paying their accounts, is posted to the __________________________
(a) Credit of the discount allowed account.
(b) Debit of the discount allowed account
(c) Credit of the discount received account.
2. Cash book is a type of __________ but treated as a ____________ of accounts.
(a) Subsidiary book, principal book
(b) Principal book, subsidiary book
(c) Subsidiary book, subsidiary book

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2.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. Which of the following is not a column of a three-column cash book?

(a) Cash column
(b) Bank column
(c) Petty cash column
4. Contra entries are passed only when __________________________
(a) Double-column cash book is prepared
(b) Three-column cash book is prepared
(c) Simple cash book is prepared
5. The Cash Book records __________________________
(a) All cash receipts
(b) All cash payments
(c) All cash receipts and payments
6. The balance in the petty cash book is __________________________
(a) An expense
(b) A profit
(c) An asset
7. If Ram has sold goods for cash, the entry will be recorded __________________________
(a) In the Cash Book
(b) In the Sales Book
(c) In the Journal

Theory Questions
1. Is cash book a subsidiary book or a principal book? Explain.
2. What are the various kinds of cash book?
3. What are the advantages of a three column cash book?

Practical Questions
1. Shri Ramaswamy maintains a Columnar Petty Cash Book on the Imprest System. The imprest amount
is ` 500. From the following information, show how his Petty Cash Book would appear for the week
ended 12th September, 2020:
`
7-9-2020 Balance in hand 134.90
Received Cash reimbursement to make up the imprest 365.10

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91 ACCOUNTING PROCESS 2.91

Stationery 49.80
8-9-2020 Miscellaneous Expenses 20.90
9-9-2020 Repairs 156.70
10-9-2020 Travelling 68.50
11-9-2020 Stationery 71.40
12-9-2020 Miscellaneous Expenses 6.30
Repairs 48.30

ANSWERS/HINTS
True and False
1. True: Since the balance is taken to the Trial balance cash book is a subsiadiary book as wellas principal
book.
2. False: Two column cash book consists of two columns cash column & discount column.
3. True: Discount column is totaled and transferred to the discount allowed or received account.
4. False: Contra entry is passed in a three column cash book which includes bank and cash columns.
5. True: Usually the debit side of opening balance shows a favorable balance, where there is unfavorable-
overdraft then it should be shown on the credit side
6. False: A cash book records only cash transactions.
7. False: Discount column of cash book records the cash discount. Trade discount is not shown in the
books of accounts.

Multiple Choice Questions

1. (b) 2. (a) 3. (c) 4. (b) 5. (c) 6. (c) 7. (a)

Theoretical Questions
1. Cash transactions are straightaway recorded in the Cash Book and on the basis of such a record, ledger
accounts are prepared. Therefore, the Cash Book is a subsidiary book. But the Cash Book itself serves
as the cash account and the bank account; the balances are entered in the trial balance directly. The
Cash Book, therefore, is part of the ledger also. Hence, it has also to be treated as the principal book.
The Cash Book is thus both a subsidiary book and a principal book.
2. The main Cash Book may be of the three types:
(i) Simple Cash Book;
(ii) Two-column Cash Book;
(iii) Three-column Cash Book.

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2.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

In addition to the main Cash Book, firms also generally maintain a petty cash book but that is purely a
subsidiary book.
3. The advantages of three column Cash Book are that -
(a) the Cash Account and the Bank Account are prepared simultaneously, therefore the double
entry is completed in the Cash Book itself. Thus the contra entries can be easily cross-checked
in Cash column in one side and the Bank column in the other side of the Cash Book. Also the
chances of error are reduced.
(b) the information regarding Cash in Hand and the Bank Balance can be obtained very easily and
quickly as there is no need to prepare Ledger of the Bank Account.

Practical Problems
Answer 1
Petty Cash Book
Date Receipts Amount Date Payments Total Stationery Travelling Misc Repairs
2020 ` 2020 Amount ` ` Exps. `
` `
Sept. 7 To Balance b/d 134.90 7 By Stationery 49.80 49.80
To Reimbursement 365.10 8 By Misc. Expenses 20.90 20.90
9 By Repairs 156.70 156.70
10 By Travelling 68.50 68.50
11 By Stationery 71.40 71.40
12 By Misc. Expenses 6.30 6.30
By Repairs 48.30 48.30
421.90 121.20 68.50 27.20 205.00
By Balance c/d 78.10
500.00 500.00
13 To Balance b/d 78.10

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UNIT 6 : RECTIFICATION OF ERRORS

LEARNING OUTCOMES

After studying this unit, you would be able to

 Understand different types of errors which may occur in course of recording transactions and
events.
 Be familiar with the steps involved in locating errors.
 Learn the nature of one-sided errors and two-sided errors.
 Understand why suspense account is opened for rectification of errors.
 Understand the technique of correcting errors of one period in the next accounting period.

UNIT OVERVIEW

Errors of
Principal

Errors of Types of Erros of

Omissions Errors Commission

Compensating
Errors

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2.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

6.1 INTRODUCTION
Unintentional omission or commission of amounts and accounts in the process of recording the transactions are
commonly known as errors. These various unintentional errors can be committed at the stage of collecting
financial information/data on the basis of which financial statements are drawn or at the stage of recording this
information. Also errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies,
misinterpretation of facts, or oversight. To check the arithmetic accuracy of the journal and ledger accounts, trial
balance is prepared. If the trial balance does not tally, then it can be said that there are errors in the accounts
which require rectification thereof. Some of these errors may affect the Trial Balance and some of these do not
have any impact on the Trial Balance although such errors may affect the determination of profit or loss, assets
and liabilities of the business.
Illustrative Case of Errors and their Nature
We have seen that after preparing ledger accounts a trial balance is taken out where debit and credit balances
are separately listed and totalled. If the two totals do not agree, it is definite that there have been some errors
We shall now study the types of errors which may be committed and how they may be rectified. For this purpose,
the working of the following illustrative cases should be carefully seen.
Illustrative Cases of Errors
(a) Wrong Entry: Let us start from the first phase in the accounting process. Wrong entry of the value of
transactions and events in the subsidiary books, Journal Proper and Cash Book may occur.
Example 1: Credit purchases `17,270 are entered in the Purchases Day Book as `17,720. Credit sales
of `15,000 gross less 1% trade discount are wrongly entered in Sales Day Book at `15,000. Cheque
issued `19,920 are wrongly entered in the credit of bank column in the Cash Book as `19,290.
(b) Wrong casting of subsidiary books: Subsidiary books are totalled periodically and posted to the
appropriate ledger accounts. There may arise totalling errors. Totalling errors may arise due to wrong
entry or simply these may be independent errors.
Example 2: For the month of January, 2020 total of credit sales are `1,75,700, this is wrongly totalled
as `1,76,700 and posted to sales account as `1,76,700.
(c) In case of cash book, wrong castings result in wrong calculation of the balance c/d.
Example 3: The following cash transactions of M/s. Tularam & Co. occurred:
2021
Jan. 1 Balance - cash `1,200 bank `16,000;
Jan. 2 Cheque issued to M/s. Bholaram & Co., a supplier, for `22,500;
Jan. 6 Cheque collected from M/s. Scindia & Bros. `42,240 and deposited for clearance;
Jan. 7 Cash sales `27,200 paid wages `12,400;
Jan. 8 Cash sales ` 37,730 cash deposited to bank ` 35,000.

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95 ACCOUNTING PROCESS 2.95

The following Cash Book entries are passed:

Dr. Cash Book Cr.
Date Particulars Cash Bank Date Particulars Cash Bank
2021 ` ` 2021 ` `
Jan. 1 To Balance b/d 1,200 16,000 Jan. 2 By M/s Bholaram & Co. A/c 22,500
Jan. 6 To M/s. Scindia & Bros. A/c 42,420 By Wages A/c 12,200
Jan. 7 To Sales A/c 27,200 By Bank A/c 34,500
Jan. 8 To Sales A/c 37,370 By Balance c/d 19,070 71,420

Jan. 8 To Cash A/c 34,500

65,770 93,920 65,770 93,920

Wrong entries and wrong casting are shown in bold prints. However, errors of cash entries generally are
not carried. Usually cash balances are tallied daily. So errors are identified at an early stage. But bank
balance cannot be checked daily and thus errors may be carried until bank reconciliation is made. In the
above example, there are four wrong entries and one wrong casting. Bank and cash balances are
affected by these errors.
(d) Wrong posting from subsidiary books: In this case, the wrong amount may be posted to the ledger
account or the amount may posted to the wrong side or to the wrong account. For example, purchases
from A may be posted to B’s account.
(e) Wrong casting of ledger balances: Likewise Cash Book, any ledger account balance may be cast
wrongly. Obviously wrong postings make the balance wrong; but that is not wrong casting of balances.
Whenever there arises independent casting error as in the case of bank column in the Cash Book of
example (4), that is called wrong casting of ledger balances.
Example 4: The following are the credit purchases of M/s. Ballav Bros.:
2021
Jan. 1 Purchases from M/s. Saurabh & Co.- gross `1,00,000 less 1% trade discount.
Jan. 3 Purchases from M/s. Netai & Co.- gross ` 70,000 less 1% trade discount.
Jan. 6 Purchases from M/s. Saurabh & Co.- gross ` 60,000 less 1% trade discount
Let us cast M/s. Saurabh & Co.’s Account:
Dr. M/s Saurabh & Co. Account Cr.
Date Particulars Amount ` Date Particulars Amount `
2021 2021
Jan. 1 To Balance c/d 1,55,400 Jan. 1 By Purchases A/c 99,000
Jan. 6 By Purchases A/c 59,400
1,55,400 *1,55,400
*While casting the credit side an error has been committed and so the account is wrongly balanced.

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2.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

Example 5: Goods are purchased on credit from M/s. Saurabh & Co. for ` 27,030 and from
M/s. Karnataka Suppliers for ` 28,050. The following Day Book is prepared:
Purchases Day Book
Date Particulars Amount
`
M/s. Saurabh & Co. 27,050
M/s. Karnataka Suppliers 28,030
55,080

In the Day Book both the transactions are entered wrongly but the first error has been compensated by
the second. Even if these errors are not rectified Trial Balance would tally.
Trial Balance
Particulars Dr. Cr.
` `
M/s. Saurabh & Co. 27,050
M/s. Karnataka Suppliers 28,030
Purchases Account 55,080
55,080 55,080

6.2 STAGES OF ERRORS

Errors may occur at any of the following stages of the accounting process:
AT THE STAGE OF RECORDING THE TRANSACTIONS IN JOURNAL
Following types of errors may happen at this stage:
(i) Errors of principle,
(ii) Errors of omission,
(iii) Errors of commission.
AT THE STAGE OF POSTING THE ENTRIES IN LEDGER
(i) Errors of omission:
(a) Partial omission,
(b) Complete omission.
(ii) Errors of commission:
(a) Posting to wrong account,
(b) Posting on the wrong side,
(c) Posting of wrong amount.

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AT THE STAGE OF BALANCING THE LEDGER ACCOUNTS

(a) Wrong Totalling of accounts,
(b) Wrong Balancing of accounts.
AT THE STAGE OF PREPARING THE TRIAL BALANCE
(a) Errors of omission,
(b) Errors of commission:
1. Taking wrong account,
2. Taking wrong amount,
3. Taking to the wrong side.
On the above basis, we can classify the errors in four broad categories:
1. Errors of Principle,
2. Errors of Omission,
3. Errors of Commission,
4. Compensating Errors.

6.3 TYPES OF ERRORS

Basically errors are of two types:
(a) Errors of principle: When a transaction is recorded in contravention of accounting principles, like
treating the purchase of an asset as an expense, it is an error of principle. In this case there is no effect
on the trial balance since the amounts are placed on the correct side, though in a wrong account.
Suppose on the purchase of a computer, the office expenses account is debited; the trial balance will
still agree.
(b) Clerical errors: These errors arise because of mistake committed in the ordinary course of the
accounting work. These are of three types:
(i) Errors of Omission: If a transaction is completely or partially omitted from the books of account,
it will be a case of omission. Examples would be: not recording a credit purchase of furniture or
not posting an entry into the ledger.
(ii) Errors of Commission: If an amount is posted in the wrong account or it is written on the wrong
side or the totals are wrong or a wrong balance is struck, it will be a case of “errors of
commission.”
(iii) Compensating Errors: If the effect of errors committed cancel out, the errors will be called
compensating errors. The trial balance will agree. Suppose an amount of `10 received from A
is not credited to his account and the total of the sales book is `10 in excess. The omission of
credit to A’s account will be made up by the increased credit to the Sales Account.

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From another point of view, error may be divided into two categories:
(a) Those that affect the trial balance - because of these errors, trial balance does not agree; these
are the following:
(i) Wrong casting of the subsidiary books.
(ii) Wrong balancing of an account.
(iii) Posting an amount on the wrong side.
(iv) Posting the wrong amount.
(v) Omitting to post an amount from a subsidiary book.
(vi) Omitting to post the totals of subsidiary book.
(vii) Omitting to write the cash book balances in the trial balance.
(viii) Omitting to write the balance of an account in the trial balance.
(ix) Writing a balance in wrong column of the trial balance.
(x) Totalling the trial balance wrongly.
(b) The errors that do not affect the trial balance are the following:
(i) Omitting an entry altogether from the subsidiary book.
(ii) Making an entry with the wrong amount in the subsidiary book.
(iii) Posting an amount in a wrong account but on the correct side, e.g., an amount to be
debited to A is debited to B, the trial balance will still agree.

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99 ACCOUNTING PROCESS 2.99

6.4 STEPS TO LOCATE ERRORS

Even if there is only a very small difference in the trial balance, the errors leading to it must be located and
rectified. A small difference may be the result of a number of errors. The following steps will be useful in locating
errors :
(i) The two columns of the trial balance should be totalled again. If in place of a number of accounts, only
one amount has been written in the trial balance the list of such accounts should be checked and totalled
again. List of Trade receivables is the example from which Trade receivable balance is derived.
(ii) It should be seen that the cash and bank balances have been written in the trial balance.
(iii) The exact difference in the trial balance should be established. The ledger should be gone through; it is
possible that a balance equal to the difference has been omitted from the trial balance. The difference
should also be halved; it is possible that balance equal to half the difference has been written in the
wrong column.
(iv) The ledger accounts should be balanced again.
(v) The casting of subsidiary books should be checked again, especially if the difference is
` 1, ` 100 etc.
(vi) If the difference is very big, the balance in various accounts should be compared with the corresponding
accounts in the previous period. If the figures differ materially the cases should be seen; it is possible
that an error has been committed. Suppose the sales account for the current year shows a balance of
` 32,53,000 whereas it was ` 36,45,000 last year; it is possible that there is an error in the Sales
Account.
(vii) Postings of the amounts equal to the difference or half the difference should be checked. It is possible
that an amount has been omitted to be posted or has been posted on the wrong side.
(viii) If there is still a difference in the trial balance, a complete checking will be necessary. The posting of all
the entries including the opening entry should be checked. It may be better to begin with the nominal
accounts.

6.5 RECTIFICATION OF ERRORS

Errors should never be corrected by overwriting. If immediately after making an entry it is clear that an error has
been committed, it may be corrected by neatly crossing out the wrong entry and making the correct entry. If
however the errors are located after some time, the correction should be made by making another suitable entry,
called rectification entry. In fact the rectification of an error depends on at which stage it is detected. An error can
be detected at any one of the following stages:
(a) Before preparation of Trial Balance.
(b) After Trial Balance but before the final accounts are drawn.
(c) After final accounts, i.e., in the next accounting period.

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2.100 PRINCIPLES AND PRACTICE OF ACCOUNTING

6.5.1 Before preparation of Trial Balance

There are some errors which affect one side of an account or which affect more than one account in such a way
that it is not possible to pass a complete rectification entry. In other words, there are some errors which can be
corrected, if detected at this stage, by making rectification statement in the appropriate side(s) of concerned
account(s). It is important to note here that such errors may involve only one account or more than one account.
Read the following illustrations:
(i) The sales book for November is undercast by ` 200. The effect of this error is that the Sales Account
has been credited short by ` 200. Since the account is posted by the total of the sales book, there is no
error in the accounts of the customers since they are posted with amounts of individual sales. Hence
only the Sales Accounts is to be corrected. This will be done by making an entry for ` 200 on the credit
side: “By undercasting of Sales Book for November ` 200”.
(ii) While posting the discount column on the debit side of the cash book the discount of
` 10 allowed to Ramesh has not been posted. There is no error in the cash book, the total of discount
column presumably has been posted to the discount account on the debit side. The error is in not
crediting Ramesh by ` 10. This should now be done by the entry “By omission of posting of discount on
----- `10”.
(iii) ` 200 received from Ram has been entered by mistake on the debit side of his account. Since the cash
book seems to have been correctly written, the error is only in the account of Ram - he should have been
credited and not debited by ` 200. Not only is the wrong debit to be removed but also a credit of ` 200
is to be given. This can be done now by entering ` 400 on the credit side of his account. The entry will
be “By Posting on the wrong side - ` 400”.
(iv) ` 50 was received from Mahesh and entered on the debit side of the cash book but was not posted to
his account. By the error, which affects only the account of Mahesh, ` 50 has been omitted from the
credit side of his account. The rectification will be by the entry. “By Omission of posting on the ` 50.”
(v) ` 51 paid to Mohan has been posted as `15 to the debit of his account. Mohan has been debited short
by ` 36. The rectifying entry is “To mistake in posting on ` 36”.
(vi) Goods sold to Ram for `1,000 was wrongly posted from sales day book to the debit of purchase account.
Ram has however been correctly debited. Here the error affects two accounts, viz., purchases account
and sales account but we cannot pass a journal entry for its rectification because both the accounts need
to be credited. The rectification will be by the entry “By wrong posting on ` 1,000” in the credit of
purchases account and also “By omission of posting on - ` 1,000” in the credit sales account.
(vii) Bills receivable from Mr. A of ` 500 was posted to the credit of Bills payable Account and also credited
to A account. Here also although two accounts are involved we cannot pass a complete journal entry for
rectification. The rectification will be by the entry “To wrong posting on ` 500” in debit of Bills payable
Account and also “To omission of posting on ` 500” in the debit of Bills Receivable Account.
(viii) Goods purchased from Vinod for ` 1,000 was wrongly credited to Vimal account by ` 100. Again we
cannot pass a complete journal entry for rectification even though two accounts are involved. The
rectification will be done by the entry “To wrong posting on `100” in the debit of Vimal account and “By
omission of posting on ` 1,000” in the credit of Vinod account.

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101 ACCOUNTING PROCESS 2.101

Thus, from the above illustrations we are convinced that the general rule that errors affecting two accounts can
always be corrected by a journal entry is not always valid.

ILLUSTRATION 1

How would you rectify the following errors in the book of Rama & Co.?
1. The total to the Purchases Book has been undercast by ` 100.
2. The Returns Inward Book has been undercast by ` 50.
3. A sum of ` 250 written off as depreciation on Machinery has not been debited to Depreciation Account.
4. A payment of ` 75 for salaries (to Mohan) has been posted twice to Salaries Account.
5. The total of Bills Receivable Book ` 1,500 has been posted to the credit of Bills Receivable Account.
6. An amount of `151 for a credit sale to Hari, although correctly entered in the Sales Book, has been
posted as ` 115.
7. Discount allowed to Satish ` 25 has not been entered in the Discount Column of the Cash Book. the
amount has been posted correctly to the credit of his personal account.

SOLUTION

1. The Purchases Account should receive another debit of `100 since it was debited short previously:
“To Undercasting of Purchases Book for the month of --- `100.”
2. Due to this error the Returns Inward Account has been posted short by ` 50 : the correct entry will be:
“To Undercasting of Returns Inward Book for the month of --- `50.”
3. The omission of the debit to the Depreciation Account will be rectified by the entry:
“To Omission of posting on ` 250”.
4. The excess debit will be removed by a credit in the Salaries Account by the entry:
“By double posting on ` 75”.
5. `1,500 should have been debited to the Bills Receivable Account and not credited. To correct the
mistake, the Bills Receivable Account should be debited by ` 3,000 by the entry:
“To Wrong posting of B/R received on ` 3,000”
6. Hari’s personal A/c is debited ` 36 short. The rectification entry will be:
“To Wrong posting ` 36”.
7. Due to this error, the discount account has been debited short by ` 25. The required entry is :
“To Omission of discount allowed to Satish on ` 25.”
So far we have discussed the correction of errors which affected only one Account or more than one account but
for which rectifying entries were not complete journal entries. We shall now take up the correction of errors which
affect more than one account in such a way that complete journal entries are possible for their rectification. Read
the following illustrations:

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2.102 PRINCIPLES AND PRACTICE OF ACCOUNTING

(i) The purchase of machinery for ` 2,000 has been entered in the purchases book. The effect of the entry
is that the account of the supplier Ram & Co. has been credited by ` 2,000 which is quite correct. But
the debit to the Purchases Account is wrong : the debit should be to Machinery Account. To rectify the
error, the debit in the purchases Account has to be transferred to the Machinery Account. The correcting
entry will be to Credit Purchases Account and debit the Machinery Account. Please see the three entries
made below: the last entry rectifies the error:
Wrong Entry: ` `
Purchases Account Dr. 2,000
To Ram & Co. 2,000
Correct Entry:
Machinery Account Dr. 2,000
To Ram & Co. 2,000
Rectifying Entry:
Machinery Account Dr. 2,000
To Purchases Account 2,000

(ii) `100 received from Kamal Kishore has been credited in the account of Krishan Kishore. The error is that
there is a wrong credit in the account of Krishan Kishore and omission of credit in the account of Kamal
Kishore; Krishan Kishore should be debited and Kamal Kishore be credited. The following three entries
make this clear:
Wrong Entry: ` `
Cash Account Dr. 100
To Krishan Kishore 100
Correct Entry:
Cash Account Dr. 100
To Kamal Kishore 100
Rectifying Entry:
Krishan Kishore Dr. 100
To Kamal Kishore 100

(iii) The sale of old machinery, `1,000 has been entered in the sales book. By this entry the account of the
buyer has been correctly debited by `1,000. But instead of crediting the Machinery Account. Sales
Account has been credited. To rectify the error this account should be debited and the Machinery
Account credited. See the three entries given below:
Wrong Entry: ` `
Buyer’s Account Dr. 1,000
To Sales Account 1,000
Correct Entry:

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103 ACCOUNTING PROCESS 2.103

Buyer’s Account Dr. 1,000

To Machinery Account 1,000
Rectifying Entry:
Sales Account Dr. 1,000
To Machinery Account 1,000

ILLUSTRATION 2

The following errors were found in the book of Ram Prasad & Sons. Give the necessary entries to correct them.
(1) ` 500 paid for furniture purchased has been charged to ordinary Purchases Account.
(2) Repairs made were debited to Building Account for ` 50.
(3) An amount of `100 withdrawn by the proprietor for his personal use has been debited to Trade Expenses
Account.
(4) `100 paid for rent debited to Landlord’s Account.
(5) Salary ` 125 paid to a clerk due to him has been debited to his personal account.
(6) ` 100 received from Shah & Co. has been wrongly entered as from Shaw & Co.
(7) ` 700 paid in cash for a typewriter was charged to Office Expenses Account.

SOLUTION

Journal
Particulars L.F. Dr. Cr.
` `
(1) Furniture A/c Dr. 500
To Purchases A/c 500
(Correction of wrong debit to Purchases A/c for furniture purchased)
(2) Repairs A/c Dr. 50
To Building A/c 50
(Correction of wrong debit to building A/c for repairs made)
(3) Drawings A/c. Dr. 100
To Trade Expenses A/c 100
(Correction of wrong debit to Trade Expenses A/c for cash withdrawn
by the proprietor for his personal use)
(4) Rent A/c Dr. 100
To Landlord’s Personal A/c 100
(Correction of wrong debit to landlord’s A/c for rent paid)
(5) Salaries A/c Dr. 125
To Clerk’s (Personal) A/c 125
(Correction of wrong debit to Clerk’s personal A/c for salaries paid)

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2.104 PRINCIPLES AND PRACTICE OF ACCOUNTING

(6) Shaw & Co. Dr. 100

To Shah & Co. 100
(Correction of wrong credit to Shaw & Co. Instead of Shah & Co.)
(7) Typewriter A/c Dr. 700
To Office Expenses A/c 700
(Correction of wrong debit to Office Expenses A/c for purchase of
typewriter)

ILLUSTRATION 3

Give journal entries to rectify the following:

(1) A purchase of goods from Ram amounting to `150 has been wrongly entered through the Sales Book.
(2) A Credit sale of goods amounting `120 to Ramesh has been wrongly passed through the Purchase
Book.
(3) On 31st December, 2020 goods of the value of ` 300 were returned by Hari Saran and were taken
inventory on the same date but no entry was passed in the books.
(4) An amount of ` 200 due from Mahesh Chand, which had been written off as a Bad Debt in a previous
year, was unexpectedly recovered, and had been posted to the personal account of Mahesh Chand.
(5) A Cheque for ` 100 received from Man Mohan was dishonoured and had been posted to the debit of
Sales Returns Account.

SOLUTION

Journal
Particulars L.F. Dr. Cr.
` `
(1) Purchases A/c Dr. 150
Sales A/c Dr. 150
To Ram 300
(Correction of wrong entry in the sales Book for a purchases of goods from Ram)
(2) Ramesh Dr. 240
To Purchases A/c 120
To Sales A/c 120
(Correction of wrong entry in the Purchases Book of a credit sale of goods to
Ram)
(3) Returns Inwards A/c Dr. 300
To Hari Saran 300
(Entry of goods returned by him and taken in inventory omitted from records)
(4) Mahesh Chand Dr. 200

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105 ACCOUNTING PROCESS 2.105

To Bad Debts Recovered A/c 200

(Correction of wrong credit to Personal A/c in respect of recovery of previously
written off bad debts)
(5) Man Mohan Dr. 100
To Sales Return A/c 100
(Correction of wrong debit to Sales Returns A/c for dishonour of cheque
received from Man Mohan)

Thus, it can be said that errors detected before the preparation of trial balance can be rectified either through
rectification statements (not entries) or through rectification entries.

6.5.2 After Trial Balance but before Final Accounts

The method of correction of error indicated so far is appropriate when the errors have been located before the
end of the accounting period. After the corrections the trial balance will agree. Sometimes the trial balance is
artificially made to agree inspire of errors by opening a suspense account and putting the difference in the trial
balance to the account - the suspense account will be debited if the total of the credit column in the trial balance
exceeds the total of the debit column; it will be credited in the other case.
One must note that such agreement of the trial balance will not be real. Effort must be made to locate the errors.
The rule of rectifying errors detected at this stage is simple. Those errors for which complete journal entries were
not possible in the earlier stage of rectification (i.e., before trial balance) can now be rectified by way of journal
entry(s) with the help of suspense account, for it these errors which gave rise to the suspense account in the trial
balance. The rectification entry for other type of error i.e. error affecting more than one account in such a way
that a complete journal entry is possible for its rectification, can be rectified in the same way as in the earlier
stage (i.e. before trial balance).
In a nutshell, it can be said that each and every error detected at this stage can only be corrected by a complete
journal entry. Those errors for which journal entries were not possible at the earlier stage will now be rectified by
a journal entry(s), the difference or the unknown side is being taken care of by suspense account. Those errors
for which entries were possible even at the first stage will now be rectified in the same way.
Suppose, the sales book for November, 2019 is cast `100 short; as a consequence the trial balance will not
agree. The credit column of the trial balance will be `100 short and a Suspense Account will be credited by `100.
To rectify the error the Sales Account will be credited (to increase the credit to the right figure. Since now one
error remains, the Suspense Account must be closed- it will be debiting the Suspense Account. The entry will be:
Suspense Account Dr. `100
To Sales Account `100
(Correction of error of undercasting the sales Book for November 2019)

ILLUSTRATION 4

Correct the following errors (i) without opening a Suspense Account and (ii) opening a Suspense Account:
(a) The Sales Book has been totalled `100 short.

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2.106 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) Goods worth `150 returned by Green & Co. have not been recorded anywhere.
(c) Goods purchased `250 have been posted to the debit of the supplier Gupta & Co.
(d) Furniture purchased from Gulab & Bros, `1,000 has been entered in Purchases Day Book.
(e) Discount received from Red & Black `15 has not been entered in the Discount Column of the Cash Book.
(f) Discount allowed to G. Mohan & Co. `18 has not been entered in the Discount Column of the Cash
Book. The account of G. Mohan & Co. has, however, been correctly posted.

SOLUTION

If a Suspense Account is not opened.

(a) Since sales book has been cast `100 short, the Sales Account has been similarly credited `100 short.
The correcting entry is to credit the Sales Account by `100 as “By wrong totalling of the Sales Book
`100”.
(b) To rectify the omission, the Returns Inwards Account has to be debited and the account of Green & Co.
credited. The entry:
Returns Inward Account Dr. `150
To Green & Co. `150
(Goods returned by the firm, previously omitted from the Returns Inward Book)

(c) Gupta & Co. have been debited `250 instead of being credited. This account should now be credited by
500 to remove the wrong debit and to give the correct debit. The entry will be on the credit side... “By
errors in posting `500”.
(d) By this error Purchases Account has to be debited by `1,000 whereas the debit should have been to the
Furniture Account. The correcting entry will be:
Furniture Account Dr. `1,000
To Purchases Account `1,000
(Correction of the mistake by which of the Furniture Account)

(e) The discount of `15 received from Red & Black should have been entered on the credit side of the cash
book. Had this been done, the Discount Account would have been credited (through the total of the
discount column) and Red & Black would have been debited. This entry should not be made:
Red & Black Dr. `15
To Discount Account `15
(Rectification of the error by which the discount allowed by the firm was not
entered in Cash Book)

(f) In this case the account of the customer has been correctly posted; the Discount Account has been
debited `18 short since it has been omitted from the discount column on the debit side of the cash book.
The discount account should now be debited by the entry; “To Omission of entry in the Cash Book `18.”

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If a Suspense Account is opened :

Particulars L.F. Dr. Cr.
` `
(a) Suspense Account Dr. 100
To Sales Account 100
(Being the correction arising from under- casting of Sales Day
Book)
(b) Return Inward Account Dr. 150
To Green & Co . 150
(Being the recording of unrecorded returns)
(c) Suspense Account Dr. 500
To Gupta & Co. 500
(Being the correction of the error by which Gupta & Co. was
debited instead of being credited by ` 250).
(d) Furniture Account Dr. 1,000
To Purchases Account 1,000
(Being the correction of recording purchase of furniture as
ordinary purchases)
(e) Red & black Dr. 15
To Discount Account 15
(Being the recording of discount omitted to be recorded)
(f) Discount Account Dr. 18
To Suspense Account 18
(Being the correction of omission of the discount allowed from
Cash Book customer’s account already posted correctly).

Suspense Account
Dr. Particulars Amount Date Particulars Cr.
Date ` Amount`
To Sales A/c 100 By Difference in
To Gupta & Co. 500 Trial Balance 582
By Discount A/c 18
600 600

Notes:
(i) One should note that the opening balance in the Suspense Account will be equal to the
difference in the trial balance.

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2.108 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) If the question is silent as to whether a Suspense Account has been opened, the student should
make his assumption, state it clearly and then proceed.

ILLUSTRATION 5

Correct the following errors found in the books of Mr. Dutt. The Trial Balance was out by ` 493 excess credit.
The difference thus has been posted to a Suspense Account.
(a) An amount of `100 was received from D. Das on 31st December, 2020 but has been omitted to enter in
the Cash Book.
(b) The total of Returns Inward Book for December has been cast `100 short.
(c) The purchase of an office table costing ` 300 has been passed through the Purchases Day Book.
(d) ` 375 paid for Wages to workmen for making show-cases had been charged to “Wages Account”.
(e) A purchase of ` 67 had been posted to the trade payables’ account as ` 60.
(f) A cheque for ` 200 received from P. C. Joshi had been dishonoured and was passed to the debit of
“Allowances Account”.
(g) ` 1,000 paid for the purchase of a motor cycle for Mr. Dutt had been charged to “Miscellaneous Expenses
Account”.
(h) Goods amounting to `100 had been returned by customer and were taken in to inventory, but no entry
in respect there of, was made into the books.
(i) A sale of ` 200 to Singh & Co. was wrongly credited to their account. Entry was made correctly made
in sales book.

SOLUTION

(a) Journal Entries

Particulars L.F. ` `
(a) Cash Account Dr. 100
To D. Das 100
(Being the amount received)
(b) Returns Inward Account Dr. 100
To Suspense Account 100
(Being the mistake in totalling the Returns Inward Book
corrected)
(c) Furniture Account Dr. 300
To Purchases Account 300
(Being the rectification of mistake by which purchase of
furniture was entered in Purchases book and hence debited to
Purchases Account)

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109 ACCOUNTING PROCESS 2.109

(d) Furniture Account Dr. 375

To Wages Account 375
(Being the wages paid to workmen for making show-cases
which should be capitalised and not to be charged to Wages
Account)
(e) Suspense Account Dr. 7
To Creditors (personal) Account 7
(Being the mistake in crediting the Trade payables Account less
by ` 7, now corrected)
(f) P.C. Joshi Dr. 200
To Allowances Account 200
(Being the cheque of P.C. Joshi dishonoured, previously
debited to Allowances Account)
(g) Drawings Account Dr. 1,000
To Miscellaneous Expenses 1,000
(Being the motor cycle purchased for Mr. Dutt debited to his
Drawings Account instead of Miscellaneous Expenses Account
as previously done by mistake)
(h) Returns Inward Account Dr. 100
To Debtors (Personal) Account 100
(Correction of the omission to record return of goods by
customers)
(i) Singh & Co. Dr. 400
To Suspense Account 400
(Being the correction of mistake by which the account of Singh
& Co. was credited by ` 200 instead of being debited)

Suspense Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2020 ` 2020 `
Dec.31 To Difference in Dec. 31 By Returns
Trial Balance 493 Inwards A/c 100
““ To Trade Payables A/c 7 ““ By Singh & Co. 400
500 500

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2.110 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 6

The following errors, affecting the account for the year 2020 were detected in the books of Jain Brothers, Delhi:
(1) Sale of old Furniture ` 150 treated as sale of goods.
(2) Receipt of ` 500 from Ram Mohan credited to Shyam Sunder.
(3) Goods worth ` 100 brought from Mohan Narain have remained unrecorded so far.
(4) A return of ` 120 from Mukesh posted to his debit.
(5) A return of ` 90 to Shyam Sunder posted as ` 9 in his account.
(6) Rent of proprietor’s residence, ` 600 debited to rent A/c.
(7) A payment of ` 215 to Mohammad Sadiq posted to his credit as `125.
(8) Sales Book added ` 900 short.
(9) The total of Bills Receivable Book ` 1,500 left unposted.
You are required to pass the necessary rectifying entries and show how the trial balance would be affected by
the errors.

SOLUTION

Journal
Particulars L.F. Dr. Cr.
Amount Amount
` `
(1) Sales Account Dr. 150
To Furniture Account 150
(Rectification of sales of furniture treated as sales of goods)
(2) Shyam Sunder Dr. 500
To Rama Mohan 500
(Rectification of a receipt from Ram Mohan credited to Shyam
Sunder)
(3) Purchases Account Dr. 100
To Mohan Narain 100
(Purchases of goods from Mohan Narain unrecorded)
(6) Drawing Account Dr. 600
To Rent Account 600
(Rectification of Payment of rent of proprietor’s residence
treated as payment of office rent)

N.B. : For 4, 5, 7, 8, 9 no journal entry can be passed as they affect a single account. The correction will be as
under:

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111 ACCOUNTING PROCESS 2.111

(4) Credit Mukesh’s Account with ` 240.

(5) Debit the account of Shyam Sunder by ` 81.
(7) Debit the account of Mohammad Sadiq by ` 340.
(8) Credit Sales Account by ` 900.
(9) Debit Bills Receivable Account with `1,500.
Effect of the Errors on Trial Balance
1. No effect
2. No effect
3. No effect
4. Trial Balance credit total short by ` 240.
5. Trial Balance debit total short by ` 81.
6. No effect
7. Trial Balance debit total short by ` 340.
8. Trial Balance credit total short by ` 900.
9. Trial Balance debit total short by ` 1,500.

ILLUSTRATION 7

Write out the Journal Entries to rectify the following errors, using a Suspense Account.
(1) Goods of the value of ` 100 returned by Mr. Sharma were entered in the Sales Day Book and posted
therefrom to the credit of his account;
(2) An amount of `150 entered in the Sales Returns Book, has been posted to the debit of Mr. Philip, who
returned the goods;
(3) A sale of ` 200 made to Mr. Ghanshyam was correctly entered in the Sales Day Book but wrongly posted
to the debit of Mr. Radheshyam as ` 20; and
(4) The total of “Discount Allowed” column in the Cash Book for the month of September, 2020 amounting
to ` 250 was not posted.

SOLUTION

Journal
Particulars L.F. Dr. Cr.
` `
(1) Sales Account Dr. 100
Sales Returns Account Dr. 100
To Suspense Account 200
(The value of goods returned by Mr. Sharma wrongly
posted to Sales and omission of debit to Sales Returns
Account, now rectified)

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2.112 PRINCIPLES AND PRACTICE OF ACCOUNTING

(2) Suspense Account Dr. 300

To Mr. Philip 300
(Wrong debit to Mr. Philip for goods returned by him, now
rectified)
(3) Mr. Ghanshyam Dr. 200
To Mr. Radheshyam 20
To Suspense Account 180
(Omission of debit to Mr. Ghanshyam and wrong credit
to Mr. Radhesham for sale of ` 200, now rectified)
(4) Discount Account Dr. 250
To Suspense Account 250
(The total of Discount allowed during September, 2020
not posted from the Cash Book; error now rectified)

6.5.3 Correction in the next Accounting Period

Rectification of errors discussed so far assumes that it was carried out before the books were closed for the
concerned year. However, sometimes, the rectification is carried out in the next year, carrying forward the balance
in the Suspense Account or even transferring it to the Capital Account. Suppose, the Purchase Book was cast
short by `1,000 in December, 2020 and a Suspense Account was opened with the difference in the trial balance.
If the error is rectified next year and the entry passed is to debit Purchase Account (and credit Suspense Account),
it will mean that the Purchases Account for year 2021 will be `1,000 more than the amount relating to year 2021
and thus the profit that year 2021 will be less than the actual for that year. Thus, correction of errors in this
manner will ‘falsify’ the Profit and Loss Account.
To avoid this, correction of all amounts concerning nominal accounts, i.e., expenses and incomes should be
through a special account styled as “Prior Period Items” or “Profit and Loss Adjustment Account”. The balance in
the account should be transferred to the Profit and Loss Account. However, these Prior Period Items should be
charged after deriving net profit of the current year. ‘Prior Period items’ are material income or expenses which
arise in the current period as a result of errors or omissions in the preparation of the financial statements of one
or more periods. Prior Period Items should be separately disclosed in the current statement of profit and loss
together with their nature and amount in a manner that their impact on current profit or loss can be perceived.

ILLUSTRATION 8

Mr. Roy was unable to agree the Trial Balance last year and wrote off the difference to the Profit and Loss Account
of that year. Next Year, he appointed a Chartered Accountant who examined the old books and found the
following mistakes:
(1) Purchase of a scooter was debited to conveyance account `3,000.
(2) Purchase account was over-cast by `10,000.
(3) A credit purchase of goods from Mr. P for ` 2,000 was entered as a sale.

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113 ACCOUNTING PROCESS 2.113

(4) Receipt of cash from Mr. A was posted to the account of Mr. B ` 1,000.
(5) Receipt of cash from Mr. C was posted to the debit of his account, ` 500.
(6) ` 500 due by Mr. Q was omitted to be taken to the trial balance.
(7) Sale of goods to Mr. R for ` 2,000 was omitted to be recorded.
(8) Amount of ` 2,395 of purchase was wrongly posted as ` 2,593.
Mr. Roy used 10% depreciation on vehicles. Suggest the necessary rectification entries.

SOLUTION

Journal Entries in the books of Mr. Roy

Date Particulars Dr. Cr.

` `
(1) Motor Vehicles Account Dr. 2,700
To Profit and Loss Adjustment A/c 2,700
(Purchase of scooter wrongly debited to conveyance
account now rectified-capitalisation of ` 2,700, i.e.,
` 3,000 less 10% depreciation)
(2) Suspense Account Dr. 10,000
To Profit & Loss Adjustment A/c 10,000
(Purchase Account overcast in the previous year;
error now rectified).
(3) Profit & Loss Adjustment A/c Dr. 4,000
To P’s Account 4,000
(Credit purchase from P ` 2,000, entered as sales
last year; now rectified)
(4) B’s Account Dr. 1,000
To A’s Account 1,000
(Amount received from A wrongly posted to the
account of B; now rectified)
(5) Suspense Account Dr. 1,000
To C’s Account 1,000
(` 500 received from C wrongly debited to his
account; now rectified)
(6) Trade receivables Dr. 500
To Suspense Account 500
(` 500 due by Q not taken into trial balance; now
rectified)

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2.114 PRINCIPLES AND PRACTICE OF ACCOUNTING

(7) R’s Account Dr. 2,000

To Profit & Loss Adjustment A/c 2,000
(Sales to R omitted last year; now adjusted)
(8) Suspense Account Dr. 198
To Profit & Loss Adjustment A/c 198
(Excess posting to purchase account last year,
` 2,593, instead of ` 2,395, now adjusted)
(9) Profit & Loss Adjustment A/c Dr. 10,898
To Roy’s Capital Account 10,898
(Balance of Profit & Loss Adjustment A/c transferred
to Capital Account)
(10) Roy’s Capital Account Dr. 10,698
To Suspense Account 10,698
(Balance of Suspense Account transferred to the
Capital Account)

Note : Entries No. (2) and (8) may even be omitted; but this is not advocated.
Profit and Loss Adjustment Account
(Prior Period Items)
` `

To P 4,000 By Motor Vehicles A/c 2,700

To Roy’s Capital (transfer) 10,898 By Suspense A/c 10,000
By R 2,000
By Suspense Account 198

14,898 14,898
Suspense Account
` `

To Profit & Loss Adjustment Account 10,000 By Trade Receivables (Q) 500
To C 1,000 By Roy’s Capital Account (Transfer) 10,698
To Profit & Loss Adjustment Account 198

11,198 11,198

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SUMMARY
 Unintentional omission or commission of amounts and accounts in the process of recording the
transactions are commonly known as errors.
 Accounting errors are generally of four types-
(a) Errors of Principle;
(b) Errors of Omission;
(c) Errors of Commission;
(d) Compensating Errors.
 Some errors may affect the Trial Balance and some of these do not.
 The method of rectification of errors depends on the stage at which the errors are detected. If the error
is detected before the preparation of trial balance, rectification is carried out by making the statement in
the appropriate side of the concerned account.
 In case of the errors detected after the preparation of the trial balance, we open a suspense account
with the amount of difference in the trial balance. Then complete journal entries can be passed for
rectifying the errors.
 For rectifying the errors detected in the next accounting period, a special account ‘Profit and Loss
Adjustment Account’ is opened for correction of amounts relating to expenses and incomes.

TEST YOUR KNOWLEDGE

True and False
1. The method of rectification of errors depends on the stage at which the errors are detected.
2. In case of error of complete omission, the trial balance does not tally.
3. When errors are detected after preparation of trial balance, suspense account is opened.
4. When purchase of an asset is treated as an expense, it is known as error of principle.
5. Trial balance agrees in case of compensating errors.
6. When amount is written on wrong side, it is known as an error of principle.
7. On purchase of furniture, the amount spent on repairs should be debited to repairs account.
8. ‘Profit & Loss adjustment account’ is opened to rectify the errors detected in the current accounting
period.
9. Rent paid to land lord of the proprietors house, must be debited to ‘Rent account’.
10. If the errors are detected after preparing trial balance, then all the errors are rectified through suspense
account.

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2.116 PRINCIPLES AND PRACTICE OF ACCOUNTING

Multiple Choice Questions

1. Goods purchased from A for `10,000 passed through the sales book. The error will result in
(a) Increase in gross profit.
(b) Decrease in gross profit.
(c) No effect on gross profit.
2. If a purchase return of `1,000 has been wrongly posted to the debit of the sales returns account, but
has been correctly entered in the suppliers’ account, the total of the
(a) Trial balance would show the debit side to be `1,000 more than the credit.
(b) Trial balance would show the credit side to be ` 1,000 more than the debit.
(c) The debit side of the trial balance will be ` 2,000 more than the credit side.
3. If the amount is posted in the wrong account or it is written on the wrong side of the account, it is called
(a) Error of omission.
(b) Error of commission.
(c) Error of principle.
4. ` 200 paid as wages for erecting a machine should be debited to
(a) Repair account.
(b) Machine account.
(c) Capital account.
5. On purchase of old furniture, the amount of `1,000 spent on its repair should be debited to
(a) Repair account.
(b) Furniture account.
(c) Cash account.
6. Goods worth `50 given as charity should be credited to
(a) Charity account.
(b) Sales account.
(c) Purchase account.
7. Goods worth `100 taken by proprietor for domestic use should be credited to
(a) Sales account.
(b) Proprietor’s personal expenses.
(c) Purchases account.

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117 ACCOUNTING PROCESS 2.117

8. Sales of office furniture should be credited to

(a) Sales Account.
(b) Furniture Account.
(c) Purchase Account.
9. The preparation of a trial balance is for:
(a) Locating errors of commission.
(b) Locating errors of principle.
(c) Locating clerical errors.
10. ` 200 received from Smith whose account, was written off as a bad debt should be credited to:
(a) Bad Debts Recovered account.
(b) Smith’s account.
(c) Cash account.
11. Purchase of office furniture `1,200 has been debited to General Expense Account. It is:
(a) A clerical error.
(b) An error of principle.
(c) An error of omission.

Theory Questions
1. How does errors of omission differ from errors of commission?
2. What is error of principle and how does it affect Trial Balance?
3. When and how is Suspense account used to rectify errors?

Practical Questions
1. The trial balance of Mr. W & H failed to agree and the difference `20,570 was put into suspense pending
investigation which disclosed that:
(i) Purchase returns day book had been correctly entered and totalled at `6,160, but had not been
posted to the ledger.
(ii) Discounts received `1,320 had been debited to discounts allowed.
(iii) The Sales account had been under added by `10,000.
(iv) A credit sale of `1,470 had been debited to a customer account at `1,740.
(v) A vehicle bought originally for `7,000 four years ago and depreciated to `1,200 had been sold
for `1,500 in the beginning of the year but no entries, other than in the bank account had been
passed through the books.
(vi) An accrual of `560 for telephone charges had been completely omitted.

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2.118 PRINCIPLES AND PRACTICE OF ACCOUNTING

(vii) A bad debt of `1,560 had not been written off and provision for doubtful debts should have been
maintained at 10% of Trade receivables which are shown in the trial balance at `23,390 with a
credit provision for bad debts at `2,320.
(viii) Tools bought for `1,200 had been inadvertently debited to purchases.
(ix) The proprietor had withdrawn, for personal use, goods worth `1,960. No entries had been made
in the books.
You are required to give rectification entries without narration to correct the above errors before
preparing annual accounts.
2. On going through the Trial balance of Ball Bearings Co. Ltd. you find that the debit is in excess by `150.
This was credited to “Suspense Account”. On a close scrutiny of the books the following mistakes were
noticed:
(1) The totals of debit side of “Expenses Account” have beeen cast in excess by ` 50.
(2) The “Sales Account” has been totalled in short by `100.
(3) Supplier account has been overcast by 225.
(4) The sale return of `100 from a party has not been posted to that account though the Party’s
account has been credited.
(5) A cheque of `500 issued to the Suppliers’ account (shown under Trade payables) towards his
dues has been wrongly debited to the purchases.
(6) A credit sale of `50 has been credited to the Sales and also to the Trade receivables Account.
You are required to
(i) Pass necessary journal entries for correcting the above;
(ii) Show how they affect the Profits; and
(iii) Prepare the “Suspense Account” as it would appear in the ledger.
3. Mr. A closed his books of account on September 30, 2020 in spite of a difference in the trial balance.
The difference was `830 the credits being short; it was carried forward in a Suspense Account. In 2021
following errors were located:
(i) A sale of `2,300 to Mr. Lala was posted to the credit of Mrs. Mala.
(ii) The total of the Returns Inward Book for July, 2020 `1,240 was not posted in the ledger.
(iii) Freight paid on a machine `5,600 was posted to the Freight Account as `6,500. 10%
Depreciation is charge on this machines.
(iv) White carrying forward the total in the Purchases Account to the next page, `65,590 was written
instead of `56,950.
(v) A sale of machine on credit to Mr. Mehta for `9,000 on 30th sept. 2020 was not entered in the
books at all. The book value of the machine was `6,750.
Pass journal entries to rectify the errors. Have you any comments to make?

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4. A merchant’s trial balance as on June 30, 2020 did not agree. The difference was put to a Suspense
Account. During the next trading period, the following errors were discovered:
(i) The total of the Purchases Book of one page, `4,539 was carried forward to the next page as
`4,593.
(ii) A sale of `573 was entered in the Sales Book as `753 and posted to the credit of the customer.
(iii) A return to a creditor, `510 was entered in the Returns Inward Book; however, the creditor’s
account was correctly posted.
(iv) Cash received from C. Dass, `620 was posted to the debit of G. Dass.
(v) Goods worth `840 were despatched to a customer before the close of the year but no invoice
was made out.
(vi) Goods worth `1,000 were sent on sale or return basis to a customer and entered in the Sales
Book. At the close of the year, the customer still had the option to return the goods. The sale
price was 25% above cost.
You are required to give journal entries to rectify the errors in a way so as to show the current year’s
profit or loss correctly.

ANSWERS/HINTS
True and False
1. True: There are 3 different stages when the mistakes are identified and then the rectification depends
on the stage of identification of errors.
2. False: In case of error of complete omission, the trial balance tallies.
3. True: In order to balance the difference of balances in the trial balance suspense account is opened.
4. True: Where the accounts being debited is principally incorrect it is termed as error of principle.
5. True: Compensating errors cancel out each other when Trial balance is prepared as the mistake pertains
to the same amount being credited and later debited on account of two different mistakes.
6. False: When amount is written on wrong side, it is known as an error of commission.
7. False: On purchase of furniture, the amount spent on repairs should be debited to furniture account as
it is a capital expense.
8. False: ‘Profit & Loss adjustment account’ is opened to rectify the errors detected in the next accounting
period.
9. False: Rent paid to land lord of the proprietors house, must be debited to ‘Drawings account’.
10. False: If the errors are detected after preparing trial balance, then all the errors are not rectified through
suspense account. There may be principal errors, which can be rectified without opening a suspense
account.

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2.120 PRINCIPLES AND PRACTICE OF ACCOUNTING

Multiple Choice Questions

1. (a) 2. (c) 3. (b) 4. (b) 5. (b) 6. (c)

7. (c) 8. (b) 9. (c) 10. (a) 11. (b)

Theoretical Questions
1. (i) Errors of Omission: If a transaction is completely or partially omitted from the books of account,
it will be a case of omission. Examples would be: not recording a credit purchase of furniture or
not posting an entry into the ledger.
(ii) Errors of Commission: If an amount is posted in the wrong account or it is written on the wrong
side or the totals are wrong or a wrong balance is struck, it will be a case of “errors of
commission.”
2. Errors of principle: When a transaction is recorded in contravention of accounting principles, like
treating the purchase of an asset as an expense, it is an error of principle. In this case there is no effect
on the trial balance since the amounts are placed on the correct side, though in a wrong account.
Suppose on the purchase of a typewriter, the office expenses account is debited; the trial balance will
still agree.
The method of correction of error indicated so far is appropriate when the errors have been located
before the end of the accounting period. After the corrections the trial balance will agree. Sometimes the
trial balance is artificially made to agree inspite of errors by opening a suspense account and putting
the difference in the trial balance to the account - the suspense account will be debited if the total of the
credit column in the trial balance exceeds the total of the debit column; it will be credited in the other
case. Each and every error detected can only be corrected by a complete journal entry. Those errors for
which journal entries were not possible at the earlier stage will now be rectified by a journal entry(s), the
difference or the unknown side is being taken care of by suspense account. Those errors for which
entries were possible even at the first stage will now be rectified in the same way.

Practical Questions
Answer 1
Particulars Dr. Cr.
(i) Suspense Account Dr. 6,160
To Return Outward A/c 6,160
(ii) Suspense Account Dr. 2,640
To Discount Allowed Account 1,320
To Discount Received Account 1,320
(iii) Suspense Account Dr. 10,000
To Sales Account 10,000

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121 ACCOUNTING PROCESS 2.121

(iv) Suspense Account Dr. 270

To Customer Account 270
(v) Suspense Account Dr. 1,500
To Vehicle Account 1,200
To Profit on Sale of Vehicle Account 300
(vi) Telephone Charges Account Dr. 560
To Outstanding Expenses Account 560
(vii) Bad Debts Account Dr. 1,560
To Trade receivables Account 1,560
Provision for Doubtful Debts Account Dr. 164
To Profit and Loss Account 164
(viii) Loose Tools Account Dr. 1,200
To Purchases Account 1,200
(ix) Drawings Account Dr. 1,960
To Purchases Account 1,960

1. Bad debts will be debited in the profit and loss account.

2. Provision @ 10% of `21,560 i.e. 2,156; Excess provision `164 (2320 - 2156 = 164).
Working Notes :
(i) Trade receivables as per books 23,390
Deduction vide item (iv) 270 270
Bad Debts 1,560 1,830
21,560
(ii) Suspense Account
` `
To Return outward Account 6,160 By balance b/d 20,570
To Discount allowed Account 1,320
To Discount Received Account 1,320
To Sales Account 10,000
To Customers Account 270
To Vehicles Account 1,200
To Profit on Sale of Vehicle 300
20,570 20,570

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2.122 PRINCIPLES AND PRACTICE OF ACCOUNTING

Answer 2
Journal Entries
Particulars L.F. Dr. Cr.
` `
Suspense Account Dr. 50
To Expenses Account 50
(Being the mistake in totalling of Expenses Account,
rectified)
Suspense Account Dr. 100
To Sales Account 100
(Being the mistake in totalling of Sales Accounts rectified)
Supplier* Dr. 225
To Suspense Account 225
(Being the mistake in posting from Day Book to Ledger
rectified)
Sales Returns Account Dr. 100
To Suspense Account 100
(Being the sales return from a party not posted to “Sales
Returns” now rectified)
Trade payables Account Dr. 500
To Purchases Account 500
(Being the payments made to supplier wrongly posted to
purchases now rectified)
Trade receivables Account Dr. 100
To Suspense Account 100
(Being the sales wrongly credited to Customer’s Account
now rectified)
Suspense Account
Dr. ` Cr. `
To Expenses Account 50 By Difference in Trial Balance 150
To Sales Account 100 By Trade payables 225
To Balance c/d 425 By Sales Returns Account 100
By Trade receivables 100
575 575
By Balance b/d 425

Since the Suspense Account does not balance, it is clear that all the errors have not been traced. As a result of
the above corrections the Net Profit will be:

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123 ACCOUNTING PROCESS 2.123

Increased by Decreased by
` `
Mistake in totalling in “Expenses” 50
Mistake in totalling in “Sales” 100
Mistake in posting from day book to Ledger under
“Purchases” 500
Omission in posting under “Sales Returns” 100
650 100
Net Increase 550

As a result of these adjustments, the Profits will be increased by `550.

Answer 3
Journal of Mr. A
Date Particulars L.F. Dr. Cr.
` `
2021 (i) Mrs. Mala Dr. 2,300
Mr. Lala Dr. 2,300
To Suspense A/c 4,600
(Correction of error by which a sale of ` 2,300
to Mr. Lala was posted to the Credit of Mrs. Mala)
(ii) Profit and Loss Adjustment A/c Dr. 1,240
To Suspense A/c 1,240
(Rectification of omission to post the total of
Returns Inward Book for July, 2020)
(iii) (a) Machinery A/c Dr. 5,600
Suspense A/c Dr. 900
To Profit & Loss Adjustment A/c 6,500
(Correction of error by which freight paid for
a machine ` 5,600 was posted to Freight
Account at ` 6,500 instead of capitalising it)
(b) Profit & Loss Adjustment A/c Dr. 560 560
To Plant and Machinery A/c
(Depreciation @ 10% charged on freight paid on
a machine capitalised)

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2.124 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iv) Suspense A/c Dr. 8,640

To Profit & Loss Adjustment A/c 8,640
(Correction of wrong carry forward of total in the
purchase Account to the next page ` 65,590
instead of ` 56,950)
(v) Mr. Mehta Dr. 9,000
To Plant & Machinery A/c 6,750
To Profit & Loss Adjustment A/c 2,250
(Correction of omission of a sale of machine on
credit to Mr. Mehta for ` 9,000 )

Comments
The Suspense Account will now appear as shown below:
Suspense Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
` `
2021 To Profit and Loss 2020 By Balance b/d 830
Adjustment A/c 900 Oct. 1 By Sundries
To Profit and Loss Mrs. Mala 2,300
Adjustment A/c 8,640 Mr. Lala 2,300
By Profit and Loss
Adjustment A/c 1,240
By balance c/d 2,870
9,540 9,540

Since the Suspense Account still shows a balance, it is obvious that there are still some errors left in the books.
Profit & Loss Adjustment A/c
(For Prior Period Items)
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2021 ` 2021 `
To Suspense A/c 1,240 By Machinery A/c 5,600
To Plant and Machinery A/c 560 By Suspense A/c 900
To Balance c/d 15,590 By Suspense A/c 8,640
By Mr. Mehta 2,250
17,390 17,390

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125 ACCOUNTING PROCESS 2.125

Answer 4
Journal Entries
Particulars L.F. Dr. Cr.
` `
(i) Suspense Account Dr. 54
To Profit and Loss Adjustment A/c 54
(Correction of error by which Purchase Account was over debited
last year- `4,593 carried forward instead of `4,539)
(ii) Profit & Loss Adjustment A/c Dr. 180
Customer’s Account Dr. 1,326
To Suspense Account 1,506
(Correction of the entry by which (a) Sales A/c was over credited
by `180 (b) customer was credited by `753 instead of being
debited by `573)
(iii) Suspense Account Dr. 1,020
To Profit & Loss Adjustment A/c 1,020
(Correction of error by which Returns Inward Account was
debited by `510 instead of Returns Outwards Account being
credited by ` 510)
(iv) Suspense Account Dr. 1,240
To C. Dass 620
To G. Dass 620
(Removal or wrong debit to G. Dass and giving credit to C. Dass
from whom cash was received).
(v) Customer’s Account Dr. 840
To Profit & Loss Adjustment A/c 840
(Rectification of the error arising from non- preparation of invoice
for goods delivered)
(vi) Profit & Loss Adjustment A/c Dr. 200
Inventory Account Dr. 800
To Customer’s Account 1,000
(The Customer’s A/c credited with `1,000 for goods not yet
purchased by him; cost of the goods debited to inventory and
“Profit” debited to Profit & Loss Adjustment Account)
(vii) Profit & Loss Adjustment A/c Dr. 1,534
To Capital Account 1,534
(Transfer of Profit & Loss Adjustment A/c balance to the Capital
Account)

© The Institute of Chartered Accountants of India

CHAPTER
3

BANK RECONCILIATION
STATEMENT

LEARNING OUTCOMES
After studying this chapter, you will be able to:
 Learn the design of a Bank Pass Book.
 Understand the reasons for difference between Cash Book balance and Pass Book
balance and try to ascertain the amount of such differences.
 Learn, how to resolve such difference in a systematic manner.
 Understand the purpose for preparing the bank reconciliation statement and its
utility.

CHAPTER OVERVIEW
Salient Features of Bank Reconciliation Statement

The reconciliation will bring out Any undue delay in the A regular reconciliation
any errors that may have been clearance of cheques will discourages the accountant of
committed either in the cash be shown up by the
the bank from embezzlement
book or in the pass book reconciliation

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3.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

Causes of difference in the balances of pass book and cash book

Differences arising due to

Timing differences errors in recording the
entries

1. INTRODUCTION
Banks are essential institutions in a modern society. With the increase in volume of trade, commerce and
business, business entities faced difficulty in transacting in cash for each business activity. They discovered that
dealing through bank, on regular basis, would be the better and safer option and finally large business entities
switched over to banking transactions instead of dealing in cash. Now-a-days, most of the transactions of the
business are done through bank whether it is a receipt or a payment. Rather, it is legally necessary to operate
the transactions through bank after a certain limit.
A Bank accepts from people, in general, deposits in various forms, and lends funds to those who need; it also
invests some funds in profitable investments. Thus, money which would have been otherwise idle is put to use
and is made available to those who need it. Those who deposit the money are able to withdraw it according to
the settled terms and conditions. Apart from receiving deposits from and handling cash transactions on behalf of
its customers, the bank also renders some other useful services as indicated below:
(i) The bank discounts promissory notes or hundies, i.e., it enables a customer to receive the cash before
the due date in consideration of a small charge called discount.
(ii) The bank allows overdraft to its good customers so that they can make payments even when they do
not have sufficient balance at the bank. Of course, the overdraft is generally secured and must be cleared
later.
(iii) The bank gives loans for a year or so, to its customers so that they can continue their operations. Such
financial assistance is of great help for business.
(iv) The bank on behalf of the customer collects the amount of dividend warrants or interest on securities
etc.
(v) On instruction of the customer, the bank makes payments of insurance premium, rent etc. on the due
dates.
(vi) The bank sells and purchases shares, debentures or government securities on behalf of its customers.
(vii) Money can be remitted to another place or persons through the bank at a low cost.
(viii) The bank in return, for a consideration, furnishes security or guarantee for its customers whose credit is
good.
(ix) The bank also issues letter of credit or travellers’ cheque to facilitate commerce or travel.

© The Institute of Chartered Accountants of India

3 BANK RECONCILIATION STATEMENTS 3.3

2. BANK PASS BOOK

Bank pass book is merely a copy of the customer’s account in the book of a bank. The bank either sends periodical
statements of account or gives a pass book to its customer in which all deposits and withdrawals made by the
customer during the particular period is recorded. Both represent almost a copy of the ledger account of the
customer in the books of the bank. Thus, it is the bank’s way of keeping the customers informed of the entries
made in his account. It is the customer’s duty to check the entries and immediately inform the bank of any error
that he may notice. These days with customers can easily access their bank statement online any time as
facilitated by Net Banking. The form of the pass book is given below:
PASS BOOK
Messers.........................................
in account with
Punjab National Bank
Daryaganj, New Delhi-110002
Date Particulars Cheque No. Withdrawals Deposits Balance
Dr. Cr.
Dr. or Cr.
` ` `

The bank statement of account also has a similar form except that it is on loose sheets or can be in an online
format. The bank itself sends the statements to customers but if the customer wants to maintain a passbook then
its is their duty to send the pass book to the bank periodically so that it is updated by the bank. These days, many
bank ATMs have the automated machines where one can get the passbook updated without any manual
intervention.
Business houses should also obtain at the end of the year a certificate from the bank duly stamped and signed,
showing the balance which the firm carries with the bank as of date. The bank balance shown in the passbook is
known as pass book balance for reconciliation purpose. The credit balance as per pass book at a particular point
of time is the deposit made by the customer while debit balance as per pass book is the overdraft balance for the
customer (i.e. customer owes to bank).
Students may note here that the nature of balance shown by pass book (in the books of bank) and cash book (in
the books of customer) is quite different. The debit balance in the pass book represents the credit balance as per
the cash book and vice-versa because the business enterprise treats the bank as a debtor/Trade receivable and
bank treats the business enterprise as a creditor/Trade payable.

3. BANK RECONCILIATION STATEMENT

To reconcile means to identify or find out the difference between two different sources and eliminating that
difference. Whenever we deposit or withdraws money from banks, it is always recorded at two places:-

© The Institute of Chartered Accountants of India

3.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

1. Bank column of the cash book (in customer books); and

2. Bank statement (pass book, i.e. in the banks books)
The cash book is maintained by the person having the bank account whereas the bank statement is prepared by
the bank. Therefore, the balance in both should be equal and opposite in nature. For eg:- if Mr. A deposited
` 1,00,000 in his bank account it will be recorded on the Dr. side of his cash book, but for the bank it’s a receipt
so it will be recorded as a Cr. Entry in the bank statement or the pass book.
But most of the times these two balances do not match. The reasons for difference in balances can be many and
are explained later in this chapter. It is possible to eliminate this difference by matching all the facts and figures
of the two statements. The process of eliminating this difference and bringing the two statements in line with each
other is known as “Reconciliation” , and the statement which reconciles the bank balance as per cash book with
the balance as per the pass book by showing all the causes of difference is known as “BANK RECONCILIATION
STATEMENT”.

4. IMPORTANCE OF BANK RECONCILIATION STATEMENT

Bank reconciliation statement is a very important tool for internal control of cash flows. It helps in detecting errors,
frauds and irregularities occurred, if any, at the time of passing entries in the cash book or in the pass book,
whether intentionally or unintentionally. Since frauds can be detected on the preparation of bank reconciliation
statement therefore accountants are careful while preparing and maintaining the records of the business
enterprise. Hence it works as an important mechanism of internal control. Following are the salient features of
bank reconciliation statement:
(i) The reconciliation will bring out any errors that may have been committed either in the cash book or in
the pass book;
(ii) Any undue delay in the clearance of cheques will be shown up by the reconciliation;
(iii) A regular reconciliation discourages the accountant of the bank from embezzlement of funds. There have
been many cases when the cashiers merely made entries in the cash book but never deposited the cash
in the bank; they were able to get away with it only because of lack of reconciliation.
(iv) It helps in finding out the actual or true position of the bank balance by incorporating the effect of any
uncleared funds as well.

CAUSES OF DIFFERENCE
The difference in the both balances (bank balance as per cash book and pass book) may arise because of the
following reasons:-
1. TIMING:- Sometimes a transaction is recorded at two different times in cash book and the pass book.
This may happen in the following cases:-
 Mr. A has issued a cheque to PQR ltd., now it will be recorded in his cash book immediately but
the bank will recognize this transaction only when the same cheque will be presented to it by
PQR ltd.
 Similarly for PQR ltd , entry in the cash book will be made immediately as the cheque is received
from Mr. A but the bank account will be credited when it collects money in respect of that cheque.

© The Institute of Chartered Accountants of India

5 BANK RECONCILIATION STATEMENTS 3.5

2. TRANSACTIONS:- There are various transactions which the bank carries out by itself without intimating
the customer. For e.g.:- interest received on a savings bank account, it will be credited by the bank
immediately but the entry in the cash book will be made only when the customer comes to know about
it, which is usually at a later stage. Similar is the case with Bank charges (which are debited from the
customer account by bank).
3. ERRORS:- Mistakes or errors made in preparing the accounts either by the bank or the customer can
also result in disagreement of the two statements. For this reason rectification of errors is required to be
done in both the statements before preparing any Bank Reconciliation Statement.

SOME OF THE ITEMS THAT FREQUENTLY CAUSE A DIFFERENCE:-

(i) Cheques issued but not presented for payment: The entry in the cash book is made immediately on
issue of cheque but naturally entry will be made by the bank only when the cheque is presented for payment.
Thus there will be a gap of some days between the entry in the cash book and in the pass book.
Example: The balance as per Cash Book and Pass Book are `10,000. Cheque of ` 2,000 is issued but not
presented for payment. Then the balances as per cash book and pass book will be as follows:
Cash book (bank column only)
Particulars ` Particulars `
To balance b/f 10,000 By Vendor A/c (to whom cheque is 2,000
issued)
By balance c/f 8,000

10,000 10,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 10,000(cr.)

On the issue of aforesaid cheque, the bank account in Cash Book is credited by `2,000 and so balance is reduced
to ` 8,000. Whereas balance in the Pass Book remains `10,000 until the cheque is presented for payment.
(ii) Cheques deposited with the bank but not cleared: As soon as cheques are sent to the bank (i.e.
deposited with bank), entries are made on the debit side of the bank column of the cash book. But usually banks
credit the customer’s account only when they have received the payment from the bank concerned- in other
words, when the cheques have been cleared. Again there will be some gap between the depositing of the cheques
and the credit given by the bank.
Example : The balance as per Cash book and Pass Book are ` 12,000. Cheque of ` 3,000 is deposited but not
cleared.
Cash book
Particulars ` Particulars `
To balance b/f 12,000 By balance c/f 15,000
To Vendor A/c 3,000
15,000 15,000

© The Institute of Chartered Accountants of India

3.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Bank statement (pass book)

Date Particulars Dr. (withdrawn) Cr. (deposited) Balance

Balance b/f 12,000 (cr.)

When cheque is deposited into bank, the bank account in Cash Book is increased to `15,000, but the balance in
the Pass Book remains ` 12,000 until the cheque is cleared.
(iii) Interest allowed by bank : If the bank has allowed interest to the customer, the entry will normally be
made in the customer’s account and later shown in the pass book. The customer usually comes to know the
amount of the interest by pursuing the pass book and only then he makes relevant entry in the cash book.
Example: The balance as per Cash Book and Pass Book are ` 10,000. The bank has allowed ` 1,000 interest
on saving account to customer.
Cash book
Particulars ` Particulars `
To balance b/f 10,000 By balance c/f 10,000
10,000 10,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 10,000(cr.)
Interest 1,000 11,000(cr.)

Because of such interest balance of Pass Book is increased to `11,000. Whereas balance in the Cash Book
remains `10,000 until information reaches customer and he records such transaction.
(iv) Interest and expenses charged by the bank: Like (iii) above, the interest charged by the bank and
the amount of the bank charges are entered in the customer account and later in the pass book. The customer
makes the required entries only after he sees the pass book or bank statement. These are debited to customer
account by bank therefore till such entry is passed in cash book, bank balance as per pass book is less than
bank balance as per cash book.
(v) Interest and dividends collected by the bank: Sometimes investments are left with the bank in the
safe custody; the bank itself sees to it that the interest or the dividend is collected on the due dates. Entries are
made as indicated in (iii) above.
Example: The balance as per Cash Book and Pass Book are `15,000. The bank has collected dividend of
` 2,000.
Cash book
Particulars ` Particulars `
To balance b/f 15,000 By balance c/f 15,000
15,000 15,000

© The Institute of Chartered Accountants of India

7 BANK RECONCILIATION STATEMENTS 3.7

Bank statement (pass book)

Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 15,000(cr.)
Dividend 2,000(Cr.) 17,000(cr.)

On collection of dividend bank credits the amount to customer’s account, so balance in Pass Book is increased
to ` 17,000. Whereas balance in the Cash Book remains ` 15,000 until the information of such dividend collection
reaches the customer and he records such transaction.
(vi) Direct payments by the bank: The bank may be given standing instructions for certain payments such
as for insurance premium. In this case also, the customer may come to know of the payment only on seeing the
pass book. The entries in the pass book and in the cash book may thus be on different dates.
Example: The balance as per Cash Book and Pass Book of Mr. X are ` 20,000. The bank has instruction to pay
insurance premium of ` 1,500 directly to insurance company at the end of each month
Cash book
Particulars ` Particulars `
To balance b/f 20,000 By balance c/f 20,000
20,000 20,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 20,000 (cr.)
Insurance premium 1,500 18,500 (cr.)

On payment of insurance premium bank debits the customer’s account by ` 1,500 so balance in Pass Book is
decreased to ` 18,500. Whereas balance in the Cash Book remains ` 20,000 until the information of such
payment reaches the customer and he records such transaction.
(vii) Direct payment into the bank by a customer: If such a payment is received by the bank, it will be
entered in the customer’s account and also in the pass book; the account holder may come to know of the amount
only when he sees the pass book.
(viii) Dishonour of a bill discounted with the bank: If the bank is not able to receive payment on promissory
notes discounted by it, it will debit the customer’s account together with the charges it may have incurred. The
customer will naturally make the entry only when he sees the pass book.
Example : The balances as per Cash Book and Pass Book of Mr. X are ` 20,000. Mr. X deposited a cheque of
` 3,000 and debited to his bank account ` 3,000 immediately. But bank will credit X’s account on realization of
amount. Now the cheque is dishonoured for non-payment. Bank charges ` 100 in this connection.

© The Institute of Chartered Accountants of India

3.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

Cash book
Particulars ` Particulars `
To balance b/f 20,000 By balance c/f 23,000
To bank a/c 3,000
23,000 23,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 20,000 (cr.)
Bank charges 100 19,900 (cr.)

Thus, balance of Mr. X’s account in Pass Book stands ` 19,900 after this transaction while balance as per Cash
Book stand ` 23,000. So Mr. X should deduct ` 3,000 the amount of dishonoured cheque, plus ` 100 the amount
of bank charges for reconciliation.
(ix) Bills collected by the bank on behalf of the customer: If goods are sold, the documents may be sent
through the bank. If the bank is able to collect the amount, it will credit the customer’s account. The customer
may make the entry only on receiving the pass book.
All these timing differences will lead to difference in balances as shown by the cash book and the pass book.
Following is the table summarising in brief the timings of different transactions:
Sl. Transaction Time of recording in cash Time of recording in pass
No. book book
1. Payment done by the account At the time of issuing the cheque At the time presenting the
holder through issuing a cheque cheque to the bank for payment
or clearing of funds.
2. Receipt by the account holder At the time of depositing the At the time of collection of
through a cheque cheque into the bank comes into amount from the account of the
notice. issuing party.
3. Collection of bills/cheque When the entry posted in the When the amount is collected by
directly on behalf of the account pass book comes into notice. the bank.
holder
4. Direct payment to the third party When the entry posted in the When the amount is paid by the
on behalf of the account holder pass book comes into notice. bank
5. Dishonour of cheque/bills When the entry posted in the When the cheque is
receivable. pass book comes into notice. dishonoured.
6. Bank charges levied by the bank When the entry posted in the When charges are levied by the
pass book comes into notice. bank
7. Interest and dividend credited When the entry posted in the When interest or dividend is
by the bank pass book comes into notice. allowed or collected by the bank.
8. Interest debited by the bank When the entry is posted in the When interest is charged by the
pass book comes into notice. bank

© The Institute of Chartered Accountants of India

9 BANK RECONCILIATION STATEMENTS 3.9

To illustrate this, we give below an extract from a pass book and the bank column of the cash book in
Illustration 1:

ILLUSTRATION 1

Messer’s Tall & Short, Faiz Bazar, New Delhi-110002

in account with
Punjab National Bank, Daryaganj, New Delhi-110002
PASS-BOOK
Date Particulars Withdrawals Deposits Dr. or Cr. Balance
` ` `
2019
Jan. 2 By Cash 4,00,000 Cr. 4,00,000
“ 4 To Furniture Dealers Ltd. 60,000 Cr. 3,40,000
“ 4 To Das & Co. 1,25,000 Cr. 2,15,000
“ 10 By J. Johnson & Co.’s 35,000 Cr. 2,50,000
cheque
“ 12 To Roy & James 1,00,000 Cr. 1,50,000
“ 15 By B. Babu & Co’s cheque 76,000 Cr. 2,26,000
“ 16 By Cash 30,000 Cr. 2,56,000
“ 20 To Cash 50,000 Cr. 2,06,000
“ 26 By J. Rai & Bros cheque 43,000 Cr. 2,49,000
“ 31 To Premium paid as per
standing instructions 25,000 Cr. 2,24,000
31 To Bank Charges 1,000 Cr. 2,23,000
31 By Interest collected on 20,000 Cr. 2,43,000
Government Securities

CASH-BOOK (Bank column only)

Date Particulars Amount Date Particulars Amount
` `
2019 2019
Jan. 1 To Cash 4,00,000 Jan. 2 By Furniture
Jan. 2 To J. Johnson & Co. 35,000 Dealers Ltd. 60,000
Jan. 8 To B. Babu& Co. 76,000 Jan. 2 By Roy & James 1,00,000
Jan. 10 To Cash 30,000 Jan. 2 By Das & Co. 1,25,000
Jan. 16 To J. Rai & Bros. 43,000 Jan. 4 By K. Nagpal & Co. 73,000
Jan. 20 To M. Mohan & Co. 1,05,000 Jan. 17 By Cash 50,000

© The Institute of Chartered Accountants of India

3.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

Jan. 22 To N. Nandy & Sons 34,000 Jan. 20 By B. Babu & Co. 78,000
Jan. 31 By Balance c/d 2,37,000
7,23,000 7,23,000
Feb. 1 To Balance b/d 2,37,000

It will be seen that whereas the pass book shows a credit balance of ` 2,43,000, the cash-book shows a debit
balance of ` 2,37,000. We shall compare the two to establish the reasons for the difference The reconciliation of
the two statements can be done in two ways:-
1. Arrive at pass book balance from cash book.
2. Arrive at cash book balance from pass book.
Let us start with the pass book balance and arrive at the balance as per cash book.
Step: 1 Compare the debit side of cash book with the deposits column of pass book:-
We find that the following cheques are recorded in the cash book but not in the pass book. Therefore if we enter
these two cheques in the deposit side of the pass book the balance becomes:-
Existing balance 2, 43,000
Add:- M Mohan & Co. 1,05,000
N. Nandy & Sons 34,000

Total 3,82,000

Step: 2 Compare the credit side of the cash book with the withdrawal column of the pass book
We find that the following cheques are not recorded. Therefore, if we enter these two cheques on the withdrawal
side of the pass book the balance becomes: -
Existing balance 3,82,000
Less:- K Nagpal & Co. (73,000)
B Babu & Co. (78,000)

Total 2,31,000

There is an item Interest on Government Securities which appears on the deposit side of the pass book but not in the debit
side of the cash book, so this item should be deducted from pass book balance:-
Existing balance 2,31,000
Less:- Interest on govt. securities (20,000)

Total 2,11,000

© The Institute of Chartered Accountants of India

11 BANK RECONCILIATION STATEMENTS 3.11

Further, there are two items which appear on the withdrawal side of the pass book i.e. they have been deducted
from the bank balance but not on the credit side of the cash book, so these items should be added in order to
reconcile the balance:-
Existing balance:- 2,11,000
Add: Insurance premium 25,000
Add: Bank charges 1,000

Total 2,37,000

Therefore, we have arrived at the balance as per the cash book from the pass book.
This process shows that the difference between the two balance arise only because there are some entries made
in the cash-book but not in the pass book and some entries which are made in the pass book but not in the cash
book. A comparison of the two shows up such entries and then, on that basis, the reconciliation is prepared. To
illustrate it again, let us proceed from the cash book balance of ` 2,37,000. Since cheques totalling ` 1,39,000
have not been entered in the pass book, let us assume that they are also omitted from the cash book, this will
reduce the cash book balance to ` 98,000. Cheques totalling ` 1,51,000 have been entered on the credit side of
the cash book but not in the pass book their omission from the cash book will increase the cash book balance to
` 2,49,000. Amounts totalling ` 26,000 have been entered in the withdrawals column of the pass book but not in
the cash book; an entry on the credit side of the cash book for these amounts will reduce the balance to
` 2,23,000. The deposits column shows an entry of ` 20,000 not found on the debit side of the cash book; the
entry made in the cash book will increase balance to ` 2,43,000 as shown in the pass book.
(x) Errors: While recording the entries errors can occur both in the cash book and in the pass book. A bank
rarely makes and error but if does, the balance in the pass book will naturally differ from cash book. Similarly if
any error is committed in the cash book then it’s balance will be different from that of the pass book.
Some of the errors include commission of entry, recording of an incorrect amount, recording of entry on the wrong
side of the book, wrong totalling of the account or wrong balancing of the book and recording of transactions of
other party.
Example: Mr. A’s cash book shows following transactions:
CASH-BOOK (Bank column only)
Date Particulars Amount Date 2019 Particulars Amount
` `
Mar 31 By balance c/d 1,00,000
April 7 To Wayne Ltd. 60,000 Apr 1 By balance b/d 10,000
April 11 To Cash A/c 80,000 April 29 By Cash A/c 2,000
By Balance c/d 1,28,000
1,40,000 1,40,000

© The Institute of Chartered Accountants of India

3.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

PASS-BOOK
Date Particulars Withdrawals Deposit Balance
` ` ` (cr.)
2019
April 1 Balance b/d 1,00,000
April 7 By Wayne Ltd. 60,000 1,60,000
April 11 By Cash 80,000 2,40,000
April 13 To Vandy Ltd. 90,000 3,30,000
April 29 To Cash A/c 2,000 3,28,000

Here there are several errors made by accountant:

April 1: Balance should be have bought down in debit side as ` 1,00,000
April 13: Also a cheque issued to Vandy Ltd. has been omitted in the books of ` 90,000
So, on correcting these entries balance as per Cash Book will be:
Existing Balance ` 1,28,000
Add: Correct Opening Balance ` 1,00,000
Add: Incorrect Opening Balance ` 10,000
(Since it was bought down on credit side it will be added back)
Less: Cheque issued not recorded ` 90,000
Closing Balance as per Cash Book ` 1,48,000
Balance as per Pass Book 3,28,000
Less: Cheque to Vandy Ltd wrongly added to existing balance
instead of being subtracted 1,80,000 ` 1,48,000
Difference in balances between cash book and pass book Nil

5. PROCEDURE FOR RECONCILING THE CASH BOOK BALANCE

WITH THE PASS BOOK BALANCE
Before proceeding further students must understand that ‘Dr. balance as per cash book’ means deposits in the
bank or cash at bank or Cr. balance as per pass book. Similarly ‘Cr. balance as per cash book’ means excess
amount over deposits withdrawn by the account holder or overdraft balance or Dr. balance as per pass book.
It means that students can be required to start bank reconciliation from any of the following four balances as may
be given in the question:
1. Dr. balance as per cash book
2. Cr. balance as per cash book
3. Dr. balance as per pass book
4. Cr. balance as per pass book

© The Institute of Chartered Accountants of India

13 BANK RECONCILIATION STATEMENTS 3.13

While doing reconciliation, the following types of problems can be given:-

TYPES OF PROBLEMS

1. When causes 2. When causes

of difference are of difference are
given not given

a. Reconciliation b. Reconciliation b. Reconciliation b. Reconciliation

without adjusting after adjusting after adjusting after adjusting
cash book cash book cash book cash book

When causes of differences are known then students can start reconciliation by taking any of the balance
stated above and proceed further with the causes. Given the causes of disagreement, the balance of the other
book can be either more or less on account of the said causes. If the balance of the other book is more on account
of the said causes then add the amount. If the balance of the other book is less on account of the said causes
then subtract the amount.
For example, if the reconciliation is initiated with Dr. balance as per the cash book and there is a cheque deposited
in the bank but not yet cleared, then on account of non-clearance of the cheque, the Cr. balance of the pass book
would be less. In this case, the amount of cheque should be subtracted from the cash book balance to arrive at
the balance as per the pass book. Similarly, after making all the adjustments the balance as per the other book
is obtained. It is necessary to note here that if a student starts from debit balance of cash book and after all
adjustments the balance arrived is positive then it is known as Cr. balance as per the pass book and if the balance
is negative then it is said to be Dr. balance as per the pass book and vice-versa.
But if causes of differences are not known then one has to compare the debit entries of cash book with the
credit entries of the pass-book and vice-versa. The entries, which do not tally in the course, are the causes of
difference in the balances of both the books. Once the causes are located their effects on both the books are
analysed and then reconciliation statement is prepared to arrive at the actual bank balance.
In this procedure students, should also take into care that whether opening balance of both the books at particular
point of time from where the books are compared, tallies or not. If opening balances are not same then unticked
items are divided into two categories i.e., one relating to reconciliation of opening balance and other relating to
reconciliation of closing balance.
Example: Jolly Ltd has following entries in its cash book and pass book:
CASH-BOOK (Bank column only)
Date Particulars Amount Date Particulars Amount
2019 ` 2019 `
May 1 To Balance b/d 70,000 May 15 By Richa Ltd. 20,000
May 9 To Avengers Ltd. 50,000

© The Institute of Chartered Accountants of India

3.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

May13 To Cash A/c 80,000

May 30 By Balance c/d 1,80,000
2,00,000 2,00,000
PASS-BOOK
Date Particulars Withdrawals Deposits Dr. or Cr. Balance
` ` `
2019
May 1 Balance b/d Cr. 1,00,000
May 7 To Mr. A 30,000 Cr. 70,000
May 12 By Avengers Ltd. 50,000 Cr. 1,20,000
May 13 By Cash A/c 80,000 Cr. 2,00,000
May 23 To Richa Ltd. 20,000 Cr. 1,80,000
May 29 Bank Charges 2,000 Cr. 1,78,000

Here when we compare Cash Book and Pass Book we find out following 2 entries remain unticked in pass book
i.e. they don’t appear in cash book:
Cheque to Mr. A - ` 30,000
Bank Charges - ` 2,000
Excess withdrawals as per pass book - ` 32,000
However if we difference between closing balances of two books is only ` 2,000 but at the same time there is a
difference of ` 30,000 in opening balances. Thus we need to bifurcate the unticked items as:
Regarding Opening Balance Regarding Closing Balance
Cheque to Mr. A - ` 30,000 Bank Charges - ` 2,000

This is an item which must have been recorded in These have been charged by the bank but not
Cash book during previous month when cheque would recorded in books.
have been issued and would have appeared as a
reconciling item in BRS of that month. Since, it has
been presented to bank by Mr. A in April, it has been
recorded now by the bank.

6. METHODS OF BANK RECONCILIATION

There are following two methods of reconciling the bank balances:

6.1 Bank Reconciliation Statement without Preparation of adjusted Cash-Book

For reconciliation purposes students can take any of the four balances as the starting point and can proceed
further with the causes of differences.

© The Institute of Chartered Accountants of India

15 BANK RECONCILIATION STATEMENTS 3.15

Based on the earlier explanation the following table has been prepared for student’s ready reference when
reconciliation is done on the basis of ‘Balance’ presentation. The final balance, which will come after addition and
subtraction, will be the balance as per the other book (on the opposite side).
Causes of differences Favourable Unfavourable Favourable Unfavourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per cash- as per cash- as per pass- as per pass-
book book book book
Cheque deposited but not cleared Subtract Add Add Subtract
Cheque issued but not presented to bank Add Subtract Subtract Add
Cheque directly deposited in bank by a Add Subtract Subtract Add
customer
Income (e.g., interest from UTI) directly Add Subtract Subtract Add
received by bank
Expenses (e.g., telephone bills, Insurance Subtract Add Add Subtract
charges) directly paid by bank on standing
instructions
Bank charges levied by bank Subtract Add Add Subtract
Locker rent levied by bank Subtract Add Add Subtract
Wrong debit in the cash book Subtract Add Add Subtract
Wrong credit in the cash book Add Subtract Subtract Add
Wrong debit in the pass book Subtract Add Add Subtract
Wrong credit in pass book Add Subtract Subtract Add
Undercasting of Dr. side of bank account in Add Subtract Subtract Add
the cash book
Overcasting of Dr. side of bank account in Subtract Add Add Subtract
cash book
Undercasting of Cr. side of bank account in Subtract Add Add Subtract
cash book
Overcasting of Cr. side of bank account Add Subtract Subtract Add
incash book
Bill receivable collected directly by bank Add Subtract Subtract Add
Interest on bank overdraft charged Subtract Add Add Subtract

© The Institute of Chartered Accountants of India

3.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

Final Balance If answer is If answer is If answer is If answer is

positive then positive then positive then positive then
favourable Unfavourable favourable Unfavourable
balance (Cr.) balance (Dr.) balance (Dr.) balance (Cr.)
as per pass- as per pass- as per cash- as per cash-
book and if book and if book and if book and if
negative then negative then negative then negative then
unfavourable Favourable unfavourable Favourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per pass- as per pass- as per cash- as per cash-
book. book book book

It is proper to prepare a neat statement showing the reconciliation of the two balances. Taking the example given
in the illustration 1, the statement may be prepared as follows:
1. ‘Balance’ presentation.
2. ‘Plus & Minus’ presentation.
1. As per Balance Presentation:
Bank Reconciliation Statement as on 31st January, 2019
Particulars Details Amount
` `
Balance as per Pass Book 2,43,000
Add: Cheques deposited but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000 1,39,000
Add: Premium paid and bank charges entered in the Pass Book but not yet 26,000
entered in the Cash-Book
4,08,000
Less: Cheques issued but not yet presented
K. Nagpal & Co. 73,000
B. Babu & Co. 78,000 1,51,000
2,57,000
Less: Interest credited by bank but not yet entered in the Cash Book 20,000
Balance as per Cash Book 2,37,000
OR
Balance as per Cash Book 2,37,000
Add: Cheques issued but not yet presented:
K. Nagpal & Co. 73,000

© The Institute of Chartered Accountants of India

17 BANK RECONCILIATION STATEMENTS 3.17

B. Babu & Co. 78,000

1,51,000

Add: Interest entered in the Pass Book, but not yet in the Cash Book 20,000
4,08,000
Less: Cheques deposited but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000 1,39,000
2,69,000
Less: Premium paid and bank charges entered in the Pass Book but not yet
in the Cash Book 26,000
Balance as per Pass Book 2,43,000

2. As per Plus-Minus Presentation:

Bank Reconciliation Statement as on 31st January, 2019
Particulars Plus Amount Minus Amount
(` ) (` )
Balance as per Cash Book 2,37,000
Cheques issued but not yet presented:
K. Nagpal & Co. 73,000
B. Babu & Co. 78,000
Interest entered in pass book but not yet entered into cash book 20,000
Cheques deposited but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000
Premium paid and bank charges entered in pass book 26,000
Balance as per pass book 2,43,000
4,08,000 4,08,000

ILLUSTRATION 2

From the following particulars, prepare a Bank Reconciliation Statement for Jindal offset Ltd.
(1) Balance as per cash book is ` 2,40,000
(2) Cheques issued but not presented in the bank amounts to ` 1,36,000.
(3) Cheques deposited in bank but not yet cleared amounts to ` 90,000.
(4) Bank charges amounts to ` 300.

© The Institute of Chartered Accountants of India

3.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

(5) Interest credited by bank amounts to ` 1,250.

(6) The balance as per pass book is ` 2,86,950.

SOLUTION

Bank Reconciliation Statement

Particulars Amount `

Balance as per cash book 2,40,000

Add: Cheque issued but not presented 1,36,000
Interest credited by bank 1,250
3,77,250
Less : Cheque deposited but not yet cleared (90,000)
Bank charges debited by bank (300)
Balance as per pass book 2,86,950

ILLUSTRATION 3

On 31st March 2019, the Bank Pass Book of Namrata showed a balance of ` 1,50,000 to her credit while balance
as per cash book was ` 1,12,050. On scrutiny of the two books, she ascertained the following causes of
difference:
i) She has issued cheques amounting to ` 80,000 out of which only ` 32,000 were presented for payment.
ii) She received a cheque of ` 5,000 which she recorded in her cash book but forgot to deposit in the bank.
iii) A cheque of ` 22,000 deposited by her has not been cleared yet.
iv) Mr. Gupta deposited an amount of ` 15,700 in her bank which has not been recorded by her in Cash
Book yet.
v) Bank has credited an interest of ` 1,500 while charging ` 250 as bank charges.
Prepare a bank reconciliation statement.

SOLUTION

Bank Reconciliation Statement as on 31st March, 2019

Particulars Details (` ) Amount (`)
Balance as per Pass Book (Cr.) 1,50,000
Add: Cheque deposited but not yet cleared 22,000
Add: Cheque recorded in Cash Book but not yet deposited 5,000
Add: Bank Charges debited by bank 250 27,250
Less: Cheque issued but not yet presented 48,000

© The Institute of Chartered Accountants of India

19 BANK RECONCILIATION STATEMENTS 3.19

Less: Amount deposited but not recorded in Cash Book 15,700

Less: Interest allowed by bank 1,500 65,200
Balance as per Cash Book 1,12,050

ILLUSTRATION 4

From the following particulars ascertain the balance that would appear in the Bank Pass Book of A on
31st December, 2019.
(1) The bank overdraft as per Cash Book on 31st December, 2019 ` 6,340.
(2) Interest on overdraft for 6 months ending 31st December, 2019 ` 160 is entered in Pass Book.
(3) Bank charges of ` 400 are debited in the Pass Book only.
(4) Cheques issued but not cashed prior to 31st December, 2019, amounted to ` 11,68,000.
(5) Cheques paid into bank but not cleared before 31st December, 2019 were for ` 22,17,000.
(6) Interest on investments collected by the bank and credited in the Pass Book ` 12,00,000.

SOLUTION

Bank Reconciliation Statement

As on 31st December, 2019
Particulars Amount
`
Overdraft as per Cash Book 6,340
Add: Interest debited in the Pass Book but not yet entered in the Cash Book 160
Add: Bank charges debited in the Pass Book but not entered in the Cash Book 400
Add : Cheques deposited but not yet credited in the Pass Book 22,17,000
22,23,900
Less: Cheques issued but not yet presented (11,68,000)
Less: Interest collected and credited by bank but not yet entered in Cash Book (12,00,000)
Balance as per Pass Book (Credit/Favourable balance) (1,44,100)

The above illustration can also be presented with the column for “Plus” and “Minus.”
Particulars Plus Amount Minus Amount
` `
Overdraft as per Cash Book 6,340
Interest debited in Pass Book but not yet in Cash Book 160
Cheque issued but not yet presented 11,68,000
Cheques paid in but not yet credited by the Bank 22,17,000
Bank charges 400

© The Institute of Chartered Accountants of India

3.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

Interest collected and credited by the Bank in the Pass

Book but not yet entered in Cash Book 12,00,000
Balance as per Pass Book (Credit/Favourable balance) 1,44,100
Total 23,68,000 23,68,000

6.2 Bank Reconciliation Statement after the Preparation of adjusted Cash-Book

6.2.1 Meaning of adjusted cash book
When the balance in the cash book is first adjusted for certain adjustments before taking it to the bank
reconciliation statement, then it is known as adjusted cash book balance. Adjusting the cash-book before
preparing the bank reconciliation statement is completely optional, if reconciliation is done during different
months. But if reconciliation is done at the end of the accounting year or financial year, the cash-book must be
adjusted so as to reflect the correct bank balance in the balance sheet.
While adjusting the cash-book the following adjustments are considered:-
1. All the errors (like incorrect amount recorded in the cash-book, entry posted twice in the cash-book,
over/undercasting of the balance etc.) and
2. Omissions (like bank charges recorded in the pass-book only, interest debited by the bank, direct receipt
or payment by the bank, dishonour of cheques/bills etc.) by the cash-book are taken into care
Only above transactions are considered for adjusting cash book. Apart from this, any delay in recording in the
pass-book due to difference in timing (like cheque issued but not presented for payment, cheque deposited but
not cleared) is taken to bank reconciliation statement. This adjusted cash-book balance is taken to bank
reconciliation statement.

Errors occurring in the pass-book are not to be adjusted in the cash book. All the adjustments
considered in the adjusted cash-book are not carried again to the bank reconciliation statement.

ILLUSTRATION 5

On 30th September, 2019, the bank account of X, according to the bank column of the Cash- Book, was
overdrawn to the extent of ` 4,062. On the same date the bank statement showed a credit balance of ` 20,758
in favour of X. An examination of the Cash Book and Bank Statement reveals the following:
1. A cheque for ` 13,14,000 deposited on 29th September, 2019 was credited by the bank only on 3rd
October, 2019.
2. A payment by cheque for ` 16,000 has been entered twice in the Cash Book.
3. On 29th September, 2019, the bank credited an amount of ` 1,17,400 received from a customer of X,
but the advice was not received by X until 1st October, 2019.
4. Bank charges amounting to ` 580 had not been entered in the Cash Book.
5. On 6th September, 2019, the bank credited ` 20,000 to X in error.

© The Institute of Chartered Accountants of India

21 BANK RECONCILIATION STATEMENTS 3.21

6. A bill of exchange for ` 1,40,000 was discounted by X with his bank. This bill was dishonoured on 28th
September, 2019 but no entry had been made in the books of X.
7. Cheques issued upto 30th September, 2019 but not presented for payment upto that date totalled
` 13,26,000.
You are required :
(a) to show the appropriate rectifications required in the Cash Book of X, to arrive at the correct balance on
30th September, 2019 and
(b) to prepare a bank reconciliation statement as on that date.

SOLUTION

(a) Cash Book (Bank Column)

Date Particulars Amount Date Particulars Amount
2019 ` 2019 `
Sept. 30 To Party A/c 16,000 Sept. 30 By Balance b/d 4,062
To Customer A/c By Bank charges 580
(Direct deposit) 1,17,400 By Customer A/c
To Balance c/d 11,242 (B/R dishonoured) 1,40,000
1,44,642 1,44,642

(b) Bank Reconciliation Statement as on 30th September, 2019

Particulars Amount
`
Overdraft as per Cash Book 11,242
Add: Cheque deposited but not collected upto 30th September, 2019 13,14,000
13,25,242
Less: Cheques issued but not presented for payment upto 30th September, 2019 (13,26,000)
Credit by Bank erroneously on 6th September (20,000)
Credit balance as per bank statement 20,758

Note: Bank has credited X by 20,000 in error on 6th September, 2019. If this mistake is rectified in the
bank statement, then this will not be deducted in the above statement along with ` 13,26,000 resulting
in credit balance of ` 758 as per pass-book.

ILLUSTRATION 6

On 30th December, 2019 the bank column of A. Philip’s cash book showed a debit balance of ` 4,610. On
examination of the cash book and bank statement you find that:
1. Cheques amounting to ` 6,30,000 which were issued to trade payables and entered in the cash book
before 30th December, 2019 were not presented for payment until that date.

© The Institute of Chartered Accountants of India

3.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. Cheques amounting to ` 2,50,000 had been recorded in the cash book as having been paid into the
bank on 30th December, 2019, but were entered in the bank statement on1st January, 2020.
3. A cheque received for ` 73,000 had been dishonoured prior to 30th December, 2019, but no record of
this fact appeared in the cash book.
4. A dividend of ` 3,80,000, paid direct to the bank had not been recorded in the cash book.
5. Bank interest and charges amounting to ` 4,200 had been charged in the bank statement but not entered
in the cash book.
6. No entry had been made in the cash book for a trade subscription of ` 10,000 paid vide banker’s order
in November, 2019.
7. A cheque for ` 27,000 drawn by B. Philip had been charged to A. Philip’s bank account by mistake in
December, 2019.
You are required:
(a) to make appropriate adjustments in the cash book bringing down the correct balance, and
(b) to prepare a statement reconciling the adjusted balance in the cash book with the balance shown in the
bank statement.

SOLUTION

(a) A. Philip
Dr. Cash Book (Bank column) Cr.
Date Particulars Amount Date Particulars Amount
2019 ` 2019 `
Dec. 30 To Balance b/d 4,610 Dec. 30 By Trade receivables- 73,000
To Dividend received 3,80,000 Cheque dishonoured
By Bank interest and 4,200
charges
By Trade Subscription 10,000
Dec. 31 By Balance c/d 2,97,410
3,84,610 3,84,610
2020
Jan. 1 To Balance b/d 2,97,410

(b) Bank Reconciliation Statement as at 30th December, 2019

Particulars Amount
`
Balance per cash book 2,97,410
Add: Cheques not yet presented 6,30,000

© The Institute of Chartered Accountants of India

23 BANK RECONCILIATION STATEMENTS 3.23

9,27,410
Less: Lodgement not yet recorded by bank (2,50,000)
6,77,410
Less: Cheque wrongly charged (27,000)
Balance as per the bank statement 6,50,410

ILLUSTRATION 7

From the following information, prepare a Bank reconciliation statement as at 31st December, 2019 for Messrs
New Steel Limited : `
(1) Bank overdraft as per Cash Book on 31st December, 2019 22,45,900
(2) Interest debited by Bank on 26th December, 2019 but no advice received 2,78,700
(3) Cheque issued before 31st December, 2019 but not yet presented to Bank 6,60,000
(4) Transport subsidy received from the State Government directly by the Bank but not 14,25,000
advised to the company
(5) Draft deposited in the Bank, but not credited till 31st December, 2019 13,50,000
(6) Bills for collection credited by the Bank till 31st December, 2019 but no advice received 8,36,000
by the company
(7) Amount wrongly debited to company account by the Bank, for which no details are 7,40,000
available

SOLUTION

M/s. New Steel Ltd.

Bank Reconciliation Statement as on 31st Dec, 2019

Particulars Details Amount `

`
Overdraft as per Cash Book 22,45,900
Add : Interest charged by the bank 2,78,700
Draft deposited in bank but not yet credited 13,50,000
Wrong debit by the bank, under verification 7,40,000 23,68,700
46,14,600
Less: Cheque issued but not yet presented (6,60,000)
Transport subsidy not yet recorded in the Cash Book (14,25,000)
Bills for collection credited in the bank not yet entered in the cash book (8,36,000) (29,21,000)
Overdraft as per bank statement 16,93,600

© The Institute of Chartered Accountants of India

3.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 8

The Cash Book of Mr. Gadbadwala shows ` 8,36,400 as the balance at Bank as on 31st December, 2019, but
you find that it does not agree with the balance as per the Bank Pass Book. On scrutiny, you find the following
discrepancies:
(1) On 15th December, 2019 the payment side of the Cash Book was undercast by ` 10,000.
(2) A cheque for ` 1,31,000 issued on 25th December, 2019 was not taken in the bank column.
(3) One deposit of ` 1,50,000 was recorded in the Cash Book as if there is no bank column therein.
(4) On 18th December, 2019 the debit balance of ` 15,260 as on the previous day, was brought forward as
credit balance.
(5) Of the total cheques amounting to ` 11,514 drawn in the last week of December, 2019, cheques
aggregating ` 7,815 were encashed in December.
(6) Dividends of ` 25,000 collected by the Bank and subscription of ` 1,000 paid by it were not recorded in
the Cash Book.
(7) One out-going Cheque of ` 3,50,000 was recorded twice in the Cash Book. Prepare a Reconciliation
Statement.

SOLUTION

(If the books are not closed on 31st December, 2019)

Bank Reconciliation Statement of Mr. Gadbadwala as on 31st Dec., 2019
Particulars Details Amount
` `
Balance as per the Cash Book 8,36,400
Add : Mistake in bringing forward ` 15,260 debit balance as credit 30,520
balance on 18th Dec., 2019
Cheques issued but not presented :
Issued 11,514
Cashed 7,815 3,699
Dividends directly collected by bank but not yet
entered in the Cash Book 25,000
Cheque recorded twice in the Cash Book 3,50,000
Deposit not recorded in the Bank column 1,50,000 5,59,219
13,95,619
Less : Wrong casting in the Cash Book on 15th Dec. 10,000

© The Institute of Chartered Accountants of India

25 BANK RECONCILIATION STATEMENTS 3.25

Cheques issued but not entered in the Bank column 1,31,000

Subscription paid by the bank directly not yet recorded in the
Cash Book 1,000 (1,42,000)
Balance as per the Pass Book 12,53,619

If the books are to be closed on 31st December, then adjusted cash book will be prepared as given below:
ADJUSTED CASH BOOK

Particulars Amount (`) Particulars Amount (`)

To Balance b/d 8,36,400 By wrong casting 10,000
To error for wrong posting 30,520 By cheques not entered 1,31,000
To dividends collected by bank 25,000 By subscription 1,000
To cheques recorded twice 3,50,000 By balance c/d 12,49,920
To deposit not recorded 1,50,000
13,91,920 13,91,920

Bank Reconciliation Statement

Particulars `
Balance as per the Cash Book (corrected) 12,49,920
Add: Cheques issued but not yet presented 3,699
Balance as per the Pass Book 12,53,619

ILLUSTRATION 9

The following are the Cash Book (bank column) and Pass Book of Jain for the months of March, 2019 and April,
2019:
Cash Book (Bank Column only)
Date Particulars Amount Date Particulars Amount
Dr. Cr.
` `
01/3/2019 To Balance b/d 60,000 03/3/2019 By Cash A/c 2,00,000
06/3/2019 To Sales A/c 3,00,000 07/3/2019 By Modi 60,000
10/3/2019 To Ram 65,000 12/3/2019 By Patil 30,000
18/3/2019 To Singhal 2,70,000 18/3/2019 By Suresh 40,000
25/3/2019 To Goyal 33,000 24/3/2019 By Ramesh 1,50,000
31/3/2019 To Patel 65,000 30/3/2019 By Balance c/d 3,13,000
7,93,000 7,93,000

© The Institute of Chartered Accountants of India

3.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

Pass Book
Date Particulars Amount Amount Dr. or Balance
Dr. Cr. Cr. `
` `
1/4/2019 By Balance b/d 3,65,000 Cr. 3,65,000
3/4/2019 By Goyal 33,000 Cr. 3,98,000
5/4/2019 By Patel 65,000 Cr. 4,63,000
7/4/2019 To Naresh 2,80,000 Cr. 1,83,000
12/4/2019 To Ramesh 1,50,000 Cr. 33,000
15/4/2019 To Bank Charges 200 Cr. 32,800
20/4/2019 By Usha 17,000 Cr. 49,800
25/4/2019 By Kalpana 38,000 Cr. 87,800
30/4/2019 To Sunil 6,200 Cr. 81,600

Reconcile the balance of cash book on 31/3/2019.

SOLUTION

1. On scrutiny of the debit side of the Cash Book of March 2019 and receipt side of the Pass Book of April,
2019 reveals that two cheques deposited in Bank (Goyal ` 33,000 and Patel ` 65,000) in March were
not credited by the Bank till 31/3/2019.
2. On scrutiny of the credit side of the cash book and payment side of the Pass Book reveals that a cheque
issued to Ramesh for ` 1,50,000 in March 2019, had not been presented for payment in Bank till
31/3/2019. Therefore the Bank Reconciliation statement on 31/3/2019 will appear as follows :
Bank Reconciliation Statement as on 31st March, 2019
Particulars Amount
`
Balance as per the Cash Book 3,13,000
Add : Cheque issued but not presented for payment 1,50,000
4,63,000
Less : Cheque deposited but not credited by Bank (98,000)
Balance as per the Pass Book 3,65,000

ILLUSTRATION 10

When Nikki & Co. received a Bank Statement showing a favourable balance of ` 10,39,200 for the period ended
on 30th June, 2019, this did not agree with the balance in the cash book.
An examination of the Cash Book and Bank Statement disclosed the following :
1. A deposit of ` 3,09,200 paid on 29th June, 2019 had not been credited by the Bank until 1st July, 2019.

© The Institute of Chartered Accountants of India

27 BANK RECONCILIATION STATEMENTS 3.27

2. On 30th March, 2019 the company had entered into hire purchase agreement to pay by bank order a
sum of ` 3,00,000 on the 10th of each month, commencing from April, 2019. No entries had been made
in Cash Book.
3. A customer of the firm, who received a cash discount of 4% on his account of ` 4,00,000 paid the firm
a cheque on 12th June. The cashier erroneously entered the gross amount in the bank column of the
Cash Book.
4. Bank charges amounting to ` 3,000 had not been entered in Cash-Book.
5. On 28th June, a customer of the company directly deposited the amount in the bank ` 4,00,000, but no
entry had been made in the Cash Book.
6. ` 11,200 paid into the bank had been entered twice in the Cash Book.
7. A debit of ` 11,00,000 appeared in the Bank Statement for an unpaid cheque, which had been returned
marked ‘out of date’. The cheque had been re-dated by the customer and paid into Bank again on 5th
July, 2019.
Prepare Bank Reconciliation Statement on 30 June, 2019.

SOLUTION

Bank Reconciliation Statement on 30th June, 2019

Particulars Details Amount
` `
Balance as per the Pass Book 10,39,200
Add: Deposited with bank but not credited 3,09,200
Payment of Hire Purchase installments not entered in the Cash Book 9,00,000
(` 3,00,000 x 3)
Discount allowed wrongly entered in bank column 16,000
Bank charges not entered in the Cash Book 3,000
Deposit entered in the Cash Book twice 11,200
Cheque returned ‘out of date’ entered in the Cash Book 11,00,000 23,39,400
33,78,600
Less: Direct deposit by customer not entered in the Cash Book (4,00,000)
Balance as per the Cash Book 29,78,600

ILLUSTRATION 11

The bank column of cash book of Mukesh was balanced on 31st March, 2019. It showed an overdraft of ` 5,000.
This did not agree with the balance shown by bank statement of Mukesh. You are required to prepare a bank
reconciliation statement taking the following into account :
(1) Cheques issued but not presented for payment till 31.3.2019 ` 12,00,000.
(2) Cheques deposited but not collected by bank till 31.3.2019 ` 20,00,000.

© The Institute of Chartered Accountants of India

3.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

(3) Interest on term-loan ` 10,00,000 debited by bank on 31.3.2019 but not accounted in Mukesh’s book.
(4) Bank charges ` 2,500 was debited by bank during March, 2019 but accounted in the books of Mukesh
on 4.4.2019.
(5) An amount of ` 30,68,000 representing collection of Remesh’s cheque was wrongly credited to the
account of Mukesh by the bank in their bank statement.

SOLUTION

In the books of Mukesh

Bank Reconciliation Statement as on 31st March, 2019
Particulars Details Amount
`
Overdraft as per the cash book 5,000
Add: Cheques deposited in bank but not collected and credited by bank till 20,00,000
31.3.2019
Interest on term loan not accounted in books 10,00,000
Bank charges not accounted in books 2,500 30,02,500
30,07,500
Less: Cheques issued but not presented for payment till 31.3.2019 (12,00,000)
18,07,500
Less: Erroneous credit by bank to Mukesh’s account (30,68,000)
Balance as per the bank statement (12,60,500)

SUMMARY
 Bank pass book is merely a copy of the customer’s account in the book of a bank.
 Bank reconciliation statement is a statement which reconciles the bank balance as per cash book with
the balance as per bank pass book by showing all causes of difference between the two.
 The salient features of bank reconciliation statement:
 The reconciliation will bring out any errors that may have been committed either in the cash
book or in the pass book;
 Any undue delay in the clearance of cheques will be shown up by the reconciliation;
 A regular reconciliation discourages the accountant of the bank from embezzlement. There have
been many cases when the cashiers merely made entries in the cash book but never deposited
the cash in the bank; they were able to get away with it only because of lack of reconciliation.
 It helps in finding out the actual position of the bank balance.

© The Institute of Chartered Accountants of India

29 BANK RECONCILIATION STATEMENTS 3.29

 The difference in the balances of both the books can be because of the following reasons:
1. Timing differences,
2. Transactions;
3. Errors.
 Bank reconciliation can be start from any of the following four balances given in the question:
1. Dr. balance as per cash book
2. Cr. balance as per cash book
3. Dr. balance as per pass book
4. Cr. balance as per pass book
 There are two methods of reconciling the bank balances :
1. Bank reconciliation statement without preparation of adjusted cash-book.
2. Bank reconciliation statement after the preparation of adjusted cash-book.

TEST YOUR KNOWLEDGE

True or False
1. Bank Reconciliation is the process of reconciling cash column of the cash book and bank column of the
cash book.
2. There are 3 types of differences between cash book and pass book namely Timing, Transactions &
Errors.
3. Adjusting the cash book for any errors and/or omissions before preparing bank reconciliation is optional
when the reconciliation is done at the end of the financial year.
4. Debit balance in cash book is same as overdraft as per pass book.
5. Bank charges debited by the bank is an example of timing difference for the purposes of bank
reconciliation.
6. Overcasting of the debit side of the cash book is an example of a difference that is due to error.
7. When we start bank reconciliation with a debit balance in cash book, then cheques issued but not yet
presented should be added back to arrive at the balance as per pass book.
8. The bank charges charged by the bank should be deducted when bank reconciliation statement is being
prepared starting from a credit balance of pass book.
9. When the causes of differences between pass book balance and cash book is not known, then the bank
reconciliation statement can be prepared by matching the two books and identifying any unticked items
in both sets.
10. While preparing the bank reconciliation statement starting with debit balance as per pass book or bank
statement, the deposited cheques that are not yet cleared need not be adjusted.

© The Institute of Chartered Accountants of India

3.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

11. Cash book shows a debit balance of ` 50,000 and the only difference from the balance as shown in pass
book relates to cheques issued for ` 60,000 but not yet presented for payment. The balance as per pass
book should be ` 1,10,000.
12. Overcasting of credit side of the cash book shall result in a higher bank balance in cash book when
compared with pass book balance.
13. A cheque for ` 25,000 that was issued and was also presented for payment in same month but
erroneously recorded on debit side of the cash book would cause a difference of ` 50,000 from the
balance in pass book.
14. A direct debit by bank on account of any payment as may be instructed by customer should be recorded
on credit side of cash book.
15. Bank Reconciliation Statement can be prepared in two formats – “Balance” presentation and “Plus &
Minus” presentation.
16. The difference between cash book & pass book that relates to errors are those mostly made by Bank.
17. A cheque for ` 80,000 that was discounted from bank was dishonoured and the bank charged ` 1,600
as the charges on account of same. While starting with debit balance in cash book for preparing bank
reconciliation statement, we need to deduct ` 78,400 to reconcile with pass book.
18. Interest on savings bank that is allowed or credited by bank is generally recorded in cash book prior to
it being recorded by bank.
19. A regular bank reconciliation discourages the accountants to be involved in any kind of funds
embezzlement.
20. Timing difference relates the transactions that are recorded in the same period in both cash book and
also the bank pass book.

Multiple Choice Questions

1. When the balance as per Cash Book is the starting point, direct deposits by customers are:
(a) Added (b) Subtracted (c) Not required to be adjusted.
2. A debit balance in the depositor’s Cash Book will be shown as:
(a) A debit balance in the Bank Statement.
(b) A credit balance in the Bank Statement.
(c) An overdrawn balance in the Bank Statement.
3. When balance as per Pass Book is the starting point, interest allowed by Bank is
(a) Added (b) Subtracted (c) Not required to be adjusted
4. A Bank Reconciliation Statement is prepared with the help of:
(a) Bank statement and bank column of the Cash Book.
(b) Bank statement and cash column of the Cash Book
(c) Bank column of the Cash Book and cash column of the Cash Book.

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31 BANK RECONCILIATION STATEMENTS 3.31

5. The cash book showed an overdraft of ` 1,50,000, but the pass book made up to the same date showed
that cheques of ` 10,000, ` 5,000 and ` 12,500 respectively had not been presented for payments; and
the cheque of ` 4,000 paid into account had not been cleared. The balance as per the pass book will
be:
(a) ` 1,10,000 (b) ` 2,17,500 (c) ` 1,26,500
6. When drawing up a Bank Reconciliation Statement, if you start with a debit balance as per the Bank
Statement, the unpresented cheques should be:
(a) Added; (b) Deducted; (c) Not required to be adjusted.
7. When drawing up a BRS if you start with a Dr. Balance as per Bank Statement, the following are added:
1. Cheque issued but not presented to bank
2. B/R collected directly by bank
3. Overcasting of the Dr. Side of bank A/c in the cash book.
(a) only 1
(b) only 1& 2
(c) all of the above
(d) only 3.

Theory Questions
1. Write short note on Bank reconciliation statement.
2. State the causes of difference between the balance shown by the pass book and the cash book.

Practical Questions
1. From the following particulars prepare a bank reconciliation statement as on 31st December 2019:
(i) On 31st December, 2019 the cash-book of a firm showed a bank balance of ` 60,000 (debit
balance).
(ii) Cheques had been issued for ` 15,00,000, out of which cheques worth ` 4,00,000 only were
presented for payment.
(iii) Cheques worth ` 11,40,000 were deposited in the bank on 28th December, 2019 but had not
been credited by the bank. In addition to this, one cheque for ` 5,00,000 was entered in the
cash book on 30th December, 2019 but was banked on 3rd January, 2020.
(iv) A cheque from Susan for ` 4,00,000 was deposited in the bank on 26th December 2019 but
was dishonoured and the advice was received on 2nd January, 2020.
(v) Pass-book showed bank charges of ` 2000 debited by the bank.
(vi) One of the debtors deposited a sum of ` 5,00,000 in the bank account of the firm on 20th
December, 2019 but the intimation in this respect was received from the bank on 2nd January,
2020.

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3.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

(vii) Bank pass-book showed a debit balance of ` 3,82,000 on 31st December, 2019.
2. According to the cash-book of Gopi, there was a balance of ` 44,50,000 in his bank on 30th June, 2019.
On investigation you find that:
(i) Cheques amounting to ` 6,00,000 issued to creditors have not been presented for payment till
the date.
(ii) Cheques paid into bank amounting to ` 11,05,000 out of which cheques amounting to
` 5,50,000 only collected by the bank up to 30th June 2019.
(iii) A dividend of ` 40,000 and rent amounting to ` 6,00,000 received by the bank and entered in
the pass-book but not recorded in the cash book.
(iv) Insurance premium (up to 31st December, 2019) paid by the bank ` 27,000 not entered in the
cash book.
(v) The payment side of the cash book had been under casted by ` 5,000.
(vi) Bank charges ` 1,500 shown in the pass book had not been entered in the cash book.
(vii) A bill payable of ` 2,00,000 had been paid by the bank but was not entered in the cash book
and bill receivable for ` 60,000 had been discounted with the bank at a cost of ` 1,000 which
had also not been recorded in cash book.
Required:
(a) to make the appropriate adjustments in the cash book, and
(b) to prepare a statement reconciling it with the bank pass book.
3. Prepare a bank reconciliation statement as on 30th September, 2019 from the following particulars:
Particulars `
Bank balance as per pass-book 10,00,000
Cheque deposited into the bank, but no entry was passed in the cash-book 5,00,000
Cheque received, but not sent to bank 11,20,000
Credit side of the bank column cast short 2,000
Insurance premium paid directly by the bank under the standing advice 60,000
Bank charges entered twice in the cash book 2,000
Cheque issued, but not presented to the bank for payment 5,00,000
Cheque received entered twice in the cash book 10,000
Bills discounted dishonoured not recorded in the cash book. 5,00,000

4. Prepare a bank reconciliation statement from the following particulars on 31st March, 2019:
Particulars `
Debit balance as per bank column of the cash book 37,20,000
Cheque issued to creditors but not yet presented to the bank for payment 7,20,000
Dividend received by the bank but not yet entered in the cash book 5,00,000

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33 BANK RECONCILIATION STATEMENTS 3.33

Interest allowed by the bank 12,500

Cheques deposited into bank for collection but not collected by bank up to this date. 15,40,000
Bank charges 2,000
A cheque deposited into bank was dishonoured, but no intimation received 3,20,000
Bank paid house tax on our behalf, but no information received from bank in this 3,50,000
connection.

ANSWERS/HINTS
True and False
1. False : Bank Reconciliation Statement reconciles bank column of cash book with the balance in the pass
book i.e. customer account in the books of bank.
2. True : These are the three broad categories.
3. False : Adjusting the cash book is mandatory when bank reconciliation is done at the end of the financial
year.
4. False : Debit balance as per cash book should be represented by credit or favourable balance in pass
book.
5. False : Bank charges are example of the transactions that bank carries out by itself and the same has
not been recorded in the cashbook until statement is obtained from the bank.
6. True : Overcasting is an example of an error.
7. True : Since the cheques issued would have been recorded as payments and bank balance was credited
in cash book, we need to add it back as the same is not yet deducted from our bank balance.
8. False : Bank charges should be added when we start with credit or favourable balance in pass book as
bank would have debited the charges.
9. True : Since, we don’t know the causes of difference, matching the two statements is only efficient way
to identify the difference.
10. False : Cheques deposited but not yet cleared should be subtracted from debit or unfavourable balance
in pass book.
11. True : Cheques issued but not yet presented should be added back to a debit balance in cash book to
arrive at pass book balance i.e. ` 50,000 + ` 60,000 = ` 1,10,000.
12. False : Overcasting of credit side means excessive payments are recorded and hence would lower the
bank balance.
13. True: ` 25,000 payment is recorded as a receipt and hence it will have to be adjusted twice (once to
nullify and then once to record actual payment) hence causing the difference of double amount.
14. True : It is an example of a payment instructed by customer to be directly debited by bank, and hence
credited in the cash book.
15. True : Reconciliation statement can be prepared in either of the two formats.

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3.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

16. False : Bank rarely makes mistakes, and hence differences that relate to errors are generally made in
cash book.
17. False : We need to deduct ` 81,600 (i.e. both cheque returned & charges) from debit balance in cash
book to arrive at balance as per pass book.
18. False : Interest allowed by bank is mostly recorded in cash book after the entry has been made in the
pass book or bank statement.
19. True : In absence of any reconciliation, the accountants can mis-utilize the funds temporarily by recording
the entry without actual depositing the cash.
20. False : Timing differences relate to the transactions that are recorded in cash book and pass book in two
different periods.

Multiple Choice Questions

1. (a) 2. (b) 3. (b) 4. (a) 5. (c) 6. (a)
7. (b)

Theoretical Questions
1. Bank reconciliation statement is prepared as on a particular date to reconcile and explain the causes of
difference between the bank balance as per cash book and the same as per savings bank pass book or
current account statement. At the end of each month, the bank balance as per cash book and that as
per pass book /bank statement should be compared and, if there is disagreement, these balances should
be reconciled stating exact reasons of disagreement. The reconciliation is made in a statement called
the bank reconciliation statement.
2. The difference between the balance shown by the passbook and the cashbook may arise on account of
the following:
(i) Cheques issued but not yet presented for payment.
(ii) Cheques deposited into the bank but not yet cleared.
(iii) Interest allowed by the bank.
(iv) Interest and expenses charged by the bank.
(v) Interest and dividends collected by the bank.
(vi) Direct payments by the bank.
(vii) Direct deposits into the bank by a customer.
(viii) Dishonour of a bill discounted with the bank.
(ix) Bills collected by the bank on behalf of the customer.
(x) An error committed in cash book or by the bank etc.
(xi) Undercasting or Overcasting in cashbook.

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35 BANK RECONCILIATION STATEMENTS 3.35

Practical Questions
Answer 1
Bank Reconciliation Statement
as on 31st December, 2019
` `
Bank balance (Dr.) as per cash book 60,000
Add: Cheques issued but not yet presented for payment 11,00,000
Cheques directly deposited by a customer not yet recorded in cash book 5,00,000 16,00,000
16,60,000
Less: Cheques deposited but not yet credited by bank 11,40,000
Cheque received and recorded in cash book but not yet banked 5,00,000
Cheque dishonoured by the bank; the dishonour entry not yet passed 4,00,000
in cash book
Bank charges not recorded in cash book 2,000 (20,42,000)
Bank balance (Dr.) as per pass book (3,82,000)

Answer 2
Cash Book (Bank Column)
Receipts ` Payments `
To Balance b/d 44,50,000 By Insurance premium A/c 27,000
To Dividend A/c 40,000 By Correction of errors 5,000
To Rent A/c 6,00,000 By Bank charges 1,500
To Bill receivable A/c 59,000 By Bill payable 2,00,000
By Balance c/d 49,15,500
51,49,000 51,49,000

Bank Reconciliation Statement

as on 30th June, 2019

`
Adjusted balance as per cash book (Dr.) 49,15,500
Add: Cheques issued but not presented for payment till 30th June, 2019 6,00,000
Less: Cheques paid into bank for collection but not collected till 30th June, 2019 (5,55,000)
Balance as per pass book 49,60,500

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3.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

Answer 3
Bank Reconciliation Statement as on 30th September, 2019
` `
Bank balance as per pass book 10,00,000
Add: Cheque received but not sent to the bank 11,20,000
Credit side of the bank column cast short 2,000
Insurance premium paid directly not recorded in the cash book 60,000
Cheque received entered twice in the cash book 10,000
Bills dishonoured not recorded in the cash book 5,00,000 16,92,000
26,92,000
Less: Cheque deposited into the bank but no entry was passed in the cash book 5,00,000
Bank charges recorded twice in the cash book 2,000
Cheque issued but not presented to the bank 5,00,000 (10,02,000)
Bank balance as per cash book 16,90,000

Answer 4
Bank Reconciliation Statement
as on 31st March, 2019
` `
Debit balance as per cash book 37,20,000
Add: Cheque issued but not yet presented to bank for payment 7,20,000
Dividend received by bank not entered in cash book 5,00,000
Interest allowed by bank 12,500 12,32,500
49,52,500
Less: Cheques deposited into bank but not yet collected 15,40,000
Bank charges 2,000
A cheque deposited into bank was dishonoured 3,20,000
House tax paid by bank 3,50,000 (22,12,000)
Credit balance as per pass book 27,40,500

© The Institute of Chartered Accountants of India

CHAPTER
4
INVENTORIES
LEARNING OUTCOMES
After studying this chapter, you will be able to:
 Understand the meaning of term 'Inventory'.
 Learn the technique of Specific identification method, FIFO, Average Price, Weighted Average
Price and Adjusted Selling Price methods of inventory valuation.
 Understand the methods of inventory record keeping and comprehend the intricacies relating to
Inventory taking.

CHAPTER OVERVIEW

Type of Inventory

In case of Manufacturing concerns In case of Trading concerns

Raw Work -in- Finished Stores and Packing Traded

Materials progress Goods Spares Material Goods

Formulae for Determining Cost of Inventory

Inventory Valuation Technoquies

Historical cost Non-Historical

methods cost methods
Inventory, not ordinarily Inventory, ordinarily Adjusrted
Interchangeable Interchangeable Selling Price
Specific identificaion Historical cost
method methods
Weigthted
FIFO LIFO
Average Price

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4.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

Basis of Inventory Valuation

Cost Net realisation

Value

Whichever is less

1. MEANING
Inventory can be defined as assets held
 for sale in the ordinary course of business, or
 in the process of production for such sale, or
 for consumption in the production of goods or services for sale, including maintenance supplies and
consumables other than machinery spares, servicing equipment and standby equipment.
There can be different types of inventory based on nature of business of an enterprise. The inventories of a
trading concern consist primarily of products purchased for resale in their existing form. It may also have an
inventory of supplies such as wrapping paper, cartons, and stationery. The inventories of manufacturing concern
consist of several types of inventories: raw material (which will become part of the goods to be produced), work-
in-process (partially completed products in the factory) and finished products. In manufacturing concerns
inventories will also include maintenance supplies, consumables, loose tools and spare parts. However,
inventories do not include spare parts, servicing equipment and standby equipment which can be used only in
connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are
generally accounted for as fixed assets. Similarly, in an enterprise engaged in construction business, projects
under construction are also considered as inventory.
At the year-end every business entity needs to ascertain the closing balance of Inventory which comprise of
Inventory of raw material, work-in-progress, finished goods and other consumable items. Value of closing
Inventory is put at the credit side of the Trading Account and asset side of the Balance Sheet. So, before
preparation of final accounts, the accountant should know the value of Inventory of the business entity. However,
we shall restrict our discussion on inventory valuation of a manufacturing concern and goods of a trading concern.

2. INVENTORY VALUATION
A primary issue in accounting for inventories is the determination of the value at which inventories are carried in
the financial statements until the related revenues are recognized. Inventory is generally the most significant
component of the current assets held by a trading or manufacturing enterprise. It is widely recognized that
inventory is one of the major assets that affects efficiency of operations. Both excess of inventory and its shortage
affects the production activity, and the profitability of the enterprise whether it is a manufacturing or a trading

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3 INVENTORIES 4.3

business. Proper valuation of inventory has a very significant bearing on the authenticity of the financial
statements. The significance of inventory valuation arises due to various reasons as explained in the following
points:
(i) Determination of Income
The valuation of inventory is necessary for determining the true income earned by a business entity
during a particular period. To determine gross profit, cost of goods sold is matched with revenue of the
accounting period. Cost of goods sold is calculated as follows:
Cost of goods sold = Opening inventory + Purchases + Direct expenses - Closing inventory.
Inventory valuation will have a major impact on the income determination if merchandise cost is large
fraction of sales price. The effect of any over or under statement of inventory may be explained as:
(a) When closing inventory is overstated, net income for the accounting period will be overstated.
(b) When opening inventory is overstated, net income for the accounting period will be understated.
(c) When closing inventory is understated, net income for the accounting period will be understated.
(d) When opening inventory is understated, net income for the accounting period will be overstated.
The effect of misstatement of inventory figure on the net income is always through cost of goods sold.
Thus, proper calculation of cost of goods sold and for that matter, proper valuation of inventory is
necessary for determination of correct income.
(ii) Ascertainment of Financial Position
Inventories are classified as current assets. The value of inventory on the date of balance sheet is
required to determine the financial position of the business. In case the inventory is not properly valued,
the balance sheet will not disclose the truthful financial position of the business.
(iii) Liquidity Analysis
Inventory is classified as a current asset, it is one of the components of net working capital which reveals
the liquidity position of the business. Current ratio which studies the relationship between current assets
and current liabilities is significantly affected by the value of inventory.
(iv) Statutory Compliance
Schedule III to the Companies Act, 2013 requires valuation of each class of goods i.e. raw material,
work-in-progress and finished goods under broad head to be disclosed in the financial statements. As
per the requirements of the Accounting Standards, the financial statements should disclose:
(a) the accounting policies adopted in measuring inventories, including the cost formula used, and
(b) the total carrying amount of inventories and its classification appropriate to the enterprise.
The common classification of inventories are raw materials; work-in-progress; finished goods; stores-in-
trade (in respect of goods acquired for trading) and spares and loose tools.

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4.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. BASIS OF INVENTORY VALUATION

Inventories should be generally valued at the lower of cost or net realizable value. This principle is governed
by ‘Principle of Conservative Accounting’ under which any expenses or losses from transactions entered or event
occurred are to be recognized immediately, however, any gains or profits are recognized until its becomes due
or are actually realized. Under the principle of ‘lower of cost or net realizable value’ any loss due to decrease in
sales price of the inventory below its cost is recognized immediately as it is anticipated that the enterprise will
make losses whenever it will sell.
Cost: As per Accounting Standards, Cost of inventories should comprise
1. all cost of purchase,
2. costs of conversion (primarily for finished goods and work - in progress) and
3. other costs incurred in bringing the inventories to their present location and condition.
Cost of purchase consist of purchase price including duties and taxes (other than those subsequently
recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly
attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in
determining costs of purchase. In other words, cost includes any amount paid to the seller reduced by any
discounts/rebates given by the seller. Similarly, any duties paid to the supplier will be part of cost of the inventory
unless the enterprises can recover these taxes duties from the authorities.
Costs of conversion of inventories include costs directly related to the units of production, such as direct labour.
They also include a systematic allocation of fixed and variable overheads.
Other Costs may include administrative overheads incurred to bring the inventory into present location and
condition or any cost specifically incurred on inventory of a specified customer. Interest and other borrowing costs
are generally not included in the cost of inventory. However, in some circumstances where production process is
longer and it is required to carry inventory for a long period e.g. wine, rice and timber it may be appropriate to
consider interest and other borrowing cost also part of cost of inventory.
Exclusions from cost of inventories: Following expenses are generally not included in the costs of inventories:
(a) abnormal amounts of wasted materials, labour or other production overheads;
(b) storage costs, unless those costs are necessary in the production process prior to further production
stage;
(c) administrative overheads that do not contribute to bringing the inventories to their present location
and condition; and
(d) selling and distribution costs
Net realizable value: This is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale. In case of finished goods and traded
goods Net realizable value will generally mean selling price which reduced by selling and distribution expenses.
In case of work in progress, expenses and overheads required to be incurred to convert work -In progress into
finished goods and making it ready for sale will also be reduced from selling price. In case of raw materials,
replacement cost is generally considered as net realizable value.

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5 INVENTORIES 4.5

An assessment is made of as at each balance sheet date. Inventories are usually written down to net realizable
value on an item-by-item basis. In some circumstances, however, it may be appropriate to group similar or related
items e.g. in case of interchangeable items it may not be possible to identify cost and net realizable value of each
item separately.

4. INVENTORY RECORD SYSTEMS

There are two principal systems of determining the physical quantities and monetary value of inventories sold
and in hand. One system is known as ‘Periodic Inventory System’ and the other as the ‘Perpetual Inventory
System’. The periodic system is less expensive to use than the perpetual method. But the useful information
obtained from perpetual system is more than cost incurred on it. These systems are distinguished on the basis
of the actual records kept to ascertain the cost of goods sold and the closing inventory valuations.

4.1 PERIODIC INVENTORY SYSTEM

Periodic inventory system is a method of ascertaining inventory by taking an actual physical count (or measure
or weight) of all the inventory items on hand at a particular date on which inventory is valued. It is because of
actual physical count that the system is also called physical inventory system. The cost of goods sold is
determined as shown below:
Opening inventory (known) + Purchases (known) - closing inventory (physically counted) = Cost of goods sold.
Periodic inventory system is simple and less expensive than the perpetual system. In this system, inventory
account is adjusted at the end of the accounting period to determine cost of goods sold. This system suffers from
various limitations:
(i) Physical inventory taking is required more than once a year for preparation of quarterly or half yearly
financial statements thereby making this system more expensive.
(ii) Physical count of goods requires closure of normal operations of business.
(iii) As cost of goods sold is taken as residual figure, it is not possible to identify loss of goods due to
pilferage, damage or even fraud.
(iv) Inventory control is not possible under this system.
(v) Books of accounts does not reflect inventory in hand and its value therefore, it is difficult to plan
operations e.g. how much or when to order/manufacture.
This system is used by small enterprises where is easy to control physical inventory. This system is not
considered suitable for medium or larger enterprises which generally use Perpetual Inventory system.

4.2 PERPETUAL INVENTORY SYSTEM

Perpetual inventory system is a system of recording inventory balances after each receipt and issue. In order
to ensure accuracy of perpetual inventory records, physical inventory should be checked and compared with
recorded balances. Under this system, cost of goods issued is directly determined and inventory of goods is
taken as residual figure with the help of inventory ledger in which flow of goods is recorded on continuous basis.
The basic feature of this system is the maintenance of inventory ledger to have records of goods on continuous
basis. Under perpetual inventory system, closing inventory is determined as follows:

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4.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Opening inventory (known) + Purchases during the period (known) – Cost of Goods Sold (known) = Closing
Inventory (balancing figure)
Perpetual inventory system helps to overcome the limitations of periodic system. As inventory is taken as residual
figure, it includes loss of goods. However, the main limiting factor is the cost of using this system.

4.3 DISTINCTION BETWEEN PERIODIC INVENTORY SYSTEM AND PERPETUAL

INVENTORY SYSTEM
Both the systems - Periodic Inventory System and Perpetual Inventory System are not mutually exclusive and
complementary in nature. Distinction between both the systems can be explained as follows:
S. Periodic Inventory System Perpetual Inventory System
No.
1. This system is based on physical verification. It is based on book records.
2. This system provides information about It provides continuous information about inventory
inventory and cost of goods sold at a and cost of sales.
particular date.
3. This system determines inventory and takes It directly determines cost of goods sold and
cost of goods sold as residual figure. computes inventory as balancing figure.
4. Cost of goods sold includes loss of goods as Closing inventory includes loss of goods as all unsold
goods not in inventory are assumed to be goods are assumed to be in Inventory.
sold.
5. Under this method, inventory control is not Inventory control can be exercised under this
possible. system.
6. This system is simple and less expensive. It is costlier method.
7. Periodic system requires closure of business Inventory can be determined without affecting the
for counting of inventory. operations of the business.

5. FORMULAE/METHODS TO DETERMINE COST OF INVENTORY

5.1 HISTORICAL COST METHODS
There is no unique formula for determination of historical cost of inventories. The different techniques for valuation
of inventory have been discussed below:
(i) Specific Identification Method
Pricing under this method is based on actual physical flow of goods. It attributes specific costs to identified goods
and requires keeping different lots purchased separately to identify the lot out of which units in inventories are
left. The historical costs of such specific purpose inventories may be determined on the basis of their specific
purchase price or production cost.
This method is generally used to ascertain the cost of inventories of items that are not ordinarily interchangeable
and their value is high like expensive medical equiptment, otherwise it requires the use of FIFO (First in first out)
or weighted average price/average price formula.

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7 INVENTORIES 4.7

ILLUSTRATION 1

Surekha Ltd deals in 3 products P, Q & R, which are neither similar nor interchangeable. At the end of a financial
year, the Historical Cost and NRV of items of Closing Stock are given below. Determine the value of Closing
Stock.
Items Historical Cost (in ` Lakhs) Net Realisable Value (in ` Lakhs)
P 38 42
Q 29 29
R 17 14

SOLUTION

Inventories are to be valued at the lower of cost and Net Realisable Value (NRV). Inventories are usually written
down to NRV on an item-by-item basis. The Value of Closing Stocks is determined as under:
Items Historical Cost Net Realisable Value Valuation = Least of Cost
(in ` Lakhs) (in ` Lakhs) or NRV
P 38 42 38
Q 29 29 29
R 17 14 14
Total 81

(ii) FIFO (First in first out) Method

This method is based on the assumption that cost should be charged to revenue in the order in which they are
incurred, that is, it is assumed that the issue of goods is usually from the earliest lot on hand. The inventory of
goods on hand therefore, consists of the latest consignments. Thus, the closing inventory is valued at the price
paid for such consignments.
The FIFO formula assumes that the items of inventories which were purchased or produced first are consumed
or sold first and consequently items remaining in the inventory at the end of the period are those most recently
purchased or produced. This assumption is in line with the good business practice to disposing goods in the order
of their acquisition especially in the case of perishable goods and items with frequent technological changes. It
must be kept in mind that this assumption of cost flow or goods flow need not be true as a physical fact i.e. not
necessary goods are physically also sold or issued in the chronological order of their purchase or production. It
relates only to the method of accounting and not to the actual physical movement of goods.
Now, let us take an example to understand the application of FIFO method.

ILLUSTRATION 2

A manufacturer has the following record of purchases of a condenser, which he uses while manufacturing radio
sets:
Date Quantity (units) Price per unit
Dec. 4 900 50

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4.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

Dec. 10 400 55
Dec. 11 300 55
Dec. 19 200 60
Dec. 28 800 47
2,600

1,600 units were issued during the month of December till 18th December.

SOLUTION

The closing inventory is 1,000 units and would consist of:

800 units received on 28th December; and
200 units received on 19th December as per FIFO

`
The value of 800 units @ ` 47 37,600

The value of 200 units @ ` 60 12,000

Total 49,600

(iii) LIFO (Last in first out) Method

As the name suggests, the LIFO formula assigns to cost of goods sold, the cost of goods that have been
purchased last though the actual issues may be made out of the earliest lot on hand to prevent unnecessary
deterioration in value. The closing inventory then is assumed to consist of earlier consignments and its value is
then calculated according to such consignments. Under this basis, goods issued are valued at the price paid for
the latest lot of goods on hand which means inventory of goods in hand is valued at price paid for the earlier lot
of goods. In the absence of details of issue, the price paid for the earliest consignments is used for valuing closing
inventory. LIFO method is based on the principle of matching current cost with current revenue as cost of recently
purchased or produced goods are charged to cost against each sale. The cost of goods sold under this method
represents the cost of recent purchases resulting that there is better matching of current costs with current sales.

ILLUSTRATION 3

In the previous example assume that following issues were made during the month of December:
Record of issues
Date Quantity (units)
Dec. 5 500
Dec. 20 600
Dec. 29 500
Total 1,600

© The Institute of Chartered Accountants of India

9 INVENTORIES 4.9

SOLUTION

Computation of closing stock under perpetual inventory system

Using LIFO method, following will be stock ledger:
Date Receipts Issues Balance inventory
Dec. Qty. Rate Amount Qty Rate Amount Qty. Rate Amount
4 900 50 45,000 - - - 900 50 45,000
5 - - - 500 50 25,000 400 50 20,000
10 400 55 22,000 - - - 400 50 20,000
400 55 22,000
11 300 55 16,500 - - - 400 50 20,000
400 55 22,000
300 55 16,500
19 200 60 12,000 - - - 400 50 20,000
400 55 22,000
300 55 16,500
200 60 12,000
20 - - - 200 60 12,000
- - - 300 55 16,500
- - - 100 55 5,500 400 50 20,000
300 55 16,500
28 800 47 37,600 - - - 400 50 20,000
300 55 16,500
28 800 47 37,600
29 - - - 500 47 23,500 400 50 20,000
300 55 16,500
300 47 14,100

Therefore, cost of closing inventory of 1,000 pcs will be ` 50,600.

Computation under periodic inventory system
In the above example, if the entity followed periodic inventory valuation, closing inventory of 1,000 pcs. will be
valued as follows:
800 pcs. @ ` 47 each (purchased on Dec. 28th) = ` 37,600
200 pcs. @ ` 60 each (purchased on Dec. 19th) = ` 12,000
Total 1,000 pcs. = ` 49,600
We can see that cost of closing inventory has changed following LIFO method based on perpetual inventory
method and periodic inventory method.

© The Institute of Chartered Accountants of India

4.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

"LIFO method is based on an irrational assumption that inventories entering last in the stores are issued or
consumed first. However, the flow of goods which is generally observed in business entities is contradictory to
this assumption. It should be noted that while applying LIFO, there will be difference in cost of goods sold and
value of closing inventory, if the entity follows periodic as against perpetual method of inventory valuation.
(Periodic and Perpetual methods have been explained later in this chapter). Therefore, LIFO method is no longer
adopted for valuing inventories. Accounting Standards also does not permit the usage of LIFO Method. Generally,
in practice, FIFO and Weighted Average Price Method are popular among the business entities and both these
methods are also permitted by Accounting Standards."
(iv) Simple Average Price Method
Simple Average price for computing value of inventory is a very simple approach. All the different prices are
added together and then divided by the number of prices. The closing inventory is then valued according to the
price ascertained. This method is generally followed by the entities using periodic inventory method as it does
not require efforts of identifying that closing inventory belongs to which consignments or lots.

ILLUSTRATION 4

In the same example of a manufacturer of radio sets given earlier, let us calculate the value of closing inventory
using Average Price Method:

SOLUTION

The simple average in this question is:

[(50 + 55 + 55 + 60 + 47)/5] = 267/5 = ` 53.4
1,000 units valued at ` 53.4 would be ` 53,400
Let us try to analyse the impact of FIFO, LIFO and Simple Average Price Method with the help of the following
chart:

Units Received Units Issued

10th Jan – 500 units at ` 50 20th Jan – 500 units
15th Jan – 500 units at ` 60

FIFO LIFO Simple Average Method

500 units at ` 60 = ` 30,000 500 units at ` 50 = ` 25,000 500 units at ` 55 = ` 27,500

Thus, we see that value of inventories changes based on different cost formula used.

© The Institute of Chartered Accountants of India

11 INVENTORIES 4.11

(v) Weighted Average Price Method

Simple average price does not consider quantities purchased in various lots. However, it is more logical to
compute weighted average price using the quantities purchased in a lot as weights. Under weighted average
price method, cost of goods available for sale during the period is aggregated and then divided by number of
units available for sale during the period to calculate weighted average price per unit. Thus

Total cost of goods available for sale during the period

Weighted average price per unit =
Total number of units available for sale during the period
Closing inventory = No. of units in inventory × Weighted average price per unit
Cost of goods sold = No. of units sold × Weighted average price per unit.

ILLUSTRATION 5

On the basis of the data given in illustration 2 and 3, calculate the weighted average price and also the value of
closing inventory by weighted average price method.

SOLUTION

The computation of weighted average price in the referred example is shown below:
A new average rate would be calculated on receiving a fresh consignment. Answer on that basis would be as
under:
Date Receipts Issues Balance inventory
Qty Rate Amount Qty Rate Amount Qty Rate Amount
Dec. 4 900 50 45,000 - - - 900 50 45,000
Dec. 5 - - - 500 50 25,000 400 50 20,000
Dec. 10 400 55 22,000 - - - 800 52.5 42,000
Dec. 11 300 55 16,500 - - - 1,100 53.18 58,500
Dec. 19 200 60 12,000 - - - 1,300 54.23 70,500
Dec. 20 - - - 600 54.23 32,538 700 54.23 37,962
Dec. 28 800 47 37,600 - - - 1,500 50.37 75,562
Dec. 29 - - - 500 50.37 25,185 1,000 50.37 50,377

Perpetual and Periodic Inventory System and Average Methods of Cost of Inventory
Both Simple Average Method and Weighted Average Method are applied differently in case the entity uses
periodic inventory taking or Perpetual inventory taking. In case of periodic inventory taking inventory available
for sale during the period is considered together and an average rate is computed and closing inventory is valued
using that rate. In case perpetual inventory records are maintained average rate of inventory is computed on
each new purchase and next issue is recorded using new average rate.

© The Institute of Chartered Accountants of India

4.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

Illustration 5 above is an example of Weighted average method used in perpetual inventory recording system. In
case the entity would have been using periodic inventory recording system, closing inventory would have been
valued as below:
Details of purchases/receipt during the period
Date Qty. Rate Value
Dec. 4 900 50 45,000
Dec. 10 400 55 22,000
Dec. 11 300 55 16,500
Dec. 19 200 60 12,000
Dec. 28 800 47 37,600
Total 2,600 51.19 133,100
Accordingly, closing stock of 1,000 pcs. would have been valued at 51,190 @ ` 51.19 per unit.

5.2 NON-HISTORICAL COST METHODS

Non-historical cost methods do not consider the historical cost incurred to acquire the goods. Non- historical cost
methods include Adjusted Selling Price method and Standard Cost method. Adjusted Selling Price method can
be explained as follows:
(i) Adjusted selling price method
This method is also called retail inventory method. It is used widely in retail business or in business where the
inventory comprises of items, the individual costs of which are not readily ascertainable. The use of this method
is appropriate for measuring inventories of large numbers of rapidly changing items that have similar margins
and for which it is impracticable to use other costing methods. The cost of the inventory is determined by reducing
from the sales value of the inventory an appropriate percentage of gross margin. The percentage used takes into
consideration inventory which has been marked below its original selling price. An average percentage for each
retail department is often used. The calculation of the estimated gross margin of profit may be made for individual
items or groups of items or by departments, as may be appropriate to the circumstances.

ILLUSTRATION 6

M/s X, Y and Z are in retail business, following information are obtained from their records for the year ended
31st March, 2020:
Goods received from suppliers
(subject to trade discount and taxes) ` 15,75,500
Trade discount 3% and sales tax 11%
Packaging and transportation charges ` 87,500
Sales during the year ` 22,45,500
Sales price of closing inventories ` 2,35,000

Find out the historical cost of inventories using adjusted selling price method.

© The Institute of Chartered Accountants of India

13 INVENTORIES 4.13

SOLUTION

Determination of cost of purchases:

Goods received from suppliers 15,75,500

Less: Trade discount 3% (47,265)
15,28,235
Add: Sales Tax 11% ` 1,68,106
` 16,96,341
Add: Packaging and transportation charges ` 87,500
` 17,83,841
Determination of estimated gross profit margin:

Sales during the year ` 22,45,500

Closing inventory at the selling price ` 2,35,000
24,80,500
Less: Purchases ` (17,83,841)
Gross profit ` 6,96,659
Gross profit margin 28.09%
Inventory valuation:
Selling price of closing inventories ` 2,35,000
Less: Gross profit margin 28.09% ` (66,012)
` 1,68,988

ILLUSTRATION 7

From the following information, calculate the historical cost of closing inventories using adjusted selling price
method:

`
Sales during the year 2,00,000
Cost of purchases 2,00,000
Opening inventory Nil
Closing inventory at selling price 50,000

© The Institute of Chartered Accountants of India

4.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

Calculation of gross margin of profit:

`
Sales 2,00,000
Add: Closing inventory (at selling price) 50,000
Selling price of goods available for sale: 2,50,000
Less: Cost of goods available for sale 2,00,000
Gross margin 50,000
50,000
Rate of gross margin = × 100 = 20%
2,50,000

Cost of closing inventory = 50,000 less 20% of ` 50,000 = ` 40,000

(ii) Standard cost method
This method is used when there is frequent change in the price per unit of the goods and goods are purchased
frequently by the business e.g. crude oil. Based on the experience a standard cost is determined on the basis of
frequent changes in prices and inventory is valued on that price per unit.

6. INVENTORIES TAKING
Normally all operations are suspended for one or two days during the financial year and physical inventory is
taken for everything in the godown or the store periodically. For the year-end inventory valuation, physical
inventory taking is done during the last week of the financial year or during the first week of next financial year.
If inventory taking is finished on 26th March, whereas accounting year ends on 31st March purchases and sales
between 26th and 31st March are then separately adjusted. Later, a value is put on each item. The principle of
cost or Net realizable value, whichever is lower, is applied either for the inventory as a whole or item by item.
Normally, enterprises prefer to perform inventory taking closing day, however, sometimes inventory taking cannot
be carried out on the closing day. It is carried out a few days later or sometimes even a few days earlier. In such
a case, the actual value of the inventory must be so adjusted as to relate it to the end of the year concerned. For
doing so, it will be necessary to take into account the goods that have come in (purchases and sales returns) and
those that have gone out (sales and purchase returns) during the interval between the close of the year and the
date of actual inventory taking. Further, the adjustment of all goods must be on the basis of cost. Suppose, a firm
that closes its books on 31st December, carried out the inventory taking on the 7th January next year and actual
inventory was of the cost of ` 7,85,000, during the period January 1 to 7 purchases were ` 1,53,000 and sales
` 2,50,000, the mark up being 25% on cost. The inventory on 31st December would be ` 8,32,000 as shown
below:
`
Inventory ascertained on January 7 7,85,000
Less: Purchases during the period Jan. 1 to 7 1,53,000

© The Institute of Chartered Accountants of India

15 INVENTORIES 4.15

6,32,000
Add: Cost of goods sold during the period:
2,50,000 × (100/125) 2,00,000
8,32,000

ILLUSTRATION 8

From the following particulars ascertain the value of Inventories as on 31st March, 2020:
`
Inventory as on 1.4.2019 1,42,500
Purchases 7,62,500
Manufacturing Expenses 1,50,000
Selling Expenses 60,500
Administrative Expenses 30,000
Financial Charges 21,500
Sales 12,45,000

At the time of valuing inventory as on 31st March, 2019, a sum of ` 17,500 was written off on a particular item,
which was originally purchased for ` 50,000 and was sold during the year for ` 45,000. Barring the transaction
relating to this item, the gross profit earned during the year was 20 percent on sales.

SOLUTION

Statement of Inventory in trade as on 31st March, 2020

` `
Inventory as on 1st April, 2019 1,42,500
Less: Book value of abnormal inventory
(` 50,000 - ` 17,500) 32,500 1,10,000
Add: Purchases 7,62,500
Manufacturing Expenses 1,50,000
10,22,500
Less: Cost of goods sold:
Sales as per books 12,45,000
Less: Sales of abnormal item 45,000
12,00,000
Less: Gross Profit @ 20% 2,40,000 9,60,000
Inventory in trade as on 31st March, 2020 62,500

© The Institute of Chartered Accountants of India

4.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 9

A trader prepared his accounts on 31st March, each year. Due to some unavoidable reasons, no inventory taking
could be possible till 15th April, 2020 on which date the total cost of goods in his godown came to
` 5,00,000. The following facts were established between 31st March and 15th April, 2020.
(i) Sales ` 4,10,000 (including cash sales ` 1,00,000)
(ii) Purchases ` 50,340 (including cash purchases ` 19,900)
(iii) Sales Return ` 10,000.
Goods are sold by the trader at a profit of 20% on sales.
You are required to ascertain the value of inventory as on 31st March, 2020.

SOLUTION

Statement of valuation of Inventory on 31st March, 2020

` `
Value of Inventory as on 15th April, 2020 5,00,000
Add: Cost of goods sold during the period between
31st March, 2020 to 15th April, 2020
Sales (` 4,10,000 - ` 10,000) 4,00,000
Less: Gross Profit (20% of ` 4,00,000) 80,000 3,20,000
8,20,000
Less: Purchases during the period from
31st March, 2020 to 15th April, 2020 50,340
7,69,660

ILLUSTRATION 10

Inventory taking for the year ended 31st March, 2020 was completed by 10th April 2020, the valuation of which
showed a inventory figure of ` 16,75,000 at cost as on the completion date. After the end of the accounting year
and till the date of completion of inventory taking, sales for the next year were made for ` 68,750, profit margin
being 33.33 percent on cost. Purchases for the next year included in the inventory amounted to ` 90,000 at cost
less trade discount 10 percent. During this period, goods were added to inventory at the mark up price of ` 3,000
in respect of sales returns. After inventory taking it was found that there were certain very old slow-moving items
costing ` 11,250, which should be taken at ` 5,250 to ensure disposal to an interested customer. Due to heavy
flood, certain goods costing ` 15,500 were received from the supplier beyond the delivery date of customer. As
a result, the customer refused to take delivery and net realizable value of the goods was estimated to be ` 12,500
on 31st March. Compute the value of inventory for inclusion in the final accounts for the year ended 30th March,
2020.

© The Institute of Chartered Accountants of India

17 INVENTORIES 4.17

SOLUTION

Statement showing the valuation of Inventory

as on 31st March, 2020
`
Value of Inventory as on 10th April 16,75,000
Add: Cost of goods sold after 31st March till Inventory taking 51,560
(` 68,750 – ` 17,190)
Less: Purchases for the next period (net) (81,000)
Less: Cost of Sales Returns (2,250)
Less: Loss on revaluation of slow moving inventories (6,000)
Less: Reduction in value on account of default (3,000)
Value of Inventory on 31st March 16,34,310

Note: Profit margin of 33.33 percent on cost means 25 percent on sales price.

ILLUSTRATION 11

The following are the details of a spare part of Sriram mills:

1-1-2020 Opening Inventory Nil
1-1-2020 Purchases 100 units @ ` 30 per unit
15-1-2020 Issued for consumption 50 units
1-2-2020 Purchases 200 units @ ` 40 per unit
15-2-2020 Issued for consumption 100 units
20-2-2020 Issued for consumption 100 units

Find out the value of Inventory as on 31-3-2020 if the company follows First in first out basis.

SOLUTION

First-in-First out basis

Sriram Mills
Calculation of the value of Inventory as on 31-3-2020
Receipts Issues Balance
Date Units Rate Amount Units Rate Amount Units Rate Amount
` ` ` ` ` `
1-1-2020 Balance Nil
1-1-2020 100 30 3,000 100 30 3,000
15-1-2020 50 30 1,500 50 30 1,500
1-2-2020 200 40 8,000 50 30 1,500

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4.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

200 40 8,000
15-2-2020 50 30 1,500
50 40 2,000 150 40 6,000
20-2-2020 100 40 4,000 50 40 2,000

Therefore, the value of Inventory as on 31-3-2020: 50 units @ ` 40 = ` 2,000

ILLUSTRATION 12

The following are the details of a spare part of Sriram Mills:

1-1-2020 Opening Inventory Nil
1-1-2020 Purchases 100 units @ ` 30 per unit
15-1-2020 Issued for consumption 50 units
1-2-2020 Purchases 200 units @ ` 40 per unit
15-2-2020 Issued for consumption 100 units
20-2-2020 Issued for consumption 100 units

Find out the value of Inventory as on 31-3-2020 if the company follows Weighted Average basis.

SOLUTION

Weighted Average basis

Sriram Mills
Calculation of the value of Inventory as on 31-3-2020

Receipts Issues Balance

Date Units Rate Amount Units Rate Amount Units Rate Amount
` ` ` ` ` `
1-1-2020 Balance Nil
1-1-2020 100 30 3,000 100 30 3,000
15-1-2020 50 30 1,500 50 30 1,500
1-2-2020 200 40 8,000 250 38 9,500
15-2-2020 100 38 3,800 150 38 5,700
20-2-2020 100 38 3,800 50 38 1,900

Therefore, the value of Inventory as on 31-3-2020 = 50 units @ ` 38 = ` 1,900

© The Institute of Chartered Accountants of India

19 INVENTORIES 4.19

SUMMARY
♦ Inventory can be defined as assets held for sale in the ordinary course of business, or in the process of
production for such sale, or for consumption in the production of goods or services for sale, including
maintenance supplies and consumables other than machinery spares.
♦ The inventories of manufacturing concern consist of several types of inventories: raw material (which
will become part of the goods to be produced), parts and factory supplies, work-in-process (partially
completed products in the factory) and, of course, finished products.
♦ Proper valuation of inventory has a very significant bearing on the authenticity of the financial
statements.
♦ Cost of goods sold is calculated as follows:
Cost of goods sold = Opening Inventory + Purchases + Direct expenses - Closing Inventory.
♦ Inventories should be generally valued at the lower of cost or net realizable value.
♦ Inventory Valuation Techniques:
Historical Cost Methods
 Specific Identification Method
 FIFO (First in first out) Method
 LIFO (Last in first out) Method
 Average Price Method
 Weighted Average Price Method
Non-Historical Cost Methods
 Adjusted selling price method
 Standard cost method
There are two principal systems of determining the physical quantities and monetary value of inventories sold
and in hand. One system is known as ‘Periodic Inventory System’ and the other as the ‘Perpetual Inventory
System’.

TEST YOUR KNOWLEDGE

True and False
1. Inventories are stocks of goods and materials that are maintained for mainly the purpose of revenue
generation.
2. A building is considered inventory in a construction business.
3. Inventory is valued as carrying cost less percentage decreases.
4. Management has daily information about the quantity and valuation of closing stock under physical
Inventory System.

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4.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. Periodic Inventory System is more suitable for small enterprises.

6. When closing inventory is overstated, net income for the accounting period will be understated.
7. Closing inventory = Opening inventory + Purchases + Direct expenses + Cost of goods sold.
8. Cost of inventories should comprise all cost of purchase.
9. Costs of conversion of inventories include costs directly related to the units of production. They include
allocation of fixed overheads only.
10. Abnormal amounts of wasted materials, labour or other production overheads expenses are included in
the costs of inventories.
11. Perpetual system requires closure of business for counting of inventory.
12. Periodic inventory system is a method of ascertaining inventory by taking an actual physical count.
13. The value of ending inventory under simple average price method is realistic as compare to LIFO.
14. The value of stock is shown on the assets side of the balance-sheet as fixed assets.
15. Under inflationary conditions, FIFO will not show lowest value of cost of goods sold.
16. Under LIFO, valuation of inventory is based on the assumption that costs are charged against revenue
in the order in which they occur.
17. Valuation of inventory, at cost or net realisable value, whichever less, is based on the principle of
Conservatism.
18. Finished goods are normally valued at cost or market price whichever is higher.

Multiple Choice Questions

1. The amount of purchase if
Cost of goods sold is ` 80,700
Opening Inventory ` 5,800
Closing Inventory ` 6,000
(a) ` 80,500 (b) ` 74,900 (c) ` 80,900.
2. Average Inventory = ` 12,000. Closing Inventory is ` 3,000 more than opening Inventory. The value of
closing Inventory = ______.
(a) ` 12,000 (b) ` 24,000 (c) ` 13,500.
3. While finalizing the current year’s profit, the company realized that there was an error in the valuation of
closing Inventory of the previous year. In the previous year, closing Inventory was valued more by
` 50,000. As a result
(a) Previous year’s profit is overstated and current year’s profit is also overstated
(b) Previous year’s profit is overstated and current year’s profit is understated
(c) Previous year’s profit is understated and current year’s profit is also understated

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21 INVENTORIES 4.21

4. Consider the following for Q Co. for the year 2019-20:

Cost of goods available for sale ` 1,00,000
Total sales ` 80,000
Opening inventory of goods ` 20,000
Gross profit margin on sales 25%
Closing inventory of goods for the year 2019-20 as
(a) ` 80,000 (b) ` 60,000 (c) ` 40,000
5. If the profit is 25% of the cost price then it is
(a) 25% of the sales price
(b) 33% of the sales price
(c) 20% of the sales price
6. Goods purchased ` 1,00,000. Sales ` 90,000. Margin 20% on cost. Closing Inventory = ?
(a) ` 20,000 (b) ` 10,000 (c) ` 25,000
7. A company is following weighted average cost method for valuing its inventory. The details of its
purchase and issue of raw-materials during the week are as follows:
1.12.2020 opening Inventory 50 units value ` 2,200.
2.12.2020 purchased 100 units @ `47.
4.12.2020 issued 50 units.
5.12.2020 purchased 200 units @ ` 48.
The value of inventory at the end of the week and the unit weighted average costs is
(a) ` 14,200 – ` 47.33 (b) ` 14,300 – ` 47.67 (c) ` 14,000 – ` 46.66
8. The cost of sales is equal to
(a) Opening stock plus purchases
(b) Purchases minus Closing stock
(c) Opening stock plus purchases minus closing stock
9. Inventory is disclosed in financial statements under:
(a) Fixed Assets
(b) Current Assets
(c) Current Liabilities

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4.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

10. Accounting Standards do not permit following method of inventory valuation

(a) FIFO (b) Average cost (c) LIFO
11. Which inventory costing formula calculates value of closing inventory considering that inventory most
recently purchased has not been sold?
(a) FIFO (b) LIFO (c) Weighted average cost
12. Valuing inventory at cost or net releasable value is based on which principle
(a) Consistency (b) Conservatism (c) Going concern
13. Under inflationary trend, which of the methods will show highest value of inventory?
(a) FIFO (b) Weighted average (c) LIFO
14. Which of the following methods does not consider historical cost of inventory?
(a) Weighted average (b) FIFO (c) Retail price method

Theory Questions
1. Write short notes on:
(i) Adjusted Selling Price method of determining cost of stock.
(ii) Principal methods of ascertainment of cost of inventory.
2. Distinguish between:
(i) LIFO and FIFO basis of costing of stock.
(ii) FIFO and weighted average price method of stock costing.
3. Define inventory. Explain the importance of proper valuation of inventory in the preparation of statements
of the business entity.

Practical Questions
1. X who was closing his books on 31.3.2020 failed to take the actual stock which he did only on 9th April,
2020, when it was ascertained by him to be worth ` 2,50,000.
It was found that sales are entered in the sales book on the same day of dispatch and return inwards in
the returns book as and when the goods are received back. Purchases are entered in the purchases day
book once the invoices are received.
It was found that sales between 31.3.2020 and 9.4.2020 as per the sales day book are ` 17,200.
Purchases between 31.3.2020 and 9.4.2020 as per purchases day book are ` 1,200, out of these goods
amounting to ` 500 were not received until after the stock was taken.
Goods invoiced during the month of March, 2020 but goods received only on 4th April, 2020 amounted
to ` 1,000. Rate of gross profit is 33-1/3% on cost.
Ascertain the value of physical stock as on 31.3.2020.

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23 INVENTORIES 4.23

2. From the following information, ascertain the value of stock as on 31.3.2020:

`
Value of stock on 1.4.2019 7,00,000
Purchases during the period from 1.4.2019 to 31.3.2020 34,60,000
Manufacturing expenses during the above period 7,00,000
Sales during the same period 52,20,000

At the time of valuing stock on 31.3.2019 a sum of ` 60,000 was written off a particular item which was
originally purchased for ` 2,00,000 and was sold for ` 1,60,000. But for the above transaction the gross
profit earned during the year was 25% on cost.
3. The Profit and loss account of Hanuman showed a net profit of ` 6,00,000, after considering the closing
stock of ` 3,75,000 on 31st March, 2020. Subsequently the following information was obtained from
scrutiny of the books:
(i) Purchases for the year included ` 15,000 paid for new electric fittings for the shop.
(ii) Hanuman gave away goods valued at ` 40,000 as free samples for which no entry was made
in the books of accounts.
(iii) Invoices for goods amounting to ` 2,50,000 have been entered on 27th March, 2020, but the
goods were not included in stock.
(iv) In March, 2020 goods of ` 2,00,000 sold and delivered were taken in the sales for April, 2020.
(v) Goods costing ` 75,000 were sent on sale or return in March, 2020 at a margin of profit of
33-1/3% on cost. Though approval was given in April, 2020 these were taken as sales for March,
2020.
Calculate the value of stock on 31st March, 2020 and the adjusted net profit for the year ended on that
date.
4. Physical verification of stock in a business was done on 23rd June, 2020. The value of the stock was
` 48,00,000. The following transactions took place between 23rd June to 30th June, 2020:
(i) Out of the goods sent on consignment, goods at cost worth ` 2,40,000 were unsold.
(ii) Purchases of ` 4,00,000 were made out of which goods worth ` 1,60,000 were delivered on
5th July, 2020.
(iii) Sales were ` 13,60,000, which include goods worth ` 3,20,000 sent on approval. Half of these
goods were returned before 30th June, 2020.
(iv) Goods are sold at cost plus 25%. However, goods costing ` 2,40,000 had been sold for
` 1,20,000.
Determine the value of stock on 30th June, 2020.

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4.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWERS / HINTS
True and False
1. True: Inventories refers to stocks of goods and materials that are maintained in business for revenue
generation.
2. True: For a construction business a building under construction will be inventory. The building is being
built in the normal course of business and will eventually be sold as inventory.
3. False: Inventory is valued at lower of cost or net realizable value.
4. False: Under Perpetual Inventory System management have daily information of closing stock.
5. True: A periodic inventory system is suitable to small and micro enterprises, where physical counting
of inventory is not a tedious process.
6. False: When closing inventory is overstated, net income for the accounting period will be overstated.
7. False: Closing stock = Cost of goods sold - (Opening inventory + Purchases + Direct expenses).
8. False: Cost of inventories should comprise all cost of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
9. False: Costs of conversion of inventories include costs directly related to the units of production. They
also include a systematic allocation of fixed and variable overheads as well.
10. False: Abnormal amounts of wasted materials, labour or other production overheads expenses are
generally not included in the costs of inventories.
11. False: Periodic system requires closure of business for counting of inventory.
12. True: Under Periodic inventory system actual physical count of inventory is taken of all the inventory
on hand at a particular date.
13. True: Value of Closing stock as per average method is more realistic then LIFO.
14. False: The value of stock is shown on the assets side of the balance-sheet as current assets. As it is
realisable within 12 months.
15. False: Under inflationary conditions, LIFO and weighted average will not show lowest value of cost of
goods sold.
16. False: Under FIFO, valuation of inventory is based on the assumption that costs are charged against
revenue in the order in which they occur.
17. True: The conservatism concept states that one shall not account for anticipated profits but shall
provide all prospective losses. Valuing inventory at cost or net realisable value whichever is less,
therefore is based on principle of Conservatism.
18. False: Finished goods are normally valued at cost or market price whichever is lower.

© The Institute of Chartered Accountants of India

25 INVENTORIES 4.25

Multiple Choice Questions

1. (c) 2. (c) 3. (b) 4. (c) 5. (c) 6. (c)
7. (a) 8. (c) 9. (b) 10. (c) 11. (a) 12. (b)
13. (a) 14. (c)

Theoretical Questions
1 (i) Adjusted selling method is also called retail inventory method. It is used widely in retail business
or in business where the inventory comprises of items, the individual costs of which are not
readily ascertainable. The historical cost of inventory is estimated by calculating it in the first
instance at selling price and then deducting an amount equal to the estimated gross margin of
profit on such stocks.
(ii) The specific identification method, First-In–First-Out (FIFO) and weighted average cost
formulae are the principal methods of ascertaining the cost of inventory. The cost of inventories
of items that are not ordinarily interchangeable and goods or services produced and segregated
for specific projects should be assigned by specific identification of their individual costs under
the specific identification method.
2. (i) Under FIFO method of inventory valuation, inventories purchased first are issued first. The
closing inventories are valued at latest purchase prices and inventory issues are valued at
corresponding old purchase prices. In other words, under FIFO method, costs are assigned to
the units issued in the same order as the costs entered in the inventory. During periods of rising
prices, cost of goods sold are valued at older and lower prices if FIFO is followed and
consequently reported profits rise due to lower cost of goods sold.
On the other hand, under LIFO method of inventory valuation, units of inventories issued should
be valued at the prices paid for the latest purchases and closing inventories should be valued
at the prices paid for earlier purchases. In other words, closing inventories are valued at old
purchase prices and issues are valued at corresponding latest purchase prices.
(ii) Under the First-In-First-Out (FIFO) method of valuation of stock, the actual issue of goods is
usually the earliest lot on hand. Hence, the stock in hand will therefore consist of the latest
consignments. The closing stock is valued at the price paid for such consignments.
The weighted average price method is not a simple average price method. Under this method
of valuation of stock, a stock ledger is maintained, recording receipts and issues on daily basis.
A new average would be calculated on receiving fresh consignment. The average price thus
calculated after considering arrival of new consignment with the previous value of stock and
dividing the preceding stock value and the cost of new arrival with the total units of preceding
and new arrival will give the weighted average price.
3. Inventory can be defined as assets held
 for sale in the ordinary course of business, or
 in the process of production for such sale, or

© The Institute of Chartered Accountants of India

4.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

 for consumption in the production of goods or services for sale, including maintenance supplies
and consumables other than machinery spares.
The significance of inventory valuation arises due to the following reasons:
(i) Determination of Income
(ii) Ascertainment of Financial Position
(iii) Liquidity Analysis
(iv) Statutory Compliance

Practical Questions
Answer 1
Statement of Valuation of Physical Stock as on 31st March, 2020
`
Value of stock as on 9th April, 2020 2,50,000
Add: Cost of sales during the intervening period
Sales made between 31.32020 and 9.4.2020 17,200
Less: Gross profit @25% on sales (4,300) 12,900
2,62,900
Less: Purchases actually received during the intervening period:
Purchases from 1.4.2020 to 9.4.2020 1,200
Less: Goods not received upto 9.4.2020 (500) 700
2,62,200
Less: Purchases during March, 2020 received on 4.4.2020 1,000
Value of physical stock as on 31.3.2020 2,61,200
Answer 2
Statement of Valuation of Stock as on 31st March, 2020
`
Value of stock as on 1st April, 2019 7,00,000
Add: Purchases during the period from 1.4.2019 to 31.3.2020 34,60,000
Add: Manufacturing expenses during the above period 7,00,000
48,60,000
Less: Cost of sales during the period:
Sales 52,20,000
Less: Gross profit 10,32,000 41,88,000
Value of stock as on 31.3.2020 6,72,000

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27 INVENTORIES 4.27

Working Note:
`
Calculation of gross profit:
Gross profit on normal sales 20/100 x (52,20,000 -1,60,000) 10,12,000
Gross profit on the particular (abnormal) item 1,60,000 - (2,00,000 - 60,000) 20,000
10,32,000

Note: The value of closing stock on 31st March, 2020 may, alternatively, be found out by preparing Trading
Account for the year ended 31st March, 2020.
Answer 3
Profit and Loss Adjustment Account
Particulars ` Particulars `
To Advertisement (samples) 40,000 By Net profit 6,00,000
To Sales (goods approved in April to be taken 1,00,000 By Electric fittings 15,000
as April sales: (75,000 + 25,000)
To Adjusted net profit 10,40,000 By Samples 40,000
By Stock (purchases of March not 2,50,000
included in stock)
By Sales (goods sold in March 2,00,000
wrongly taken as April sales)
By Stock (goods sent on approval 75,000
basis not included in stock)
11,80,000 11,80,000

Calculation of value of inventory on 31st March, 2020

`
Stock on 31st March, 2020 (given) 3,75,000
Add: Purchases of March, 2020 not included in the stock 2,50,000
Goods lying with customers on approval basis 75,000
7,00,000

Answer 4
Statement of Valuation of Stock on 30th June, 2020
`
Value of stock as on 23rd June, 2020 48,00,000
Add: Unsold stock out of the goods sent on consignment 2,40,000
Purchases during the period from 23rd June, 2020 to 30th June, 2020 2,40,000

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4.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

Goods in transit on 30th June, 2020 1,60,000

Cost of goods sent on approval basis (80% of ` 1,60,000) 1,28,000 7,68,000
55,68,000
Less: Cost of sales during the period from 23rd June, 2020 to 30th June,
2020
Sales (` 13,60,000 - ` 1,60,000) 12,00,000
Less: Gross profit 96,000
11,04,000
Value of stock as on 30th June, 2020 44,64,000

Working Notes:
1. Calculation of normal sales:
Actual sales 13,60,000
Less: Abnormal sales 1,20,000
Return of goods sent on approval 1,60,000 2,80,000
10,80,000
2. Calculation of gross profit:
Gross profit or normal sales 20/100 x ` 10,80,000 2,16,000
Less: Loss on sale of particular (abnormal) goods (` 2,40,000-` 1,20,000) 1,20,000

Gross profit 96,000

© The Institute of Chartered Accountants of India

CHAPTER
5
CONCEPT AND ACCOUNTING
OF DEPRECIATION
LEARNING OUTCOMES
After studying this chapter, you will be able to:
 Understand the meaning and nature of depreciation.

 Understand how to determine the amount of depreciation from the total value of Property, Plant
and Equipment and its useful life.
 Understand various methods of depreciation and learn advantages and disadvantages of such
methods.
 Understand how to calculate the amount of profit or loss resulting from the sale/disposal of
Property, Plant and Equipment.
 Familiarize with the accounting treatment for change in the method of depreciation from Straight
Line Method to Reducing Balance method.
 Familiarize with the accounting treatment for change in estimated useful life and residual value
of property, plant and equipment.

CHAPTER OVERVIEW
Objectives of providing depreciation

To present rue and fair To accumulate funds

To ascertain true To ascertain true cost
view o the financail for the replacement of
results of operations of production
position assets

Factors affecting the amount of depreciation

Expected useful life and

Cost of asset Estimated residual value
utility

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5.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1. INTRODUCTION
1.1 Concept of Depreciation
Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative
purposes; and
(b) are expected to be used during more than a period of twelve months.
These are also called fixed assets in common parlance. When a fixed asset is purchased, it is recorded in books
of account at it original or acquisition/purchase cost. However fixed assets are used to earn revenues for a
number of accounting periods in future with the same acquisition cost until the concerned fixed asset is sold or
discarded. It is therefore necessary that a part of the acquisition cost of the fixed assets is treated or allocated
as an expense in each of the accounting period in which the asset is utilized. The amount or value of fixed assets
allocated in such manner to respective accounting period is called depreciation. Value of such assets decreases
with passage of time mainly due to following reasons.
1. Wear and tear due to its use in business
2. Efflux of time even when it is not being used
3. Obsolescence due to technological or other changes
4. Decrease in market value
5. Depletion mainly in case of mines and other natural reserves
It is important to account for value of portion of property, plant and equipment utilized for generating revenue
during an accounting year to ascertain true income. This portion of cost of Property, Plant & Equipment allocated
to an accounting year is called depreciation.
As per Schedule II under the Companies Act, 2013, Depreciation is the systematic allocation of the
depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost of an
asset or other amount substituted for cost, less its residual value. The useful life of an asset is the period
over which an asset is expected to be available for use by an entity, or the number of production or similar
units expected to be obtained from the asset by the entity.
Thus, there are 3 important factors for computing depreciation:
- Estimated useful life of the asset
- Cost of the asset
- Residual value of the asset at the end of the of its estimated useful life
Depreciation of an asset begins when it is available for use, i.e., when it is in the location and condition necessary
for it to be capable of operating in the manner intended by management. Thus it is not necessary that an asset
must be used to be depreciated. There is decrease in value of assets due to normal wear and tear even when
these are not physically used. Accordingly, value of such wear and tear should be estimated and accounted for.

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3 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.3

Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period
during the expected useful life of the asset. Depreciation for a period helps to charge that portion of the cost of
the asset against the revenues earned, which is expired for that period and hence follows matching principle. In
other words the total cost of the asset is reflected in form of a) Expired cost (depreciation) and b) Unexpired Cost
which shall be the written down value of the asset being reflected in balance sheet. Also charging depreciation
every year reduces the distributable profits and hence ensuring the availability of funds whenever the replacement
is required.
The depreciation is type of loss in the value of assets employed for carrying on a business. Being an essential
element of business expenditure, it is necessary to calculate the amount of such loss and to make a provision,
and therefore, arrive at the amount of profit or loss made by the business.
Basically, the cost of an asset used for purpose of business has to be written off over its economic (not physical)
life which must be estimated. A point to remember is that usually, at the end of the economic life, an asset has
some value as scrap or otherwise. The amount to be written off in each year should be as such which will reduce
the book value of the asset, at the end of its economic life, to its estimated scrap value.

1.2 Depreciation on components of an assets

It may be noted that Accounting Standards as well as the Companies Act, 2013 requires depreciation to be
charged on a component basis. Each part of an item of Property, Plant and Equipment with a cost that is
significant in relation to the total cost of the item should be depreciated separately. An enterprise should allocate
the amount initially recognised in respect of an item of property, plant and equipment to its significant
parts/components and should depreciate each such part separately based on the useful life and residual value
of each particular component. For Example- Aircraft is a classic example of such an asset. The airframe (i.e. the
body of the aircraft), the engines and the interiors have different individual useful lives. If the life of the airframe
(being the longest of the individual lives of the three major types of components) is taken as the life of the aircraft,
it is important that other two major components i.e. engine and interiors are depreciated over their respective
useful life and not over the life of airframe. Other components (usually small and low value) which will require
replacement very frequently may be depreciated over the useful life of airframe and their frequent replacement
cost may be charged to expense as and when it is incurred.
Here it is important to note that a part of Property, Plant & Equipment to be identified as a separate component
should have both
(a) significant cost when compared to overall cost of item of property, plant and equipment and
(b) and estimated useful life or depreciation method different from rest of the parts of the property plant
and equipment.
A significant part of an item of property, plant and equipment may have a useful life and a depreciation method
that are the same as the useful life and the depreciation method of another significant part of that same item.
Such parts may be grouped in determining the depreciation charge.

© The Institute of Chartered Accountants of India

5.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.3 Objectives for Providing Depreciation

Prime objectives for providing depreciation are:
(1) Correct income measurement: Depreciation should be charged for proper estimation of periodic profit or
loss. In case an enterprise does not account for depreciation on Property, Plant & Equipment, it will not
be considering loss in value of property, plant & equipment due to their use in production or operations
of the enterprise and will not result in true profit or loss for the period.

(2) True position statement: Value of the Property, Plant & Equipment should be adjusted for depreciation
charged in order to depict the actual financial position. In case depreciation is not accounted for
appropriately, the property, plant and equipment would be disclosed in financial statements at a value
higher than their true value. Whereas we should always present the same at its unexpired cost which is
after charging the expired cost as depreciation.
(3) Funds for replacement: Generation of adequate funds in the hands of the business for replacement of
the asset at the end of its useful life. Depreciation is a good indication of the amount an enterprise should
set aside to replace a fixed asset after its economic useful life is over. However, the replacement cost
of a fixed asset may be impacted by inflation or other technological changes.

(4) Ascertainment of true cost of production: For ascertaining the cost of the production, it is necessary to
charge depreciation as an item of cost of production.
Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages, rent, etc.) does not
result in any cash outflow. Further depreciation by itself does not create funds it merely draws attention to the
fact that out of gross revenue receipts, a certain amount should be retained for replacement of assets used for
carrying on operation which is achieved by charging depreciation that reduces the distributable profits.

2. FACTORS IN THE MEASUREMENT OF DEPRECIATION

Estimation of exact amount of depreciation is not easy as it involves lot of estimation. Generally following factors
are taken into consideration for calculation of depreciation.
1. Cost of asset including expenses for installation, commissioning, trial run etc.
2. Estimated useful life of the asset (both in terms of time & also utility/units).

3. Estimated scrap value (if any) at the end of useful life of the asset.

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5 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.5

The above mentioned factors can be explained, in detail, as follows:

Cost of a depreciable asset represents its money outlay or its
equivalent in connection with its acquisition, installation and
Cost of
Historical Asset commissioning as well as for additions to or improvement thereof
for the purpose of increase in efficiency. We have discussed this
in more detail in coming paragraphs.
‘Useful Life’ is either (i) the period over which a depreciable asset
Useful life of is expected to be used by the enterprise or (ii) the number of
the Asset production or similar units expected to be obtained from the use
of the asset by the enterprise. Determination of the useful life is
a matter of estimation and is normally based on various factors
Estimated including experience with similar type of assets. Several other
factors like estimated working hours, production capacity, repairs
and renewals, etc. are also taken into consideration on
demanding situation.

Scrap Determination of the residual value is normally a difficult matter.

(residual If such value is considered as insignificant, it is normally regarded
Estimated as nil. On the other hand, if the residual value is likely to be
value)
significant, it is estimated at the time of acquisition/installation, or
at the time of subsequent revaluation of asset.
Depreciable amount of a depreciable asset is its historical cost,
Depreciable or other amount substituted for historical cost in the financial
Amount
statements (for example- revalued amount), less the estimated
residual value.
For example, a machinery is purchased for ` 1,10,000. The
residual value is estimated at ` 10,000. It is estimated that the
machinery will work for 5 years. The cost to be allocated as
depreciation in the accounting periods will be calculated as:
`

Acquisition cost 1,10,000

Less: Residual value (10,000)
Depreciable amount 1,00,000
Estimated useful life of the asset 5 years
Depreciable amount
Depreciation = i.e. ` 1,00,000/ 5 = ` 20,000 per year
Estimated useful life

© The Institute of Chartered Accountants of India

5.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Cost of Property, Plant and Equipment comprises:

(a) its purchase price, including non-refundable import duties and purchase taxes, after deducting trade
discounts and rebates.
(b) any cost directly attributable to bring the asset to the location and condition necessary for it to be capable
of operating in a manner intended by the enterprise.
(c) the initial estimate of the costs of dismantling, removing, the item and restoring the site on which an
asset is located.
Examples of costs directly attributable costs are:
(a) cost of employee benefits arising directly from acquisition or construction of an item of property, plant
and equipment.
(b) cost of site preparation
(c) initial delivery and handling costs
(d) installation and assembly costs
(e) cost of testing whether the asset is functioning properly, after deducting the net proceeds from selling
the items produced while testing (such as samples produced while testing)
(f) professional fees e.g. engineers hired for helping in installation of a machine
Thus, all the expenses which are necessary for asset to bring it in condition and location of desired used will
become part of cost of the asset. However, following expenses should not become part of cost of asset:
(a) costs of opening new facility or business, such as inauguration costs;
(b) cost of introducing new product or service (for example cost of advertisement or promotional activities).
(c) cost of conducting business in a new location or with a new class of customer (including cost of staff
training); and
(d) administration and other general overhead costs.
Once an asset has been brought to its intended condition and location of use, no cost should recognized as part
of cost of the asset unless there is major repair or addition which increases the useful life of the asset or improves
the production capacity of the asset. Accordingly, cost incurred while and item is capable of operating in intended
manner but it is not yet put to use or is used at less than full capacity should not be capitalized as part of cost of
the asset. Similarly, cost of relocation of an asset should not be capitalized.
Any additions made to a particular item of property, plant and equipment after it is initially put to use are
depreciated over the remaining useful life of the asset. Any addition or extension which has a separate identity
and is capable of being used after the existing asset is disposed of, is accounted for separately. Therefore, it is
important to maintain an asset register capturing asset wise details of cost, rate of depreciation, date of
capitalization etc. All these details need to be captured for any additions to existing assets as well. In the absence
of the adequate information, it will be very difficult to compute depreciation expense year on year. Also, at the
time of disposal or discard of a particular asset, it will not be possible to compute gain or loss on such
disposal/discard.

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7 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.7

3. METHODS FOR PROVIDING DEPRECIATION

Generally, methods for providing depreciation are based on formula, developed on a study of the behavior of the
assets over a period of years for readily computing the amount of depreciation suffered by different forms of
assets. Each of the methods, however, should be applied only after carefully considering nature of the asset and
the conditions under which it is being used.

Methods of Depreciation

Diminishing Balance Units of Production

Straight-line Method Method Method

Results in a constant charge Results in a deceasing

over the useful life if the Results in a charg based on
charge over the useful the expected use or output
residual value of the asset life
does not change

The Income Tax Rules, however, prescribe the Diminishing Balance Method except in the case of assets of an
undertaking engaged in generation and distribution of power.

3.1 Straight Line Method

According to this method, an equal amount is written off every year during the working life of an asset so as to
reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this method
is that it is simple to apply and gives accurate results especially in case of leases, and also in case of plant and
machinery. This method is also known as Fixed Instalment Method.
Cost of Asset − Scrap Value
Straight Line Depreciation =
Useful life
Straight Line Depreciation
Straight Line Depreciation Rate = x 100
Cost of Asset
The underlying assumption of this method is that the particular tangible asset generates equal utility during its
lifetime. But this cannot be true under all circumstances. The expenditure incurred on repairs and maintenance
will be low in earlier years, whereas the same will be high as the asset becomes old. Apart from this the asset
may also have varying capacities over the years, indicating logic for unequal depreciation provision. However,
many assets have insignificant repairs and maintenance expenditures for which straight line method can be
applied.
While using this method the period of use of an asset in a particular year should also be considered. In the year
of purchase of an asset it may have been available for use for part of the year only, accordingly depreciation
should be proportioned to reflect the period for which it was available for use. For example, if an asset was
purchased on March 1, 2017 and the enterprise prepares financial statements for the year ending on March 31,
2017 depreciation will be provided for a period of 1 month only. Similar situation will arise in the year in which an
asset is retired from its intended used or is sold. However, under income tax rules depreciation is provided for
full year if the asset was used for more than 180 days in a particular financial year.

© The Institute of Chartered Accountants of India

5.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.2 Reducing or Diminishing Balance Method or Written Down Value (WDV) Method
Under this system, a fixed percentage of the diminishing value of the asset is written off each year so as to reduce
the asset to its residual value at the end of its life. Repairs and small renewals are charged to revenue. This
method is commonly used for plant, fixtures, etc. Under this method, the annual charge for depreciation
decreases from year to year, so that the earlier years suffer to the benefit of the later years. Also, under this
method, the value of asset can never be completely extinguished, which happens in the earlier explained Straight
Line Method. However, it is very simple to operate. This method is based on the assumption that cost of repairs
will increase as the asset get old, therefore, depreciation in earlier years should be high when the repair cost is
expected to be low and depreciation in later years should be low when the repair cost is expected to be high.
Therefore, this method will result in almost equal burden in all the years of use of the asset as depreciation will
reduce with increase in repair costs will increase with every passing year. On the other hand, under the Straight
Line Method, the charge for depreciation is constant, while repairs tend to increase with the life of the asset.
Among the disadvantages of this method is the danger that too low a percentage may be adopted as depreciation
with the result that over the life of the asset full depreciation may not be provided; also if assets are grouped in
such a way that individual assets are difficult to identify, the residue of an asset may lie in the asset account even
after the asset has been scrapped. The last mentioned difficulty could be, however, over come if a Plant register
is maintained.
The rate of depreciation under this method may be determined by the following formula:

Residual Value
1- n x 100
Cost of Assets
where, n = useful life
Similar to straight line method, in this method also period of use in a particular year e.g. year of purchase or sale
an item of property plant and equipment needs to be considered while computing the depreciation amount.
Accounting Entries under Straight Line and Reducing Balance Methods:
There are two alternative approaches for recording accounting entries for depreciation.
First Alternative
A provision for depreciation or Accumulated Depreciation account is opened to accumulate the balance of
depreciation and the assets are carried at historical cost. This method is preferred by most of the organizations
as it presents both the gross investment and the current value of the assets.
Accounting entry
Depreciation Account Dr.
To Provision for Depreciation Account
or Accumulated Depreciation
Profit and Loss Account Dr.
To Depreciation Account

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9 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.9

Second Alternative
Amount of Depreciation is credited to the Asset Account every year and the Asset Account is carried at historical
cost less depreciation.
Accounting entries:
Depreciation Account Dr.
To Asset Account
Profit and Loss Account Dr.
To Depreciation Account

ILLUSTRATION 1

Jain Bros. acquired a machine on 1st July, 2018 at a cost of ` 14,00,000 and spent ` 1,00,000 on its installation.
The firm writes off depreciation at 10% p.a. of the original cost every year. The books are closed on 31st December
every year.
Required
Show the Machinery Account and Depreciation Account for the year 2018 and 2019.

Machinery Account
` `
2018 2018
July 1 To Bank A/c 14,00,000 Dec. 31 By Depreciation A/c
July 1 To Bank A/c - 1,00,000 10% on ` 15,00,000 for 6 75,000
Installation months
Expenses
Dec. 31 By Balance c/d 14,25,000
15,00,000 15,00,000
2019 2019
Jan. 1 To Balance b/d 14,25,000 Dec. 31 By Depreciation A/c
10% on ` 15,00,000 1,50,000
Dec. 31 By Balance c/d 12,75,000
14,25,000 14,25,000

Depreciation Account
` `
2018 2018
Dec. 31 To Machinery A/c 75,000 Dec. 31 By Profit & Loss A/c 75,000
2019 2019
Dec. 31 To Machinery A/c 1,50,000 Dec. 31 By Profit & Loss A/c 1,50,000

© The Institute of Chartered Accountants of India

5.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 2

Jain Bros. acquired a machine on 1st July, 2018 at a cost of ` 14,00,000 and spent ` 1,00,000 on its installation.
The firm writes off depreciation at 10% p.a. every year. The books are closed on 31st December every year.
Required
Show the Machinery Account on diminishing balance method for the year 2018 and 2019.

SOLUTION

As per Reducing Balance Method

Machinery Account
Date Particulars ` Date Particulars `
2018 2018
July 1 To Bank A/c 14,00,000 Dec. 31 By Depreciation A/c 75,000
July 1 To Bank A/c - 1,00,000 (` 15,00,000 x 10% x 6/12) for
6 months
Dec. 31 By Balance c/d 14,25,000
15,00,000 15,00,000
2019 2019
Jan. 1 To Balance b/d 14,25,000 Dec. 31 By Depreciation A/c 1,42,500
(` 14,25,000 x 10%)
Dec. 31 By Balance c/d 12,82,500
14,25,000 14,25,000

3.3 Sum of Years of Digits Method

It is variation of the “Reducing Balance Method”. In this case, the annual depreciation is calculated by multiplying
the original cost of the asset less its estimated scrap value by the fraction represented by:

The number of years (including the present year) of remaining life of the asset

Total of all digits of the life of the asset (in years)

Suppose the estimated life of an asset is 10 years; the total of all the digits from 1 to 10 is 55 i.e.,10 + 9 + 8 + 7
+ 6 + 5 + 4 + 3 + 2 + 1, or by the formula:

n(n+1)= 10×11= 55
2 2
The depreciation to be written off in the first year will be 10/55 of the cost of the asset less estimated scrap value;
and the depreciation for the second year will be 9/55 of the cost of asset less estimated scrap value and so on.
The method is not yet in vogue; and its advantages are the same as those of the Reducing Balance Method.

© The Institute of Chartered Accountants of India

11 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.11

ILLUSTRATION 3

M/s Akash & Co. purchased a machine for ` 10,00,000. Estimated useful life and scrap value were 10 years and
` 1,20,000 respectively. The machine was put to use on 1.1.2014.
Required

Show Machinery Account and Depreciation Account in their books for 2019 by using sum of years digits method.

SOLUTION

In the books of M/s Raj & Co.

Machinery Account
` `
2019 2019
Jan. 1 To Balance b/d (w.n.2) 3,60,000 Dec. 31 By Depreciation A/c (w.n.3) 80,000
Dec. 31 By Balance c/d 2,80,000
3,60,000 3,60,000
2020
Jan.1 To Balance b/d 2,80,000

Depreciation Account
` `
2019 2019
Dec. 31 To Machinery A/c 80,000 Dec. 31 By Profit and Loss A/c 80,000
80,000 80,000
Working Notes:
(1) Total of sum of digit of depreciation for 2014-18
10 + 9 + 8 + 7 + 6
= (` 10,00,000 - ` 1,20,000) × 10 (10 + 1)
2
40
= ` 8,80,000 × = ` 6,40,000
55
(2) Written down value as on 1-1-2019
` 10,00,000 – ` 6,40,000 = ` 3,60,000
(3) Depreciation for 2019
5
(` 10,00,000 – ` 1,20,000) × = ` 80,000.
55

© The Institute of Chartered Accountants of India

5.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.4 Machine Hour Method

Where it is practicable to keep a record of the actual running hours of each machine, depreciation may be
calculated on the basis of hours that the concerned machine worked. The machine hour rate of the depreciation,
is calculated after estimating the total number of hours that machine would work during its whole life; however, it
may have to be varied from time to time, on a consideration of the changes in the economic and technological
conditions which might take place, to ensure that the amount provided for depreciation corresponds to that
considered appropriate in the changed circumstances. It would be observed that the method is only a slight
variation of the Straight Line Method under which depreciation is calculated per year. Under this method it is
calculated for each hour the machine works.
Schedule II to the Companies Act 2013, prescribes estimated useful life of different assets for companies, also
recognizes this method to some extent. It prescribes that depreciation should be charged using estimate useful
life suggested in it, however, in certain category of plant and machinery it prescribes to charge higher amount of
depreciation if these assets are used for 2 shifts or 3 shifts. In a way, schedule II combines straight line method
and machine hour method.

ILLUSTRATION 4

A machine was purchased for ` 30,00,000 having an estimated total working of 24,000 hours. The scrap value
is expected to be ` 2,00,000 and anticipated pattern of distribution of effective hours is as follows :
Year
1–3 3,000 hours per year
4-6 2,600 hours per year
7 - 10 1,800 hours per year
Required
Determine Annual Depreciation under Machine Hour Rate Method.

SOLUTION

Statement of Annual Depreciation under Machine Hours Rate Method

Year Annual Depreciation

3,000
1-3 × (` 30,00,000 - ` 2,00,000) = ` 3,50,000
24,000

2,600
4-6 × (` 30,00,000 - ` 2,00,000) = ` 3,03,333
24,000

1,800
7 - 10 × (` 30,00,000 - ` 2,00,000) = ` 2,10,000
24,000

© The Institute of Chartered Accountants of India

13 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.13

3.5 Production Units Method

Under this method depreciation of the asset is determined by comparing the annual production with the estimated
total production. The amount of depreciation is computed by the use of following method:
Production during the period
Depreciable Amount x
Estimated total production

The method is applicable to machines producing product of uniform specifications.

ILLUSTRATION 5

A machine is purchased for ` 20,00,000. Its estimated useful life is 10 years with a residual value of ` 2,00,000.
The machine is expected to produce 1.5 lakh units during its life time. Expected distribution pattern of
production is as follows:
Year Production
1-3 20,000 units per year
4-7 15,000 units per year
8-10 10,000 units per year
Required
Determine the value of depreciation for each year using production units method.

SOLUTION

Statement showing Depreciation under Production Units Method

Year Annual Depreciation

20,000
1-3 × (` 20,00,000 - ` 2,00,000) = ` 2,40,000
1,50,000
15,000
4-7 × (` 20,00,000 - ` 2,00,000 ) = ` 1,80,000
1,50,000
10,000
8-10 × (` 20,00,000 - ` 2,00,000) = ` 1,20,000
1,50,000

3.6 Depletion Method

Depletion is the allocation of the cost of wasting natural resources such as oil, gas, timber, and minerals to the
production process. This method is used in case of mines, quarries etc. containing only a certain quantity of
product. The depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of product
likely to be available to be extracted. Annual depreciation will be the quantity extracted multiplied by the rate per
unit.

© The Institute of Chartered Accountants of India

5.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 6

M/s Surya & Co. took lease of a quarry on 1-1-2017 for ` 1,00,00,000. As per technical estimate the total quantity
of mineral deposit is 2,00,000 tonnes. Depreciation was charged on the basis of depletion method. Extraction
pattern is given in the following table:
Year Quantity of Mineral extracted
2017 2,000 tonnes
2018 10,000 tonnes
2019 15,000 tonnes
Required
Show the Quarry Lease Account and Depreciation Account for each year from 2017 to 2019.

SOLUTION

Quarry Lease Account

` `
2017 2017
Jan. To Bank A/c 1,00,00,000 Dec. 31 By Depreciation A/c 1,00,000
[(2,000/2,00,000) × ` 1,00,00,000]
Dec. 31 By Balance c/d 99,00,000
1,00,00,000 1,00,00,000
2018 2018
Jan. 1 To Balance b/d 99,00,000 Dec. 31 By Depreciation A/c 5,00,000
Dec. 31 By Balance c/d 94,00,000
99,00,000 99,00,000
2019 2019
Jan. 1 To Balance b/d 94,00,000 Dec. 31 By Depreciation A/c 7,50,000
Dec. 31 By Balance c/d 86,50,000
94,00,000 94,00,000

Depreciation Account
` `
2017 2017
Dec. 31 To Quarry lease A/c 1,00,000 Dec. 31 By Profit & Loss A/c 1,00,000
1,00,000 1,00,000
2018 2018
Dec. 31 To Quarry lease A/c 5,00,000 Dec. 31 By Profit & Loss A/c 5,00,000

© The Institute of Chartered Accountants of India

15 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.15

2019 5,00,000 2019 5,00,000

Dec. 31 To Quarry lease A/c 7,50,000 Dec. 31 By Profit & Loss A/c 7,50,000
7,50,000 7,50,000

4. PROFIT OR LOSS ON THE SALE/DISPOSAL OF PROPERTY,

PLANT AND EQUIPMENT
Whenever any depreciable asset is sold during the year, depreciation is charged on it for the period it has been
used in the sale year. The written down value after charging such depreciation is used for calculating the profit
or loss on the sale of that asset. The resulting profit or loss on sale of the asset is ultimately transferred to profit
and loss account. Thus, all entries related to sale and profit or loss on sale of asset are posted in the respective
asset account. Alternatively, a new account titled Asset disposal Account may also be opened in the ledger for
the purpose of calculating profit or loss on sale of asset. In that case the book value of the asset will be transferred
from the asset account to the asset disposal account and all entries related to sale like sale proceeds and
calculation of profit or loss on sale will be posted in the Asset disposal account.
For example: The book value of the asset as on 1st January, 2019 is ` 50,00,000. Depreciation is charged on
the asset @10%. On 1st July 2019, the asset is sold for ` 32,00,000. In such a situation, profit or loss on the
sale will be calculated as follows:
`

Book value as on 1st Jan., 2019 50,00,000

Less: Depreciation for 6 months @10% (from 1st Jan., 2019 to 30th June, 2019) (2,50,000)
Written down value as on 1st July, 2019 47,50,000
Less: Sale proceeds as on 1st July, 2019 (32,00,000)
Loss on sale of the asset 15,50,000

ILLUSTRATION 7

A firm purchased on 1st January, 2018 certain machinery for ` 5,82,000 and spent ` 18,000 on its erection. On
July 1, 2018 another machinery for ` 2,00,000 was acquired. On 1st July, 2019 the machinery purchased on
1st January, 2018 having become obsolete was auctioned for ` 3,86,000 and on the same date fresh machinery
was purchased at a cost of ` 4,00,000.
Depreciation was provided for annually on 31st December at the rate of 10 per cent p.a. on written down value.
Required
Prepare machinery account.

© The Institute of Chartered Accountants of India

5.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

Machinery Account
` `
2018 2018
Jan. 1 To Bank A/c 5,82,000 Dec. 31 By Depreciation A/c 70,000
Jan. 1 To Bank A/c –
erection charges 18,000 By Balance c/d 7,30,000
July 1 To Bank A/c 2,00,000
8,00,000 8,00,000
2019 2019
Jan. 1 To Balance b/d 7,30,000 July 1 By Depreciation on
sold machine 27,000
July 1 To Bank A/c 4,00,000 By Bank A/c 3,86,000
By Profit and Loss A/c 1,27,000
Dec. 31 By Depreciation A/c 39,000
By Balance c/d 5,51,000
11,30,000 11,30,000

Working Note:
Book Value of Machines
Machine Machine Machine
I II III
` ` `
Cost 6,00,000 2,00,000 4,00,000
Depreciation for 2018 (60,000) (10,000)
Written down value 5,40,000 1,90,000
Depreciation for 2019 (27,000) (19,000) (20,000)
Written down value 5,13,000 1,71,000 3,80,000
Sale Proceeds (3,86,000)
Loss on Sale 1,27,000

ILLUSTRATION 8

On April 1, 2018 Shubra Ltd. purchased a machinery for ` 12,00,000. On Oct 1, 2020, a part of the machinery
purchased on April 1, 2018 for ` 80,000 was sold for ` 45,000 and a new machinery at a cost of ` 1,58,000 was
purchased and installed on the same date. The company has adopted the method of providing 10% p.a.
depreciation on the written down value of the machinery.

© The Institute of Chartered Accountants of India

17 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.17

Required : Show the necessary ledger accounts for the years ended 31st March 2019 to 2021 assuming that (a)
‘Provision for Depreciation Account’ is not maintained (b) Provision for Depreciation Account is maintained.

SOLUTION

(a) When ‘Provision for Depreciation Account’ is not maintained.

Dr. Machinery Account Cr.
Date Particulars ` Date Particulars `
01.04.2018 To Bank A/c 12,00,000 31.03.2019 By Depreciation A/c 1,20,000
By Balance c/d 10,80,000
12,00,000 12,00,000
01.04.2019 10,80,000 31.03.2020 By Depreciation A/c 1,08,000
By Balance c/d 9,72,000
10,80,000 10,80,000
01.04.2020 To Balance b/d 9,72,000 01.10.2020 By bank A/c 45,000
01.10.2020 To Bank A/c 1,58,000 By Profit & Loss A/c 16,560
By Depreciation A/c 3,240
31.3.2020 By Depreciation A/c 98,620
(7,900+ 90,720)
By Balance c/d 9,66,580
(8,16,480 + 1,50,100)
11,30,000 11,30,000
(b) When ‘Provision for Depreciation Account’ is maintained
Dr. Machinery Account (at original cost) Cr.
Date Particulars ` Date Particulars `
01.04.2018 To Bank A/c 12,00,000 31.03.2019 By Balance c/d 12,00,000
01.04.2019 To Balance b/d 12,00,000 31.03.2020 By Balance c/d 12,00,000
01.04.2020 To Balance b/d 12,00,000 01.10.2020 By Machinery 80,000
Disposal A/c
01.10.2020 To Bank A/c 1,58,000 31.03.2021 By Balance c/d 12,78,000
13,58,000 13,58,000
Dr. Provision for Depreciation Account Cr.
Date Particulars ` Date Particulars `
31.03.2019 To Balance c/d 1,20,000 31.03.2019 By Depreciation A/c 1,20,000
31.03.2020 To Balance c/d 2,28,000 1.04.2019 By Balance b/d 1,20,000
31.03.2020 By Depreciation A/c 1,08,000
2,28,000 2,28,000
01.10.2020 To Machinery Disposal 18,440 01.04.2020 By Balance b/d 2,28,000
A/c

© The Institute of Chartered Accountants of India

5.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

31.03.2021 To Balance c/d 3,11,420 01.10.2020 By Depreciation A/c 3,240

31.03.2021 By Depreciation A/c 98,620
3,29,860 3,29,860
Dr. Machinery Disposal Account Cr.
Date Particulars ` Date Particulars `
01.10.2020 To Machinery Disposal 80,000 01.10.2020 By Provision for 18,440
A/c Depreciation A/c
By Bank A/c 45,000
By Profit and Loss A/c 16,560
80,000 80,000
Working Notes:
1. Calculation of Profit/Loss on Sale of Machinery
Particulars `
A. Original Cost 80,000
B. Less : Depreciation @ 10% WDV p.a. for 2 ½ years 18,440
C. Book Value as on date of Sale (A – B) 61,560
D. Less : Sale proceeds 45,000
E. Loss on Sale (C – D) 16,560
2. Calculation of Depreciation for Current Year on Machines (other than sold)
Particulars `
A. On Old Machines of ` 9,07,200 for 1 year (10% WDV) 90,720
B. On New Machine of ` 1,58,000 for ½ year 7,900
98,620

ILLUSTRATION 9

A firm purchased second hand machinery on 1st January, 2018 for ` 3,00,000, subsequent to which ` 60,000
and ` 40,000 were spent on its repairs and installation, respectively. On 1 st July, 2019 another machinery was
purchased for ` 2,60,000. On 1st July, 2020, the first machinery having become outdated was auctioned for
` 3,20,000 and on the same date, another machinery was purchased for ` 2,50,000.
On 1st July, 2021, the second machinery was also sold off and it fetched ` 2,30,000.
Depreciation was provided on machinery @ 10% on the original cost annually on 31 st December, under the
straight line method.
Required
Prepare the following accounts in the books of the company: (i) Machinery Account for the years ending
Dec. 31 2018 to 2021 and (ii) Machinery Disposal Account.

© The Institute of Chartered Accountants of India

19 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.19

SOLUTION

Dr. Machinery Account Cr.

Date Particulars ` Date Particulars `
01.01.2018 To Bank A/c (A) – Cost 3,00,000 31.12.2018 By Depreciation (A) 40,000
- Repairs 60,000 By Balance c/d (A) 3,60,000
- Installation 40,000
4,00,000 4,00,000
01.01.2019 To Balance b/d 3,60,000 31.12.2019 By Depreciation
(A) 40,000
(B) 13,000 53,000
01.07.2019 To Bank A/c (B) 2,60,000 By Balance b/d
(A) 3,20,000
(B) 2,47,000 5,67,000
6,20,000 6,20,000
01.01.2020 To Balance b/d 5,67,000 01.07.2020 By Machinery Disposal 3,00,000
A/c (A)
01.07.2020 To Bank A/c (C) 2,50,000 By Depreciation A/c
(A) 20,000
(B) 26,000
(C) 12,500 58,500
By Balance c/d
(B) 2,21,000
(C) 2,37,500 4,58,500
8,17,000 8,17,000
01.01.2021 To Balance b/d 4,58,500 01.07.2021 By Machinery Disposal 2,08,000
A/c (B)
By Depreciation A/c
(B) 13,000
(C) 25,000 38,000
By Balance c/d 2,12,500
4,58,500 4,58,500
Machinery Disposal Account
Date Particulars ` Date Particulars `
01.07.2020 To Machinery A/c (A) 3,00,000 01.07.2020 By Bank A/c 3,20,000
To Profit Loss A/c (Profit) 20,000
3,20,000 3,20,000
01.07.2021 To Machinery A/c (B) 2,08,000 01.07.2021 By Bank A/c 2,30,000
To P & L A/c (Profit) 22,000
2,30,000 2,30,000

© The Institute of Chartered Accountants of India

5.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. CHANGE IN THE METHOD OF DEPRECIATION

The depreciation method applied to an asset should be reviewed at least at each financial year-end and, if there
has been a significant change in the expected pattern of consumption of the future economic benefits embodied
in the asset, the method should be changed to reflect the changed pattern. Whenever any change in depreciation
method is made, such change in method is treated as change in accounting estimate as per Accounting
Standards. Its effect needs to be quantified and disclosed separately. A change in an accounting estimate may
affect the current period only or both the current period and future periods.
Example:
Cost of Machine ` 10,50,000
Residual Value ` 50,000
Useful life 10 years.
The company charges depreciation on straight line method for the first two years and thereafter decides to adopt
written down value method by charging depreciation @ 25%. (calculated based on useful life). You are required
to calculate depreciation for the 3rd year.
Depreciation already charged for the first 2 years as per straight line method is ` 2,00,000. Therefore, WDV for
2nd year is ` 8,50,000
Therefore, in the profit and loss account of the 3rd year, the depreciation of ` 2,12,500 (25% of ` 850,000) should
be debited. In case the entity would have continued with Straight Line Method, depreciation for 3rd year would
have been ` 1,00,000.

ILLUSTRATION 10

M/s Anshul & Co. commenced business on 1st January 2015, when they purchased plant and equipment for
` 7,00,000. They adopted a policy of charging depreciation at 15% per annum on diminishing balance basis and
over the years, their purchases of plant have been:
Date Amount `
1-1-2016 1,50,000
1-1-2019 2,00,000

On 1-1-2019 it was decided to change the method and rate of depreciation to straight line basis. On this date
remaining useful life was assessed as 6 years for all the assets purchased before 1.1.2019 with no scrap value
and 10 years for the asset purchased on 1.1.2019.
Required
Calculate the difference in depreciation to be adjusted in the Plant and Equipment Account for the year ending
31st December, 2019.

© The Institute of Chartered Accountants of India

21 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.21

SOLUTION

Depreciation on written down value basis

Purchased on Purchased on Total
Jan. 1, 2015 Jan. 1, 2016 Depreciation
` ` `
2015 Cost 7,00,000
Depreciation (1,05,000) 1,05,000
Written Down Value (WDV) 5,95,000
2016 Cost - 1,50,000
Depreciation (89,250) (22,500) 1,11,750
W.D.V. 5,05,750 1,27,500
2017
Depreciation (75,863) (19,125) 94,988
W.D.V. 4,29,887 1,08,375
2018
Depreciation (64,483) (16,256) 80,739
W.D.V. 3,65,404 92,119
2019
Depreciation (60,900) (15,353) 76,253
3,04,504 76,766
Plant and Equipment Account
` `
2019 2019
Jan. 1 To Balance b/d 4,57,523 Dec. 31 By Depreciation 96,253
(60,900+15,353+20,000)
By Balance c/d 5,61,270
To Bank 2,00,000
6,57,523 6,57,523
2020
Jan. 1 To Balance b/d 5,61,270

6. REVISION OF THE ESTIMATED USEFUL LIFE OF PROPERTY,

PLANT AND EQUIPMENT
The residual value and the useful life of an asset should be reviewed at least at each financial year-end and, if
expectations differ from previous estimates, the change(s) should be accounted for as a change in an accounting
estimate in accordance with Accounting Standards.
Whenever there is a revision in the estimated useful life of the asset, the written down value or the balance
depreciable amount should be charged over the revised remaining estimated useful life of the asset.

© The Institute of Chartered Accountants of India

5.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 11

A Machine costing ` 6,00,000 is depreciated on straight line basis, assuming 10 years working life and Nil residual
value, for three years. The estimate of remaining useful life after third year was reassessed at 5 years.
Required
Calculate depreciation for the fourth year.

SOLUTION

Depreciation per year = ` 6,00,000 / 10 = ` 60,000

Depreciation on SLM charged for three years = ` 60,000 x 3 years = ` 1,80,000
Book value of the computer at the end of third year = ` 6,00,000 – ` 1,80,000 = ` 4,20,000.
Remaining useful life as per previous estimate = 7 years
Remaining useful life as per revised estimate = 5 years
Depreciation from the fourth year onwards = ` 4,20,000 / 5 = ` 84,000 per annum

7. REVALUATION OF PROPERTY, PLANT AND EQUIPMENT

After recognizing an asset initially, the asset whose fair value could be reliably measured should be carried at
the revalued amount, being the fair value at revaluation date and reduced by successively accumulated
depreciation and successive accumulated impairment losses (permanent decline in value) (if any).
(a) Revaluations must be made at adequate intervals (say yearly) for ensuring that carrying amount doesn’t
differ substantially from that which would be determined if fair value at end of the reporting period is
used
(b) In case an item of PPE is revalued, whole class of such PPE to which such asset belongs should be
revalued
(c) In case the carrying amount of an asset increases due to revaluation, such increase should be credited
to revaluation surplus and should be accumulated in equity. However, such increase should be
recognized in Profit and Loss statement to the extent of reversal of a previous decrease of that asset
that was recognized in the Profit and Loss account.
(d) In case the carrying amount of an asset is decreased due to revaluation, such decrease should be
recognized in the Profit and Loss account. However, such decrease should be debited to the revaluation
surplus to the extent of reversal of a previous increase that was recognized in revaluation surplus for that
asset.

© The Institute of Chartered Accountants of India

23 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.23

Revaluation

Increase Decrease

Credited directly
Exceptions : Exception: When
to owners'
When it is Charged to the it is subsequent
interests under
subsequent Stetement of Decrease
the heading of
increase (Initially profit and loss (Initially
Revaluation
Decrease) Increase)
suplus

recognised in the Statement of Profit and Decrease should be debited directlly to

loss to the fextent that it reverses a owners' interests under the heading of
revaluation decrease of the same asset Revaluation surplus to the extent of any
previously recognised in the Statement of credit balance existing in the Revaluation
profit and loss surplus in respect of that asset

ILLUSTRATION 12

A machine of cost ` 12,00,000 is depreciated straight-line assuming 10 year working life and zero residual value
for three years. At the end of third year, the machine was revalued upwards by ` 60,000 the remaining useful life
was reassessed at 9 years.
Required
Calculate depreciation for the fourth year.

SOLUTION

Depreciation per year charged for three years = ` 12,00,000 / 10 = ` 1,20,000

WDV of the machine at the end of third year = ` 12,00,000 – ` 1,20,000 × 3 = ` 8,40,000.
Depreciable amount after revaluation = ` 8,40,000 + ` 60,000 = ` 9,00,000
Remaining useful life as per previous estimate = 7 years
Remaining useful life as per revised estimate = 9 years
Depreciation for the fourth year onwards = ` 9,00,000 / 9 = `1,00,000.

SUMMARY
 Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
 Objectives for providing depreciation are:
 Correct income measurement by matching the charge for the year
 True financial position statement by showing PP&E at their current value
 Funds for replacement

© The Institute of Chartered Accountants of India

5.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

 Ascertainment of true cost of production.

 Factors in the measurement of depreciation:
 Cost of asset
 Estimated useful life of the asset
 Estimated scrap value (if any) at the end of useful life of the asset.
 Methods for providing depreciation:
 Straight line method
 Reducing balance method
 Sum of years of digits method
 Machine hour method
 Production units’ method
 Depletion method
 The resulting profit or loss on sale of the tangible asset is ultimately transferred to profit and loss account.
 The depreciation method residual value & useful life applied to an asset should be reviewed at least at
each financial year-end and, if there has been a significant change in the expected pattern of
consumption of the future economic benefits embodied in the asset, on account of the above, they should
be changed to reflect the changed pattern.
 Whenever there is a revision in the estimated useful life of the asset, the balance depreciable amount
should be charged to the asset over the revised remaining estimated useful life of the asset.
 Whenever the depreciable asset is revalued, the depreciation should be charged on the revalued amount
on the basis of the remaining estimated useful life of the asset.

TEST YOUR KNOWLEDGE

True and False
1. Increase in market value of a fixed asset is one of the reasons for depreciation being charged.
2. Depreciation of an asset begins when it is available for use in the location & condition necessary for it
to be capable of being operated.
3. Cost of property, plant and equipment includes purchase price, refundable taxes & import duties after
deducting any discount or rebate.
4. Cost of fixed asset should also include cost of opening a new facility such as inauguration costs.
5. Depreciation is charged with a constant amount under straight line method and charged with a constant
percentage under diminishing balance method.
6. In case an item of Property, Plant & Equipment is revalued, whole class of assets to which that asset
being revalued belongs should be revalued.
7. In case the carrying amount of an asset is decreased due to revaluation, such decrease should always
be recognized in the Profit and Loss account.

© The Institute of Chartered Accountants of India

25 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.25

8. Akash purchased a machine for ` 12,00,000. Estimated useful life is 10 years and scrap value is
` 1,00,000. Depreciation for the first year using sum of the years digit method shall be ` 2,00,000.
9. Depletion is the allocation of the cost of intangible assets such as patents and copyrights.
10. Providing for depreciation also helps in providing for accumulation of funds to facilitate the replacement
at the end of its useful life.
11. If the equipment account has a balance of ` 12,50,000 and the accumulated depreciation account has
a balance of ` 4,00,000, the written down value of same shall be ` 16,50,000.
12. Sum of the years digit method is an example of accelerated method of charging depreciation.
13. Over the life of an asset subject to depreciation, the accelerated method will result in less Depreciation
Expense in early years and more depreciation in later years of its life.
14. While depreciating land cost, Straight line method shall give more depreciation than the written down
value.
15. Provision for depreciation account is debited at the time of recording the depreciation on an asset.
16. If adequate maintenance expenditure is incurred with relation to running repairs of an asset, we need
not charge any depreciation.
17. When a property, plant or equipment is sold then provision for depreciation account is debited, asset
account is credited and any gain or loss is recorded to profit and loss account.
18. While calculating the depreciation as per diminishing balance method, the salvage value of the asset at
the end of its life is reduced from its cost.
19. Any change in the estimated useful life of an asset should be accounted for as a change in an accounting
estimate in accordance with Accounting Standards.
20. Whenever any depreciable asset is sold during the year, depreciation is charged on it for that entire
year.

Multiple Choice Questions

1. Original cost = ` 12,60,000; Salvage value = Nil; Useful life = 6 years. Depreciation for the first year
under sum of years digits method will be
(a) ` 3,60,000 (b) ` 1,20,000 (c) ` 1,80,000
2. Obsolescence of a depreciable asset may be caused by:
I. Technological changes.
II. Improvement in production method.
III. Change in market demand for the product or service output.
IV. Legal or other restrictions.
(a) Only (I) above
(b) Both (I) and (II) above

© The Institute of Chartered Accountants of India

5.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

(c) All (I), (II), (III) and (IV) above

3. The number of production of similar units expected to be obtained from the use of an asset by an
enterprise is called as
(a) Unit life (b) Useful life (c) Production life
4. If a concern proposes to discontinue its business from March 2015 and decides to dispose of all its
plants within a period of 4 months, the Balance Sheet as on March 31, 2015 should indicate the plants
at their
(a) Historical cost (b) Net realizable value (c) Cost less depreciation
5. In the case of downward revaluation of a plant which is for the first time revalued, the account to be
debited is
(a) Plant account (b) Revaluation Reserve (c) Profit & Loss account
6. The portion of the acquisition cost of the tangible asset, yet to be allocated is known as
(a) Written down value (b) Accumulated value (c) Realisable value
7. The main objective of providing depreciation is to
(a) Create secret reserve (b) Reduce the book value of assets
(c) Allocate cost of the assets
8. Original cost of a machine was ` 25,20,000 salvage value was ` 1,20,000, useful life was 6 years.
Annual depreciation under Straight Line Method
(a) ` 4,20,000 (b) ` 4,00,000 (c) ` 3,00,000
9. The cost of a machine is ` 20,00,000. Two years later the book value is ` 10,00,000. The Straight-line
percentage depreciation is
(a) 50% (b) 33-1/3% (c) 25%
10. A machinery with original cost of ` 10,00,000 and Nil Salvage value acquired on 1st April 2017 with 4
years useful life was depreciated using Straight Line Method. It was decided to sell the machinery on
1st October 2020 for ` 1,20,000. What shall be the gain or (loss) on the sale of Machinery ?
(a) Loss of ` 1,30,000 (b) Gain of ` 1,20,000 (c) Gain of ` 5,000
(d) Loss of ` 5,000
11. Which of the following assets does not depreciate?
(a) Machinery and equipment (b) Patents (c) Land
12. A company purchased a machinery on April 01, 2014, for ` 15,00,000. It is estimated that the machinery
will have a useful life of 5 years after which it will have no salvage value. The depreciation charged
during the year 2018-19 was
(a) ` 5,00,000 (b) ` 4,00,000 (c) ` 3,00,000

© The Institute of Chartered Accountants of India

27 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.27

13. If the equipment account has a balance of ` 22,50,000 and the accumulated depreciation account has
a balance of ` 14,00,000, the book value of the equipment is
(a) ` 36,50,000 (b) ` 8,50,000 (c) ` 14,00,000
14. A plant with original cost of ` 50,00,000 was revalued after 2 years resulting in credit to Revaluation
Surplus account of ` 4,00,000. Towards the year end of 2019-20, due to COVID-19 the plan value had
gone down by ` 5,00,000 and accordingly management decided to revalue the same. What shall be the
impact of this downwards revaluation on the Profit & Loss Account ?
(a) Debit of ` 5,00,000 (b) Debit of ` 1,00,000 (c) Credit of ` 5,00,000
(d) Credit of ` 1,00,000

Theory Questions
1. Distinguish between Straight line method of depreciation and Written down value method of depreciation.
2. Write short note on Depletion method of depreciation.
3. What factors are considered for calculation of depreciation of a plant?

Practical Questions
1. A firm’s plant and machinery account at 31st December, 2018 and the corresponding depreciation
provision account, broken down by year of purchase are as follows:
Year of Purchase Plant and Machinery at cost Depreciation Provision
` `
2002 2,00,000 2,00,000
2008 3,00,000 3,00,000
2009 10,00,000 9,50,000
2010 7,00,000 5,95,000
2017 5,00,000 75,000
2018 3,00,000 15,000
30,00,000 21,35,000

Depreciation is at the rate of 10% per annum on cost. It is the Company’s policy to assume that all
purchases, sales or disposal of plant occurred on 30th June in the relevant year for the purpose of
calculating depreciation, irrespective of the precise date on which these events occurred.
During 2019 the following transactions took place:
1. Purchase of plant and machinery amounted to ` 15,00,000
2. Plant that had been bought in 2008 for ` 170,000 was scrapped.
3. Plant that had been bought in 2009 for ` 90,000 was sold for ` 5,000.
4. Plant that had been bought in 2010 for ` 2,40,000 was sold for ` 15,000.

© The Institute of Chartered Accountants of India

5.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

You are required to:

Calculate the provision for depreciation of plant and machinery for the year ended 31st December, 2019.
In calculating this provision you should bear in mind that it is the company’s policy to show any profit or
loss on the sale or disposal of plant as a completely separate item in the Profit and Loss Account. You
are also required to prepare the following ledger accounts during 2019.
(i) Plant and machinery at cost;
(ii) Depreciation provision;
(iii) Sales or disposal of plant and machinery.
2. The Machinery Account of a Factory showed a balance of ` 19,00,000 on 1st January, 2019. Its accounts
were made up on 31st December each year and depreciation is written off at 10% p.a. under the
Diminishing Balance Method.
On 1st June 2019, a new machinery was acquired at a cost of ` 2,80,000 and installation charges
incurred in erecting the machine works out to ` 8,920 on the same date. On 1st June, 2019 a machine
which had cost ` 4,37,400 on 1st January 2017 was sold for ` 75,000. Another machine which had cost
` 4,37,000 on 1st January, 2018 was scrapped on the same date and it realised nothing.
Write a plant and machinery account for the year 2019, allowing the same rate of depreciation as in the
past calculating depreciation to the nearest multiple of a Rupee.
3. The LG Transport company purchased 10 trucks at ` 45,00,000 each on 1st April 2016. On October
1st, 2018, one of the trucks is involved in an accident and is completely destroyed and ` 27,00,000 is
received from the insurance in full settlement. On the same date another truck is purchased by the
company for the sum of ` 50,00,000. The company write off 20% on the original cost per annum. The
company observe the calendar year as its financial year.
Give the motor truck account for two year ending 31 Dec, 2019.
4. A Machinery costing ` 20,00,000 is depreciated on straight line assuming 10 years working life and nil
salvage value for four years. At the end of the fourth year, the machinery was revalued upwards by
` 80,000. The remaining useful life of the machinery was also reassessed as 8 years at the end of the
fourth year. Calculate the depreciation for 5th Year.
5. Amazing group had Property, Plant & Equipment (PP&E) with a book value of ` 35,00,000 on 31st
December 2019. The balance in Revaluation Surplus on that date was ` 3,00,000. As part of their
practice of revaluing the assets on yearly basis, another revaluation was carried out on 31st December
2019. Evaluate the impact of Revaluation if the Fair Value as a result of Revaluation done on 31st
December 2019 was (a) ` 37,00,000 (b) ` 33,00,000 and (c) ` 31,00,000. Also, give the journal entries.
6. On April 1, 2018 a firm purchased a machinery for ` 2,00,000. On 1st October in the same accounting
year, additional machinery costing ` 1,00,000 was purchased. On 1st October, 2019, the machinery
purchased on 1st April 2018, having become obsolete was sold off for ` 90,000. On October 1, 2020,
new machinery was purchased for ` 2,50,000 while the machinery purchased on 1st October 2018 was
sold for ` 85,000 on the same day. The firm provides depreciation on its machinery @ 10% per annum
on original cost on 31st March every year. Show Machinery Account, Provision for Depreciation Account
and Depreciation Account for the period of three accounting years ending March 31, 2021.

© The Institute of Chartered Accountants of India

29 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.29

ANSWERS/HINTS
True and False
1. False : It is the decrease in market value as one of the reasons for depreciation. Increase in market
value may result in Revaluation.
2. True : It is not necessary that the asset must be used to be depreciated, thus depreciation may start
once it is brought in the location & condition required to be used.
3. False : Non refundable taxes & duties form part of the cost.
4. False : Inauguration costs shouldn’t be part of cost.
5. True : SLM method results in same amount and diminishing method involves same rate of depreciation.
6. True : Revaluation should be done for the whole class of the asset.
7. False : Any decrease in value of asset on account of revaluation should be first debited to Revaluation
Reserve, if any, and then to Profit & Loss account.
8. True : Sum of years digit method depreciation is calculated as 10/55 x (12,00,000 – 1,00,000) = 2,00,000
9. False : Depletion relates to allocation of cost of natural resources
10. True : Depreciation being non cash expense reduces the distributable profits and hence facilitates
replacement of asset when required.
11. False : WDV = ` 12,50,000 - ` 4,00,000 = ` 8,50,000
12. True : Higher depreciation is charged in earlier years under sum of the years digit method.
13. False : It is vice versa as under diminishing balance method; higher depreciation is charged in beginning.
14. False : Land is not depreciated.
15. False : Provision for Depreciation account is credited while charging the depreciation.
16. False : Depreciation is allocation of the cost of an asset over its useful life. Regular repairs may be
required during its life are expensed and depreciation has to be charged anyways.
17. True : At the time of sale of an asset, respective asset account is credited with provision for depreciation
account being debited and any resulting gain or loss being charged to profit & loss account.
18. False: Under diminishing balance method, salvage value is not considered initially as it assumes that at
the end of the asset’s life the remaining value shall be its salvage value.
19. True : Any change in useful life of an asset is accounted for as a change in estimate.
20. False : Whenever any depreciable asset is sold during the year, depreciation is charged on it for the
period it has been used in the sale year.

© The Institute of Chartered Accountants of India

5.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

Multiple Choice Questions

1. (a) 2. (c) 3. (b) 4. (b) 5. (c) 6. (a)
7. (c) 8. (b) 9. (c) 10. (d) 11. (c) 12. (c)
13. (b) 14. (b)

Theoretical Questions
1. Under straight line method an equal amount is written off each year throughout the working life of the
depreciable tangible asset so as to reduce the cost of the asset to nil or to its scarp value at the end.
Under reducing balance method, a fixed percentage is charged on the diminishing balance of the asset
each year so as to reduce the value of the asset to its scarp value at the end of useful life. The basic
distinction between these two methods are as follows:
Under straight line method, annual depreciation charge is equal throughout the life of the asset; but
under reducing balance method, depreciation charge is reduced over the years as the asset grows old.
Under straight-line method, the asset can be fully depreciated but under reducing balance method asset
can never be fully depreciated.
Under straight line method the charge for depreciation is constant while repair charges increase with the
life of the asset, so the total charge throughout the life of the asset will not be uniform. To the contrary,
under reducing balance method, depreciation charges become high in the initial years but generally
repair remains low. As the asset grows old depreciation charge reduces but repair expenses increase.
Thus under reducing balance method depreciation and repairs are more or less evenly distributed
throughout the life of the asset.
2. Natural resources include physical assets like mineral deposits, oil and gas resources and timber. These
natural resources exhaust by exploitation.
Depletion per unit is calculated as
Acquisition cost-Residual Value
Estimate life in terms of production units
3. The factors considered for calculation of depreciation are as: (i)Cost of asset including expenses for
installation, commissioning, trial run etc. (ii) Estimated useful life of the asset and (iii) Estimated scrap
value (if any) at the end of useful life of the asset.

Practical Questions
Answer 1
Calculation of provision for depreciation of plant and machinery for the year ended 31st December, 2019.
Plant purchased in: ` `
2002 nil
2008 nil
2009 50,000

© The Institute of Chartered Accountants of India

31 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.31

2010 1/2 year at 10% on ` 2,40,000 12,000

1 year at 10% on ` 4,60,000 46,000 58,000
2017 10% on ` 5,00,000 50,000
2018 10% on ` 3,00,000 30,000
2019 1/2 year at 10% on ` 15,00,000 75,000
2,63,000

Plant and Machinery Account (for 2019) at Cost

` `
To Balance b/d 30,00,000 By Disposals account:
To Bank A/c 15,00,000 Scrapped 1,70,000
Sold 3,30,000
By Balance c/d 40,00,000
45,00,000 45,00,000

Depreciation Provision Account (for 2019)

` `
To Disposal Account : By Balance b/d 21,35,000
Scrapped - 2008 assets 1,70,000 By Profit and Loss Account 2,63,000
Sold - 2009 assets 90,000
Sold - 2010 assets 2,16,000 4,76,000
To Balance c/d 19,22,000
23,98,000 23,98,000

Sale or disposal of Plant and Machinery Account (for 2019)

` `
To Plant and Machinery : By Provision for Depreciation 4,76,000
Scrapped 1,70,000 By Cash-Sales Proceeds 20,000
Sold 3,30,000 By Loss on sales 4,000
5,00,000 5,00,000
Answer 2
Plant and Machinery Account
` `
2019 2019
Jan. 1 To Balance b/d 19,00,000 June 1 By Bank (Sales) 75,000

© The Institute of Chartered Accountants of India

5.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

June. 1 To Bank (2,80,000 + 8,920) 2,88,920 By Depreciation 14,762

(on sold machine)
By Loss on sale 2,64,532
By Loss on scrapping 3,76,912
the machine
By Depreciation (on 16,388
scrapped machinery)
By Depreciation (Note iii) 1,32,094
By Balance c/d 13,09,232
21,88,920 21,88,920

Working Note :
(i) Calculation of loss on sale of machine on 1-6-2019
`
Cost on 1-1-2017 4,37,400
Less : Depreciation @ 10% on ` 4,37,400 (43,740)
W.D.V. on 31-12-2017 3,93,660
Less : Depreciation @ 10% on ` 3,93,660 (39,366)
W.D.V. on 31-12-2018 3,54,294
Less : Depreciation @ 10% on ` 3,54,294 for 5 months (14,762)
3,39,532
Less : Sale proceeds on 1-6-2019 (75,000)
Loss 2,64,532
(ii) Calculation of loss on scrapped machine
`
Cost on 1-1-2018 4,37,000
Less : Depreciation @ 10% on ` 4,37,000 (43,700)
W.D.V. on 1-1-2019 3,93,300
Less : Depreciation @ 10% on ` 3,93,300 for 5 months (16,388)
Loss 3,76,912
(iii) Depreciation
Balance of machinery account on 1-1-2019 19,00,000
Less : W.D.V of machinery sold 3,54,294
W.D.V. of machinery scrapped 3,93,300 (7,47,594)
W.D.V. of other machinery on 1-1-2019 11,52,406
Depreciation @ 10% on ` 11,52,406 for 12 months 1,15,240
Depreciation @ 10% on ` 2,88,920 for 7 months 16,854
1,32,094

© The Institute of Chartered Accountants of India

33 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.33

Answer 3
Date Particulars Amount Date Particulars Amount
2018 2018
Jan-01 To balance b/d 2,92,50,000 Oct-01 By bank A/c 27,00,000
To Profit & Loss A/c
Oct-01 (Profit on settlement of 4,50,000 Oct-01 By Depreciation on lost 6,75,000
Truck) assets
Oct-01 To Bank A/c 50,00,000 Oct-01 By Depreciation A/c 83,50,000
Dec-31 By balance c/d 2,29,75,000
3,47,00,000 3,47,00,000
2019 2019
Jan-01 To balance b/d 2,29,75,000 Dec-31 By Depreciation A/c 91,00,000
Dec-31 By balance c/d 1,38,75,000

2,29,75,000 2,29,75,000
Working Note:
1. Profit on settlement of truck
`
Original cost as on 1.4.2016 45,00,000
Less: Depreciation for 2016 (6,75,000)
38,25,000
Less: Depreciation for 2017 (9,00,000)
29,25,000
Less: Depreciation for 2018 (9 months) (6,75,000)
22,50,000
Less: Amount received from Insurance company (27,00,000)
4,50,000
Answer 4
Depreciation per year for first 4 years = ` 20,00,000 / 10 = ` 2,00,000
Thus, WDV of the Machinery at end of the 4th year = ` 20,00,000 – (` 2,00,000 x 4) = ` 12,00,000
Revalued Amount i.e. New Depreciable Amount shall be = ` 12,00,000 + ` 80,000 = ` 12,80,000
Original remining useful life is (10-4) = 6 Years whereas it is reassessed as 8 Years.
Hence, depreciation for 5th Year = ` 12,80,000 / 8 = ` 1,60,000
Answer 5
(a) Fair Value : ` 37,00,000
Since this is an upward revaluation and the group had a balance in revaluation surplus (i.e. there was
an upward movement earlier), hence this will result in an additional credit of ` 2,00,000 to Revaluation

© The Institute of Chartered Accountants of India

5.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

Surplus and hence the total Revaluation Surplus balance (part of other comprehensive income in Equity)
shall increase to ` 5,00,000. The Accounting journal entry shall be:
Property, Plant & Equipment A/c Dr 2,00,000
To Revaluation Surplus A/c 2,00,000
(b) Fair Value : ` 33,00,000
Since this is a downward revaluation and the group had a balance in revaluation surplus (i.e. there was
an upward movement earlier), hence this will result in a reduction or a debit to Revaluation Surplus to
the extent of balance therein and any excess shall be debited to Profit & Loss A/c. In this case, there is
a reduction in fair value of ` 2,00,000 (35,00,000 – 33,00,000) and hence the entire amount shall be
debited to Revaluation Surplus. Hence, the total Revaluation Surplus balance (part of other
comprehensive income in Equity) shall decrease to ` 1,00,000. The Accounting journal entry shall be:
Revaluation Surplus A/c Dr 2,00,000
To Property, Plant & Equipment A/c 2,00,000
(c) Fair Value : ` 31,00,000
Since this is also a downward revaluation and the group had a balance in revaluation surplus (i.e. there
was an upward movement earlier), hence this will result in a reduction or a debit to Revaluation Surplus
to the extent of balance therein and any excess shall be debited to Profit & Loss A/c. In this case, there
is a reduction in fair value of ` 4,00,000 (35,00,000 – 31,00,000) and hence the Revaluation Surplus A/c
shall be debited by ` 3,00,000 and the balance ` 1,00,000 shall be debited to Profit & Loss A/c. Hence,
the total Revaluation Surplus balance (part of other comprehensive income in Equity) shall become Nil.
The Accounting journal entry shall be:
Revaluation Surplus A/c Dr 3,00,000
Profit & Loss A/c Dr 1,00,000
To Property, Plant & Equipment A/c 4,00,000
Answer 6
Dr. Machinery Account Cr.
Date Particulars ` Date Particulars `
01.04.2018 To Bank A/c 2,00,000 31.03.2019 By Balance c/d 3,00,000
01.10.2018 To Bank A/c 1,00,000
3,00,000 3,00,000
01.04.2019 To Balance b/d 3,00,000 01.10.2019 By Bank A/c 90,000
By Provision for 30,000
Depreciation A/c
By Profit and Loss A/c 80,000
31.3.2020 By Balance c/d 1,00,000
3,00,000 3,00,000

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35 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.35

01.04.2020 To Balance b/d 1,00,000 01.10.2020 By Bank A/c 85,000

01.10.2020 To Bank A/c 2,50,000 By Provision for 20,000
Depreciation A/c
To Profit and Loss A/c 5,000 31.3.2021 By Balance c/d 2,50,000
3,55,000 3,55,000
Depreciation Account
Date Particulars ` Date Particulars `
31.03.2019 To provision for Depreciation A/c 25,000 31.03.2019 By Profit and Loss A/c 25,000
25,000 25,000
01.10.2019 To Provision for Depreciation A/c 10,000 31.03.2020 By Profit and Loss A/c 20,000
31.03.2020 To Provision for Depreciation A/c 10,000
20,000 20,000
01.10.2020 To Provision for Depreciation A/c 5,000 31.03.2021 By Profit and Loss A/c 17,500
31.03.2021 To Provision for Depreciation A/c 12,500
17,500 17,500

Dr. Provision for Depreciation Account Cr.

Date Particulars ` Date Particulars `
31.03.2019 To Balance c/d 25,000 31.03.2019 By Depreciation A/c 25,000
(` 20,000 + ` 5,000)
25,000 25,000
01.12.2019 To Machinery A/c 30,000 01.04.2019 By Balance b/d 25,000
(` 20,000 + ` 10,000)
31.03.2020 To Balance c/d 15,000 01.10.2019 By Depreciation A/c 10,000
31.03.2020 By Depreciation A/c 10,000
45,000 45,000
01.10.2020 To Machinery A/c 20,000 01.04.2020 By Balance b/d 15,000
(` 5,000 + ` 10,000+ ` 5,000)
31.03.2021 To Balance c/d 12,500 01.10.2020 By Depreciation A/c 5,000
31.03.2021 By Depreciation A/c 12,500
32,500 32,500

© The Institute of Chartered Accountants of India

CHAPTER
6
ACCOUNTING FOR
SPECIAL TRANSACTIONS
UNIT -1 BILLS OF EXHANGE AND PROMISSORY NOTES
LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand the meaning of Bills of Exchange and Promissory Notes and also try to grasp their
underlying features.
 Understand the accounting treatments relating to issue, acceptance, discounting, maturity and
endorsement of bills in the books of drawer and drawee.
 Learn the technique of accounting relating to accommodation bills.
 Learn the special treatment needed in case of insolvency as well as early retirement of bill.

UNIT OVERVIEW BILLS OF EXCHANGE

Bill of Exchanges Paromissory Note

Normal Trading Accommodation

Date of Expiry Nature of Bill Other Aspects

Due Date Bill at sight Dishonour of bill

Days of grace Bill after date Nothing charges

Maturity Date Renewal of bill

Bill on Demand
Insolvency

Reitrement of bills

Bills for collection

© The Institute of Chartered Accountants of India

6.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.1 BILLS OF EXCHANGE

It is general practice that when goods are sold or services are provided, the seller extends a credit period to
buyer. In sometimes, the seller may not be in a position to offer credit period and the purchase is not in a position
to pay immediately. In such circumstances the seller would like that the purchaser should give a definite promise
in writing to pay the amount of the goods on a certain date which he can use to generate immediate funds.
Commercial practice has developed to treat these written promises into valuable instruments of credit that when
a written promise is made in proper form and is properly stamped, it is expected that the buyer discharges his
debt and the seller receives payment. This is because written promises are often acce pted by banks and money
is advanced against them. Also, they can be endorsed, i.e., passed on from person to person. The written promise
is either in the form of a Bill of Exchange or in the form of a promissory note.
A Bill of Exchange has been defined as an “instrument in writing containing an unconditional order signed by the
maker directing certain person to pay a certain sum of money only to or to the order of a certain person or to the
bearer of the instrument”. When such an order is accepted in writi ng on the face of the order itself, it becomes a
valid bill of exchange. Suppose A orders B to pay `50,000 for three months after date and B accepts this order
by signing his name, then it will be a bill of exchange.
A Bill of Exchange has the following characteristics:
1. It must be in writing.
2. It must be dated.
3. It must contain an order to pay a certain sum of money.
4. The promise to pay must be unconditional.
5. The money must be payable to a definite person or to his order to the bearer.
6. The draft must be accepted for payment by the party to whom the order is made.
7. It should be properly stamped.
8. Payment must be in legal currency of the country.
The party which makes the order is known as the drawer. The party which accepts the order is known as the
acceptor and the party to whom the amount has to be paid is known as the payee. The drawer and the payee
can be the same.
A Bill of Exchange can be passed on to another person by endorsement. Endorsement on a bill of exchange is
made exactly as it is done in the case of a cheque. The primary liability on a bill of exchange is that of the
acceptor. If he does not pay, a holder can recover the amount from any of the previous endorsers or the drawee.
Sometimes, it may happen that a bill of exchange is drawn for foreign trade operations. Such a bill is known as
“Foreign Bill of Exchange”. A foreign bill of exchange is one which is drawn in one country and is payable in
another. It is generally drawn up in triplicate wherein each copy is sent by separate post so that at least one copy
reaches the intended party. Payment will be made only on one of the copies and when such payment is made
the other copies become useless. Section 12 of the Negotiable Instruments Act provides that all instruments,
which are not inland instrument, are foreign.

© The Institute of Chartered Accountants of India

3 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.3

A specimen of foreign bill of exchange is given below:

` 11,50,000 New Delhi
July, 2020

Ninety days after date of this First Bill of Exchange (Second and Third of the same tenure and date
being unpaid) Pay to the order of M/s Vencent John & Associates, London the sum of Rupees Eleven
lakh Fifty thousand only, value received.

To,
Wallis Sons Accepted
M/a IONX (Wallis Sons) Stamp
Birmingham, UK

Drawee
The following are examples of foreign bills:
1. A bill drawn in India on a person resident outside India and made payable outside India.
2. A bill drawn outside India on a person resident outside India.
3. A bill drawn outside India and made payable in India.
4. A bill drawn outside India and made payable outside India.

1.2 PROMISSORY NOTES

A promissory note is an instrument in writing, not being a bank note or currency note containing an unconditional
undertaking signed by the maker to pay a certain sum of money only to or to the order of a certain person. Under
Section 31(2) of the Reserve Bank of India Act a promissory note cannot be made payable to bearer.
A promissory note has the following characteristics:
1. It must be in writing.
2. It must contain a clear promise to pay. Mere acknowledgement of a debt is not a promissory note.
3. The promise to pay must be unconditional “I promise to pay `50,000 as soon as I can” is not an
unconditional promise.
4. The promiser or maker must sign the promissory note.
5. The maker must be a certain person.
6. The payee (the person to whom the payment is promised) must also be certain.
7. The sum payable must be certain. “I promise to pay `50,000 plus all fine” is not certain.
8. Payment must be in legal currency of the country.
9. It should not be made payable to the bearer.

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6.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

10. It should be properly stamped.

11. It does not require any acceptance.
Specimen of promissory note :
Specimen of a Promissory Note
` 10,00,000/- only Rohan
77, Sector-12, Ghaziabad
March 01, 2020
Three months after date I promise to pay Priya or his order the sum of ` Ten lakh only, for value received.
To,
Priya Stamp
S-11, Rohini, Delhi. (Rohan)

Payee Maker

1.3 DIFFERENCES - BILL OF EXCHANGE AND PROMISSORY

NOTE
Bill of Exchange Promissory Note
A bill contains an unconditional order to pay A promissory note contains only a promise to pay
certain sum of money
There are generally 3 parties (Drawer, Drawee There are 2 parties (Maker and Payee) in promissory
and Payee) in bill of exchange note
A bill is paid by Acceptor A promissory note is paid by maker
A bill is drawn by creditor A promissory note is made by debtor
The drawer and payee may be same person in In promissory note maker and payee cannot be same
case of bill of exchange person
In a bill of exchange the liability of drawer is In a promissory note the liability of a maker is primary
secondary and conditional and absolute
A bill of exchange can be accepted conditionally A promissory note cannot be made conditionally
In a bill of exchange, notice of dishonor must be Notice of dishonor is not required in case of promissory
given note
In case of dishonor, a bill of exchange must be Noting and protest is not required in case of dishonor
noted and protested of a promissory note.

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5 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.5

1.4 RECORD OF BILLS OF EXCHANGE AND PROMISSORY

NOTES
A party which receives a Promissory Note or receives an accepted Bill of Exchange will treat it as a new asset
under the name of Bills receivable. A party which issues a Promissory Note or accepts a Bill of Exchange will
treat it as new liability under the heading of Bills Payable. We shall first deal with the entries in the books of the
party which receives promissory notes or bills. (When we talk of bills, we include promissory notes also).
On receipt of Bill, the payee makes the following entry in his books of accounts:
Bills Receivable Account Dr.
To Drawee/Maker of the note
(1) A accepts a Bill of exchange drawn on him by B. In the books of B the entry will be :
Bills Receivable Account Dr.
To A
(2) A sends to B the acceptance of D. In this case also, the entry in the books of B will be :
Bills Receivable Account Dr.
To A
The person who receives the bill has three options. These are:
(i) He can hold the bill till maturity. (Naturally in this case no further entry is passed until the date of maturity
arrives).
(ii) The bill can be endorsed in favour of another party say Z. In this case, the entry will be to debit the party
which now receives the bill and to credit the Bills Receivable Account.
Z Dr.
To Bills Receivable Account
(iii) The Bill of Exchange can be discounted with bank. The bank will deduct a small sum of money as
discount and pay rest of the money.
Bank Account Dr. (with the amount actually received)
Discount Account Dr. (with the amount of loss or discount)
To Bills Receivable Account
On the date of maturity there will be two possibilities:
(a) The first is that the bill will be paid, that is to say, met or honoured. The entries for this will depend upon
what was done to the bill during the period of maturity. If the bill was kept, the cash will be received by
the party which originally received the bill. In his books, therefore, the entry will be :
Cash Account Dr.
To Bills Receivable Account

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6.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

But if he has already endorsed the bill in favour of his creditor or if the bill has been discounted with the
bank he will not get the amount; it will be the creditor or the bank which will receive the money. Therefore,
in these two cases, no entry will be made in the books of the party which originally received the bill.
(b) The second possibility is that the bill will be dishonoured, that is to say, the bill will not be paid. If the bill
is dishonoured, the bill becomes useless and the party from whom the bill was received will be liable to
pay the amount (and also the expenses incurred by the party).
Therefore, the following entries will be made :
1. If the bill was kept till maturity then :

Drawee / Maker of the note Dr.

To Bills Receivable Account
2. If the bill was endorsed in favour of a creditor, the entry is :
Drawee / Maker of the note Dr.
To Bill payables
3. If the bill was discounted with the bank :
Drawee / Maker of the note Dr.
To Bank A/c
Thus, it will be seen that in case of dishonour, the party which gave the bill has to be debited ( because he has
become liable to pay the amount). The credit entry is in Bills Receivable Account (if it was retained) or the Creditor
or the bank (if it was endorsed/discounted in their favour).

1.5 TERM OF A BILL

The term of bill of exchange may be of any duration. Usually the term does not exceed 90 days from the date of
the bill.
 When a bill is drawn after sight, the term of the bill begins to run from the date of ‘sighting’, i.e., when
the bill is accepted.
 When a bill is drawn after date, the term of the bill begins to run from the date of drawing the bill.

1.6 EXPIRY / DUE DATE OF A BILL 

The date on which the term of the bill terminates is called as ‘Expiry/Due Date of the bill’.

1.7 DAYS OF GRACE

Every instrument payable otherwise than on demand is entitled to three days of grace.

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7 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.7

1.8 DATE OF MATURITY OF BILL

The date which comes after adding three days to the expiry/due date of a bill, is called the date of maturity.
The maturity of a promissory note or bill of exchange is the date at which it falls due. Every promissory note or
bill of exchange gets matured on the third day after the day on which it is expressed to be payable, except when
it is expressed to be payable:
(i) on demand,
(ii) at sight, or
(iii) on presentment

1.9 BILL AT SIGHT

Bill at Sight means the instruments in which no time for payment is mentioned. A cheque is always payable on
demand. A promissory note or bill of exchange is payable on demand-
(a) when no time for payment is specified, or
(b) when it is expressed to be payable on demand, or at sight or on presentment.
Notes:

1.10 BILL AFTER DATE

Bill after date means the instrument in which time for payment is mentioned. A promissory note or bill of exchange
is a time instrument when it is expressed to be payable-
(a) after a specified period.
(b) on a specific day
(c) after sight
(d) on the happening of event which is certain to happen
Notes:
(i) The expression ‘after sight’ means-
(a) in a promissory note, after presentment for sight
(b) in a bill of exchange, after acceptance or noting for non-acceptance or protest for non-
acceptance.
(ii) A cheque cannot be a time instrument because the cheque is always payable on demand. Though a
cheque can be post dated and which can be presented on or after such date. A cheque has validity of
90 days from its date after that it becomes void, normally termed as ‘Stale Cheque’ as bank will not
honour such cheque.

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6.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.11 HOW TO CALCULATE DUE DATE OF A BILL

The due date of each bill is calculated as follows:
Case Due Date
(a) When the bill is made payable on a specific (a) That specific date will be the due date.
date.
(b) When the bill is made payable at a stated (b) That date on which the term of the bill shall expire
number of months(s) after date. will be the due date.
Note: The term shall expire on that day of the month
which corresponds with the day on which the bill is
dated. If the month in which the period terminates has
no corresponding day, the period shall be deemed to
expire on the last day of such a month. For example a
bill signed on January 31st payable after 3 months will
be due on April 30th.
(c) When the bill is made payable at a stated (c) That date which comes after adding stated
number of days after date. number of days to the date of bill, shall be the due
date.
Note: The date of Bill is excluded.
(d) When the due date is a public holiday. (d) The preceding business day will be the due date.
(e) When the due date is an emergency/due (e) The next following day will be the date.
unforeseen holiday.
Note: The term of a Bill after sight commences from the date of acceptance of the bill whereas the term of a
Bill after date commences from the date of drawing of bill.

1.12 NOTING CHARGES 

It is necessary that the fact of dishonour and the causes of dishonour should be established. If the acceptor can
prove that the bill was not properly presented to him for payment, he may escape liability. Therefore, if there is
dishonour, or fear of dishonour, the bill will be given to a public official known as “Notary Public”. These officials
present the bill for payment and if the money is received, they will hand over the money to the original party. But
if the bill is dishonoured they will note the fact of dishonour, with the reasons and give the bill back to their client.
For this service they charge a small fee. This fee is known as noting charges. The amount of noting charges is
recoverable from the party which is responsible for dishonour.
Suppose X received from Y a bill for `1,000. On Maturity the bill is dishonoured and `10 is paid as noting charges.
The entry in this case will be
` `
Y Dr. 1,010
To Bills Receivable Account 1,000
To Bank A/c 10

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9 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.9

Suppose X had endorsed this bill in favour of Z. In that case entry for dishonoured bill would have been
Y Dr. 1,010
To Z 1,010
This is because Z will claim `1,010 from X and X has the right of recovering `1,010 from Y. Similarly, if
the bill has been discounted with a bank, entry will be :
Y Dr. 1,010
To Bank A/c 1,010

1.13 RENEWAL OF BILL

Sometimes the acceptor is unable to pay the amount and he himself moves that he should be given extension of
time and in consideration agrees to bear interest for the extended time period (calculated from the date of renewal
till the date of expected settlement). In such a case a new bill will be drawn and the old bill will be cancelled. If
this happens entries should be passed for cancellation of the old bill. This is done exactly as already explained
for dishonour. When the new bill is received entries for the receipt of the bill will be repeated. The amount of the
new bill may represent any of the following:
(i) Where the drawee pays nothing: Total of amount of original bill as well as the interest for the extended
time period.
(ii) Where the drawee pays the interest amount at the time of renewal : Amount of the Original bill.
(iii) Where the drawee makes part payment of the original bill or interest amount or both : That part of total
of amount of original bill as well as the interest for the extended time period on unpaid amount.

1.14 RETIREMENT OF BILLS OF EXCHANGE & REBATE

We have seen that renewal of a bill of exchange is made when a person does not have sufficient fund to pay for
the bill of exchange on the due date and he requires a further period of credit. Many a time instances do arise
when the acceptor has spare funds much before the maturity date of the bill of exchange accepted by him. In
such circumstances he approaches the payee of the bill of exchange and asks him whether the payee is prepared
to accept cash before the maturity date. In such cases the acceptor gets a certain rebate or interest or discount
for premature payment. The rebate becomes the income of the acceptor and expense of the payee. It is a
consideration of premature payment.

ILLUSTRATION 1

Ms. Sujata receives two bills from Ms. Aruna dated 1st January 2020 for 2 months. The first bill is for 10,200 and
the second bill is for ` 15,000. The second bill was endorsed in favour or Mr. Sree on 3rd January 20 20. And the
First bill is discounted immediately with the bank for ` 10,000. Pass the necessary journal entries in the books of
Ms. Sujata.

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6.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

In the books of Sujata

Journal Entries
Date Particulars L.F. DR. (in `) CR. (in `)
01/01/2020 Bills receivables A/c Dr. 25,200
To Aruna A/c 25,200
(Being 2 bills receivable from Aruna)
03/01/2020 Sree A/c Dr. 15,000
To Bills receivables A/c 15,000
(Being the bill endorsed in favour of Mr. Sree)
01/01/2020 Bank A/c Dr. 10,000
Discount charges A/c Dr. 200
To Bills receivable A/c 10,200
(Being the bills receivable discounted with the
bank at a charge of ` 200)

ILLUSTRATION 2

Vijay sold goods to Pritam on 1st September, 2019 for ` 1,06,000. Pritam immediately accepted a three months
bill. On due date Pritam requested that the bill be renewed for a fresh period of two months. Vijay agrees provided
interest at 9% p.a. was paid immediately in cash. To this Pritam was agreeable. The second bill was met on due
date. Give Journal entries in the books of Vijay and Pritam.

SOLUTION

Books of Vijay
Journal
2019 ` `
1-Sept. Pritam Dr. 1,06,000
To Sales Account 1,06,000
(Sales of goods to Pritam as per Invoice No...)
Bills Receivable Account Dr. 1,06,000
To Pritam 1,06,000
(3 months acceptance received from Pritam for the amount due
from him)
Dec. 4 Pritam Dr. 1,06,000
To Bills Receivable Account 1,06,000
(Pritam acceptance cancelled because of renewal)

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11 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.11

Pritam Dr. 1,590

To interest 1,590
(Interest @ 9% on `1,06,000 due from Pritam for 2
months because of renewal)
Bills Receivable Account Dr. 1,06,000
Cash Account Dr. 1,590
To Pritam 1,07,590
[New acceptance for 2 months for `106,000 and
Cash (for interest) received from Pritam]
2020
Feb. 7 Cash Account Dr. 1,06,000
To Bills Receivable Account 1,06,000
(Cash received against Pritam’s second acceptance)

Books of Pritam
Journal

2019 ` `
1-Sept. Purchase Account Dr. 1,06,000
To Vijay A/c 1,06,000
(Purchase of goods from Vijay as per Invoice No...)
Vijay A/c Dr. 1,06,000
To Bills Payables Account 1,06,000
(3 months acceptance given to Vijay for the amount)
Dec. 4 Bills Payable Account Dr. 1,06,000
To Vijay A/c 1,06,000
(Cancellation of bill because of renewal)
Interest Account Dr. 1,590
To Vijay 1,590
(Interest @ 9% on `1,06,000 due to Vijay for 2 months
because of renewal)
Vijay Account Dr. 1,07,590
To Cash Account 1,590
To Bills Payable Account 1,06,000
[New acceptance for 2 months for `106,000 and Cash (for
interest) paid to Vijay]
2020
Feb. 7 Bills Payable Account Dr. 1,06,000
To Cash Account 1,06,000
(Cash paid against second bill)

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6.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 3

On 1st January, 2020, Ankita sells goods for `5,00,000 to Bhavika and draws a bill at three months for the
amount. Bhavika accepts it and returns it to Ankita. On 1st March, 2020, Bhavika retires her acceptance under
rebate of 12% per annum. Record these transactions in the journals of Ankita and Bhavika.

SOLUTION

Journal Entries in the books of Ankita

Date Particulars ` `
2020
Jan. 1 Bhavika’s account Dr. 5,00,000
To Sales account 5,00,000
(Being the goods sold to Bhavika on credit)
Bills receivable account Dr. 5,00,000
To Bhavika’s account 5,00,000
(Being the acceptance of bill received)
Mar.1 Bank account Dr. 4,95,000
Rebate on bills account Dr. 5,000
To Bills receivable account 5,00,000
(Being retirement of bill by Bhavika one month before maturity,
the rebate being given to her at 12% p.a.)

Journal Entries in the books of Bhavika

Date Particulars ` `
2020
Jan. 1 Purchases account Dr. 5,00,000
To Ankita Account 5,00,000
(Being the goods purchased from Ankita on credit)
Ankita Account Dr. 5,00,000
To Bills Payable Account 5,00,000
(Being the acceptance of bill)
Mar .1 Bills Payable Account Dr. 5,00,000
To Rebate Income Account 5,000
To Bank Account 4,95,000
(Being retirement of bill one month before maturity, the rebate
being received at 12% p.a.)

© The Institute of Chartered Accountants of India

13 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.13

ILLUSTRATION 4

Journalise the following transactions in K. Katrak’s books.

(i) Katrak’s acceptance to Basu for ` 2,500 discharged by a cash payment of ` 1,000 and a new bill for the
balance plus ` 50 for interest.
(ii) G. Gupta’s acceptance for ` 4,000 which was endorsed by Katrak to M. Mehta was dishonoured. Mehta
paid `20 noting charges. Bill withdrawn against cheque.
(iii) D. Dalal retires a bill for ` 2,000 drawn on him by Katrak for ` 10 discount.
(iv) Katrak’s acceptance to Patel for ` 5,000 discharged by Patel. Mody’s acceptance to Katrak for a similar
amount.

SOLUTION

Books of K. Katrak
Journal Entries
` `
(i) Bills Payable Account Dr. 2,500
Interest Account Dr. 50
To Cash A/c 1,000
To Bills Payable Account 1,550
(Bills Payable to Basu discharged by cash payment of `1,000 and a
new bill for ` 1,550 including ` 50 as interest)
(ii) (a) G. Gupta Dr. 4,020
To M. Mehta 4,020
(G. Gupta’s acceptance for ` 4,000 endorsed to M. Mehta
dishonoured, ` 20 paid by M. Mehta as noting charges)
(b) M. Mehta Dr. 4,020
To Bank Account 4,020
(Payment to M. Mehta on withdrawal of bill earlier received from Mr.
G. Gupta)
(iii) Bank Account Dr. 1,990
Discount Account Dr. 10
To Bills Receivable Account 2,000
(Payment received from D. Dalal against his acceptance for
` 2,000. Allowed him a discount of `10)
(iv) Bills Payable Account Dr. 5,000
To Bills Receivable Account 5,000
(Bills Receivable from Mody endorsed to Patel in settlement of bills
payable issued to him earlier)

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6.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 5

On 1st January, 2020, Vilas draws a bill of exchange for ` 10,000 due for payment after 3 months on Eknath.
Eknath accepts to this bill of exchange. On 4th March, 2020 Eknath retires the bill of exchange at a discount of
12% p.a. You are asked to show the journal entries in the books of Eknath.

SOLUTION

Journal entries in the books of Eknath

Date Particulars L.F. Debit ` Credit `
Jan. 1 Vilas A/c Dr. 10,000
To Bills Payable A/c 10,000
(Being the bill draws by him accepted)
Mar. 4 Bills Payable A/c Dr. 10,000
To Bank A/c 9,900
To Interest A/c (Discount A/c) 100
(Being retirement of acceptance 1 month before maturity,
interest allowed at 12% p.a.)

ILLUSTRATION 6

On 1st January, 2020, Vilas draws a Bill of Exchange for `10,000 due for payment after 3 months on Eknath.
Eknath accepts to this bill of exchange. On 4th March, 2020. Eknath retires the bill of exchange at a discount of
12% p.a. You are asked to show the journal entries in the books of Vilas.

SOLUTION

Journal entries in the books of Vilas

Date Particulars Debit ` Credit `
2020
Jan. 1 Bills Receivable A/c Dr. 10,000
To Eknath A/c 10,000
(Being bill of exchange no_____ drawn on Eknath due for
payment on 4th April 2020)
Mar. 4 Bank A/c Dr. 9,900
Interest A/c (Discount) A/c Dr. 100
To Bills Receivable A/c 10,000
(Being retirement of bill of exchange due for maturity on 4th
April, 2020 by Eknath 1 month before maturity, the rebate being
given to him at 12% p.a.)

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15 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.15

1.15 INSOLVENCY
Insolvency of a person means that he is unable to pay his liabilities. This means that bills accepted by him will be
dishonoured. Therefore, when it is known that a person has become insolvent, entry for dishonour of his acceptance
must be passed. Later on, something may be received from his estate. When and if an amount is received, cash
account will be debited and the personal account of the debtor will be credited. The remaining amount will be
irrecoverable and, therefore, should be written off as bad debt. The students should be careful to calculate the
amount actually received from an insolvent’s estate and amount to be written off only after preparing his account.
In the books of drawee of the bill, the amount not ultimately paid by him due to insolvency, should be credited to
Deficiency Account.

ILLUSTRATION 7

Mr. David draws two bills of exchange on 1.1.2020 for ` 6,000 and ` 10,000. The bills of exchange for ` 6,000
is for two months while the bill of exchange for `10,000 is for three months. These bills are accepted by Mr.
Thomas. On 4.3.2020, Mr. Thomas requests Mr. David to renew the first bill with interest at 18% p.a. for a period
of two months. Mr. David agrees to this proposal. On 20.3.2020, Mr. Thomas retires the acceptance for ` 10,000,
the interest rebate i.e. discount being `100. Before the due date of the renewed bill, Mr. Thomas becomes
insolvent and only 50 paise in a rupee could be recovered from his estate.
You are to give the journal entries in the books of Mr. David.

SOLUTION

Journal Entries in the books of Mr. David

2020 (` ) (` )
Jan. 1 Bills receivable (No. 1) A/c Dr. 6,000
Bills receivable (No. 2) A/c Dr. 10,000
To Mr. Thomas’s A/c 16,000
(Being drawing of bills receivable No. 1 due for maturity on 4.3.2020
and bills receivable No. 2 due for maturity on 4.4.2020)
4-Mar Mr. Thomas’s A/c Dr. 6,000
To Bills receivable (No.1) A/c 6,000
(Being the reversal entry for bill No.1 on agreed renewal)
4-Mar Bills receivable (No. 3) A/c Dr. 6,180
To Interest A/c 180
To Mr. Thomas’s A/c 6,000
(Being the drawing of bill of exchange no. 3 due for maturity on
7.5.2020 together with interest at 18%p.a. in lieu of the original
acceptance of Mr. Thomas)

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6.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

20-Mar Bank A/c Dr. 9,900

Discount A/c Dr. 100
To Bills receivable (No. 2) A/c 10,000
(Being the amount received on retirement of bills No.2 before the
due date)
7-May Mr. Thomas’s A/c Dr. 6,180
To Bills receivable (No. 3) A/c 6,180
(Being the amount due from Mr. Thomas on dishonour of his
acceptance on presentation on the due date)
7-May Bank A/c Dr. 3,090
To Mr. Thomas’s A/c 3,090
(Being the amount received from official assignee of Mr. Thomas
at 50 paise per rupee against dishonoured bill)
May 7 Bad debts A/c Dr. 3,090
To Mr. Thomas’s A/c 3,090
(Being the balance 50% debt in Mr. Thomas’s Account arising out
of dishonoured bill written as bad)

ILLUSTRATION 8

Rita owed `1,00,000 to Siriman. On 1st October, 2019, Rita accepted a bill drawn by Siriman for the amount at
3 months. Siriman got the bill discounted with his bank for `99,000 on 3rd October, 2019. Before the due date,
Rita approached Siriman for renewal of the bill. Siriman agreed on the conditions that `50,000 be paid
immediately together with interest on the remaining amount at 12% per annum for 3 months and for the balance,
Rita should accept a new bill at three months. These arrangements were carried out. But a fterwards, Rita became
insolvent and 40% of the amount could be recovered from his estate.
Pass journal entries (with narration) in the books of Siriman.

SOLUTION

In the books of Siriman

Journal Entries
Particulars L.F. ` `
Bills Receivable A/c Dr. 1,00,000
To Rita 1,00,000
(Being a 3 month’s bill drawn on Rita for the amount due)
Bank A/c Dr. 99,000
Discount A/c Dr. 1,000
To Bills Receivable A/c 1,00,000
(Being the bill discounted)

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17 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.17

Rita Dr. 1,00,000

To Bank A/c 1,00,000
(Being the bill cancelled up due to Rita’s inability to pay it)
Rita Dr. 1,500
To Interest A/c 1,500
(Being the interest due on ` 50,000 @ 12% for 3 months)
Bank A/c Dr. 51,500
To Rita 51,500
(Being the receipt of a portion of the amount due on the bill together with
interest)
Bills Receivable A/c Dr. 50,000
To Rita 50,000
(Being the new bill drawn for the balance)
Rita Dr. 50,000
To Bills Receivable A/c 50,000
(Being the dishonour of the bill due to Rita’s insolvency)
Bank A/c Dr. 20,000
Bad Debts A/c Dr. 30,000
To Rita 50,000
(Being the receipt of 40% of the amount due on the bill from Rita’s estate)

1.16 ACCOMMODATION BILLS

Bills of Exchange are usually drawn to facilitate trade transmission, that is, bills are meant to finance actual
purchase and sale of goods. But the mechanism of bill can be utilised to raise finance also. Suppose Boss needs
finance for three months. In that case he may persuade his friend Kapoor to accept his draft. The bill of exchange
may then be taken by Boss to his bank and get it discounted there. Thus, Boss will be able to make use of funds.
When the three months period expires, Boss will send the requisite amount to Kapo or and Kapoor will meet the
bill. Thus, Boss is able to raise money for his use. If both Boss and Kapoor need money, the same devise can
be used. Either Boss accepts a bill of exchange or Kapoor does. In either case, the bill will be discounted with
the bank and the proceeds divided between the two parties according to mutual agreement. The discounting
charges must also be borne by the two parties in the same ratio in which the proceeds are divided. On the due
date the acceptor will receive from the other party his share. The bill will then be met. When bills are used for
such a purpose, they are known as accommodation bills.
However, it may so happen that the drawer is not able to remit the proceeds to drawee on the due date. In such
a case, the drawee may draw a bill on the drawer, and get it discounted with the bank to honour the first bill. If
the new drawer (drawee of the first bill) also remits some proceeds of the new bill to new drawee (drawer of the
first bill), then the proportion of discount to be borne by the new drawee will be based upon the proceeds remitted
as well as the benefit obtained by him on the first bill (i.e., by not paying the amount due to the original drawee
on due date).

© The Institute of Chartered Accountants of India

6.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

Entries are passed in the books of two parties exactly in the way already pointed out for ordinary bills. The only
additional entry to be passed is for sending the remittance for one party to the other party and also debiting the
other party with the shared amount of discount.

ILLUSTRATION 9

On 1st July, 2019 Gorge drew a bill for `1,80,000 for 3 months on Harry for mutual accommodation. Harry
accepted the bill of exchange. Gorge had purchased goods worth `1,81,000 from Jack on the same date. Gorge
endorsed Harry’s acceptance to Jack in full settlement. On 1st September, 2019, Jack purchased goods worth
`1,90,000 from Harry. Jack endorsed the bill of exchange received from Gorge to Harry and paid ` 9,000 in full
settlement of the amount due to Harry. On 1st October, 2019, Harry purchased goods worth `2,00,000 from
Gorge. Harry paid the amount due to Gorge by cheque. Give the necessary Journal Entries in the books of Harry
and Gorge.

SOLUTION

In the books of Harry

Journal Entries
Date Particulars ` `
1.7.2019 Gorge’s account Dr. 1,80,000
To Bills payable account 1,80,000
(Acceptance of bill drawn by Gorge)
1.9.2019 Jack’s account Dr. 1,90,000
To Sales account 1,90,000
(Sales made to Jack)
1.9.2019 Bills receivable account Dr. 1,80,000
Bank account Dr. 9,000
Discount account Dr. 1,000
To Jack’s account 1,90,000
(Acceptance received from Jack’s endorsement of bill
received from Gorge for ` 1,80,000 and ` 9,000 received in
full settlement of the amount due)
1.9.2019 Bills payable account Dr. 1,80,000
To Bills receivable account 1,80,000
(Own acceptance received from Jack’s endorsement,
cancelled)
1.10.2019 Purchase account Dr. 2,00,000
To Gorge’s account 2,00,000
(Purchases made from Gorge)
Gorge’s account Dr. 20,000
To Bank account 20,000
(Amount paid to Gorge after adjusting `180,000 for
accommodation extended to him)

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19 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.19

In the books of Gorge

Journal Entries
Date Particulars ` `
1.7.2019 Purchases Account Dr. 1,81,000
To Jack Account 1,81,000
(Purchase of goods from Jack)
1.7.2019 Bills Receivable Account Dr. 1,80,000
To Harry Account 1,80,000
(Acceptance by Harry of bill drawn on him)
1.7.2019 Jack’s account Dr. 1,81,000
To Rebate Account 1,000
To Bills Receivable Account 1,80,000
(Harry’s bill endorsed to Jack)
1.10.2019 Harry Account Dr. 2,00,000
To Sales account 2,00,000
(Sales to Harry)
1.10.2019 Bank Account Dr. 20,000
To Harry account 20,000
(Amount received from Gorge after adjusting `180,000 for
accommodation extended by him)

ILLUSTRATION 10

For the mutual accommodation of ‘X’ and ‘Y’ on 1st April, 2019, ‘X’ drew a four months’ bill on ‘Y’ for ` 4,000. ‘Y’
returned the bill after acceptance of the same date. ‘X’ discounts the bill from his bankers @ 6% per annum and
remit 50% of the proceeds to ‘Y’. On due date ‘X’ is unable to send the amount due and therefore ‘Y’ draws a bill
for ` 7,000, which is duly accepted by ‘X’. ‘Y’ discounts the bill for ` 6,600 and sends ` 1,300 to ‘X’. Before the
bill is due for payment ‘X’ becomes insolvent. Later 25 paise in a rupee received from his estate.
Record Journal entries in the books of ‘X’.

SOLUTION

In the books of X
Journal Entries
Date Particulars Debit Credit
2019 ` `
1-Apr Bills receivable account Dr. 4,000
To Y’s account 4,000
(Acceptance received from Y for mutual accommodation)

© The Institute of Chartered Accountants of India

6.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

1-Apr Bank account Dr. 3,920

Discount account Dr. 80
To Bills receivable account 4,000
(Bill discounted for ` 3,920)
Y’s account Dr. 2,000
To Cash account 1,960
To Discount account 40
(Half of proceeds remitted to Y)
Aug. 4 Y’s account Dr. 7,000
To Bills payable account 7,000
(Acceptance given to Y, being unable to remit the due amount)
Bank account Dr. 1300

 2,000 + 1,300  Dr. 200

Discount account   400
 6,600 
To Y’s account 1500
(Amount received from Y and discount amount credited to him)
Bills payable account Dr. 7,000
To Y’s account 7,000
(Acceptance to Y dishonoured because of insolvency)
Y account Dr. 3,500
To Bank account 875
To Deficiency account 2,625
(Amount paid @ 25 paise in a rupee and balance credited to
deficiency account as being unable to pay)

ILLUSTRATION 11

X draws on Y a bill of exchange for ` 30,000 on 1st April, 2020 for 3 months. Y accepts the bill and sends it to X
who gets it discounted for ` 28,800. X immediately remits ` 9,600 to Y. On the due date, X, being unable to remit
the amount due, accepts a bill for ` 42,000 for three months which is discounted by Y for ` 40,110. Y sends
` 6,740 to X. Before the maturity of the bill X becomes bankrupt, his estate paying fifty paise in the rupee. Give
the journal entries in the books of X and Y.

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21 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.21

SOLUTION

In the books of X
Journal Entries
Date Particulars L.F. DR. (in `) CR. (in `)
01/04/2020 Bills receivables A/c Dr. 30,000
To Y A/c 30,000
(Being bill of exchange drawn on Mr. Y)
1/4/2020 Bank A/c Dr. 28,800
Discount charges A/c Dr. 1,200
To Bills receivable A/c 30,000
(Being the bills receivable discounted with the bank
at a charge of ` 1,200)
1/4/2020 Y A/c Dr. 10,000
To Bank A/c 9,600
To Discount charges 400
(Being the amount remitted to Y along with his share
of the bank charges)
04/7/2020 Y A/c Dr. 42,000
To Bills payable A/c 42,000
(Being the bills drawn by Y, due to non-payment of
earlier bill)
04/7/2020 Bank A/ c Dr. 6,740
Discount charges A/c Dr. 1,260
To Y A/c 8,000
(Being the amount discounted and sent it by Y to X)
Bills payable A/c Dr.
To Y’s A/c 42,000
(Being the bill due dishonoured due to bankruptcy)
Y A/c Dr. 28,000
To Bank A/c 14,000
To Deficiency account 14,000
(Being the amount due to Y discharged by payment
of 50 paise in a rupee)
In the books of Y
Journal Entries
Date Particulars L.F. DR. (in `) CR. (in `)
01/04/2020 X A/c Dr. 30,000
To Bills payable A/c 30,000
(Being bill of exchange accepted and sent to Mr. X)

© The Institute of Chartered Accountants of India

6.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

1/4/2020 Bank A/c Dr. 9,600

Discount charges A/c Dr. 400
To X A/c 10,000
(Being the amount received from X on account of the bills
receivable)
04/7/2020 Bills receivable A/c Dr. 42,000
To X A/c 42,000
(Being the bills accepted by X)
04/7/2020 Bank A/c Dr. 40,110
Discount charges A/c Dr. 1,890
To Bills receivable A/c 42,000
(Being X acceptance discounted with bank)
Bills payable A/c Dr. 30,000
To Bank A/c 30,000
(Being the amount met on the due date)
X A/c Dr. 8,000
To Bank A/c 6,740
To Discount account 1,260
(Being the amount received and the discount debited to X)
X A/c Dr. 42,000
To Bank A/c 42,000
(Being X’s acceptance which was discounted
dishonoured due to X’s bankruptcy)
Bank A/c Dr. 14,000
Bad debts A/c Dr. 14,000
To X A/c 28,000
(The amount received from X and the balance being
written off as debt)

ILLUSTRATION 12

Anil draws a bill for `9,000 on Sanjay on 5th April, 2019 for 3 months, which Sanjay returns it to Anil after
accepting the same. Anil gets it discounted with the bank for ` 8,820 on 8th April, 2019 and remits one-third
amount to Sanjay. On the due date Anil fails to remit the amount due to Sanjay, but he accepts a bill for `12,600
for three months, which Sanjay discounts it for ` 12,330 and remits ` 2,220 to Anil. Before the maturity of the
renewed bill Anil becomes insolvent and only 50% was realized from his estate on 15th October, 2019.
Pass necessary Journal entries for the above transactions in the books of Anil.

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23 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.23

SOLUTION

In the books of Anil

Journal Entries
Date Particulars Debit Credit
Amount Amount
2019 ` `
5-Apr Bills receivable account Dr. 9,000
To Sanjay’s account 9,000
(Being acceptance received from Sanjay for mutual
accommodation)
8-Apr Bank account Dr. 8,820
Discount account Dr. 180
To Bills receivable account 9,000
(Being bill discounted with bank)
8-Apr Sanjay’s account Dr. 3,000
To Bank account 2,940
To Discount account 60
(Being one-third proceeds of the bill sent to Sanjay)
8-Jul Sanjay’s account Dr. 12,600
To Bills payable account 12,600
(Being Acceptance given)
8-Jul Bank account Dr. 2,220
 6,000 + 2,220  Dr. 180
Discount account  12,330 × 270 
 
To Sanjay’s account 2,400
(Being proceeds of second bill received from Sanjay)
Oct.11 Bills payable account Dr. 12,600
To Sanjay’s account 12,600
(Being bill dishonoured due to insolvency)
Oct.15 Sanjay’s account (6,000+2,400) Dr. 8,400
To Bank account 4,200
To Deficiency account 4,200
(Being insolvent, only 50% amount paid to Sanjay)

© The Institute of Chartered Accountants of India

6.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.17 BILLS OF COLLECTION

When a person receives a bill of exchange, he may decide to retain the bill till the date of maturity. But in order
to ensure safety, he may send it to bank with instructions that the bill should be retained till maturity and should
be realised on that date. This does not mean discounting because the bank will not credit the client until the
amount is actually realised. If the bill is sent to the bank with such instructions it is known as “Bill sent for
collection”.
It is better to make a record of this also in books by passing following entry:
Bills for Collection Account Dr.
To Bills Receivable Account
When the amount is realised the entry will be
Bank Account Dr.
To Bills for Collection Account
When the amount is not honoured, the entry will be
Party (from whom the bill was received) Dr.
To Bills for collections A/c

1.18 BILLS RECEIVABLE AND BILLS PAYABLE BOOKS

Bills receivable and bills payable books are journals (Day Books) to record in a chronological order the details of bills
receivable and bills payable. When large number of bill transactions take place in an organization, it is convenient to
maintain these books. Wherein any bill transaction takes place, the same is entered in the Day Books in the first
instance. Postings to individual Debtors or Creditors accounts are made from the Day Books. Also totals of bills
received or accepted are posted periodically to Bills Receivable Account and Bills Payable Account respectively.
Bills receivable book and bills payable book are very useful for following up the status of outstanding bills. When there
are large number of bills and these bills fall due on different dates, some of these bills may not be honoured on maturity
due to varied reasons. It is possible from these Day Books to trace the details of the outstanding bills and to identify
the reasons for not honouring the bills. Given below are forms of Day Books for both bills receivable and bills payable:

Bills Receivable Book (Folio No . . .)

Date of Voucher Party from whom Acceptor Date Due Place of Amt. ` L.F. Mode of Disposal
receipt No. Received of Bill Date Payment

Bills Payable Book (Folio No . . .)

Date of Drawer Payee Date of Bill Due Date Place of Amt.` L.F. Mode of Disposal
Acceptance Payment

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25 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.25

SUMMARY
 A Bill of Exchange is defined as an “instrument in writing containing an unconditional order signed by
the maker directing a certain person to pay a certain sum of money only to or to the order of a certain
person or to the bearer of the instrument”.
 A promissory note is an instrument in writing, not being a bank note or currency note containing an
unconditional undertaking signed by the maker to pay a certain sum of money only to or to the order of
a certain person. Under Section 31(2) of the Reserve Bank of India Act a promissory note cannot be
made payable to bearer.
 A party which receives a Promissory Note or receives an accepted Bill of Exchange will treat it as a new
asset under the name of Bills receivable. A party which issues a Promissory Note or accepts a Bill of
Exchange will treat it as new liability under the heading of Bills Payable.

TEST YOUR KNOWLEDGE

True and False
1. Bills payable account is a nominal account.
2. Promise to pay is included in a bill of exchange.
3. Days of rebate are added to the due date to arrive at the maturity date.
4. There are always 2 parties to the bills of exchange.
5. Foreign bill is drawn in the country and payable outside the country.
6. Promissory note is different from bill of exchange because the amount is paid by the maker in case of
former and by the acceptor in the later.

Multiple Choice Questions

1. On 1.1.2019, A draws a bill on B for ` 1,20,000 for 3 months’ maturity date of the bill will be:
(a) 1.4.2019 (b) 3.4.2019 (c) 4.4.2019
2. On 16.6.2020 P draws a bill on Q for ` 1,25,000 for 30 days. 19th July is a public holiday, maturity date
of the bill will be:
(a) 19th July (b) 18th July (c) 17th July
3. PQ draws a bill on XY for ` 130,000 on 1.1.2020. XY accepts the same on 4.1.2020 for period of 3
months after date. What will be the maturity date of the bill:
(a) 4.4.2020 (b) 3.4.2020 (c) 7.4.2020
4. A draws a bill on B. A endorsed the bill to C. The payee of the bill will be
(a) A (b) B (c) C

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6.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

5. A bill of ` 120,000 was discounted by Saras with the banker for `1,18,800. At maturity, the bill returned
dishonoured, noting charges ` 200. How much amount will the bank deduct from Saras’s bank balance
at the time of such dishonour?
(a) `1,20,000 (b) `1,18,800 (c) `1,20,200
6. X draws a bill on Y for `300,000 on 1.1.2020 for 3 months after sight, date of acceptance is 6.1.2020.
Maturity date of the bill will be:
(a) 8.4.2020 (b) 9.4.2020 (c) 10.4.2020
7. X sold goods to Y for ` 5,00,000. Y paid cash `4,30,000. X will grant 2% discount on balance, and Y
request X to draw a bill for balance, the amount of bill will be:
(a) ` 98,000 (b) ` 68,000 (c) ` 68,600
8. On 1.1.2020, X draws a bill on Y for ` 5,00,000 for 3 months. X got the bill discounted 4.1.2020 at 12%
rate. The amount of discount on bill will be:
(a) ` 15,000 (b) ` 16,000 (c) ` 18,000
9. Mr. Jay draws a bill on Mr. John for ` 3,00,000 on 1.1.2020 for 3 months. On 4.2.2020, John got the bill
discounted at 12% rate. The amount of discount will be:
(a) ` 9,000 (b) ` 6,000 (c) ` 3,000
10. XZ draws a bill on YZ for ` 2,00,000 for 3 months on 1.1.2020. The bill is discounted with banker at a
charge of `1,000. At maturity the bill return dishonoured. In the books of XZ, for dishonour, the bank
account will be credited by:
(a) `199,000 (b) ` 200,000 (c) ` 201,000
11. On 1.1.2020, XA draws a bill on YB for ` 1,00,000. At maturity YB request XA to renew the bill for 2
month at 12% p.a. interest. Amount of interest will be:
(a) ` 2,000 (b) ` 1,500 (c) ` 1,800
12. A bill of exchange is drawn by a
(a) Creditor (b) Debtor (c) Debenture holder
13. At the time of drawing a bill, the drawer credits
(a) Bills Receivables A/c (b) Bills Payable A/c (c) Debtor’s A/c
14. A promissory note is made by a
(a) Seller (b) Purchaser (c) Endorsee
15. A bill of exchange contains
(a) An unconditional order (b) A promise
(c) A request to deliver the goods

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27 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.27

16. A promissory note contains

(a) An unconditional order (b) A promise
(c) A request to deliver the goods
17. The rebate on the bill shows that
(a) It has been endorsed (b) It has been paid after the date of maturity
(c) It has been paid before the date of maturity
18. Notary Public may charge his fee from the
(a) Holder of bill of exchange (b) Drawer (c) None

Theory Questions
1. Write short notes on:
(a) Accommodation bill.
(b) Renewal of bill.
(c) Noting charges.
2. What is bill of exchange? How does it differ from Promissory Note?

Practical Questions
1. On 1st January, 2020, A sells goods for `10,000 to B and draws a bill at three months for the amount.
B accepts it and returns it to A. On 1st March, 2020, B retires his acceptance under rebate of 12% per
annum. Record these transactions in the journals of B.
2. A draws upon B three Bills of Exchange of ` 3,000, ` 2,000 and ` 1,000 respectively. A week later his
first bill was mutually cancelled, B agreeing to pay 50% of the amount in cash immediately and for the
balance plus interest `100, he accepted a fresh Bill drawn by A. This new bill was endorsed to C who
discounted the same with his bankers for `1,500. The second bill was discounted by A at 5%. This bill
on maturity was returned dishonoured (nothing charge being `30). The third bill was retained till maturity
when it was duly met.
Give the necessary journal entries recording the above transactions in the books of A.
3. Journalize the following in the books of Don:
(i) Bob informs Don that Ray’s acceptance for ` 3,000 has been dishonoured and noting charges
are ` 40. Bob accepts ` 1,000 cash and the balance as bill at three months at interest of 10%.
Don accepts from Ray his acceptance at two months plus interest @ 12% p.a.
(ii) James owes Don ` 3,200; he sends Don’s own acceptance in favour of Ralph for ` 3,160; in
full settlement.
(iii) Don meets his acceptance in favour of Singh for ` 4,500 by endorsing John’s acceptance for
` 4,450 in full settlement.

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6.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iv) Ray’s acceptance in favour of Don retired one month before due date, interest is taken at the
rate of 6% p.a.

ANSWERS/HINTS
True and False
1. False: The bills payable account is a personal account that represents a liability.
2. False: Bill of exchange contains an order to pay the required amount and not a mere promise to pay .
3. False: 3 Days of grace are added to the due date to arrive at the maturity date.
4. False: There can be more than 2 parties- namely the drawer, acceptor and the payee of the bill.
5. True: When a bill is drawn in the country and is payable outside the country it is termed as a foreign bill .
6. True: In case of the promissory note, it is generally the maker who makes the payment, but in case of
the bill of exchange, the person accepting the bill shall be liable to make the payment to the holder of
the bill.

Multiple Choice Questions

1. (c) 2. (b) 3. (a) 4. (c) 5. (c) 6. (b)
7. (c) 8. (a) 9. (b) 10. (b) 11. (a) 12. (a)
13. (c) 14. (b) 15. (a) 16. (b) 17. (c) 18. (a)

Theoretical Questions
1. (a) Bills of Exchange are usually drawn to facilitate trade transmission, that is, bills are meant to
finance actual purchase and sale of goods. But the mechanism of bill can be utilised to raise
finance also. When bills are used for such a purpose, they are known as accommodation bills.
(b) When the acceptor of a bill finds himself in financial straits to honour the bill on the due date,
then he may request the drawer to cancel the original bill and draw on him a fresh bill for another
period. And if the drawer agrees, a new bill in place of the original bill may be accepted by the
drawee for another period. This is called the renewal of bill.
(c) The charges paid to Notary public for notify the dishonour are noting charges. Refer para 1.12
for details.
2. A bill of exchange has been defined as “an instrument in writing containing an unconditional order signed
by the maker directing a certain person to pay a certain sum of money only to or to the order of certain
person or to the bearer of the instrument”. When such an order is accepted by the drawee, it becomes
a valid bill of exchange. A promissory note is an instrument in writing (not being a bank note or a
government currency note) containing an unconditional undertaking, signed by the maker, to pay a
certain sum of money only to, or to the order of, a certain person, or to the bearer of the instrument.
A promissory note needs no acceptance, as the debtor himself writes the document promising to pay
the stated amount. Like bills of exchange, promissory notes are also negotiable instrum ents, and can be
transferred by endorsement. In case of bill of exchange, the drawer and the payee may be the same
person but in case of a promissory note, the maker and the payee cannot be the same person.

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29 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.29

Practical Questions
Answer 1
Journal Entries in the books of B
Date Particulars Debit Credit
2020 ` `
Jan. 1 Purchases account Dr. 10,000
To A’s account 10,000
(Being the goods purchased from A on credit)
A’s account Dr. 10,000
To Bills payable account 10,000
(Being the acceptance of bill given to A)
1-Mar Bills payable account Dr. 10,000
To Bank account 9,900
To Rebate on bills account 100
(Being the bill discharged under rebate @ 12% p.a.)

Working Note :
Calculation of rebate:
` 10,000 x 12/100 x 1/12 = ` 100
Answer 2
Journal of A
` `
Bills Receivable A/c Dr. 6,000
To B 6,000
(Three bills for `3,000, `2,000 and `1,000 drawn on B and duly accepted
by him received)
B Dr. 3,000
To Bills Receivable A/c 3,000
(Bill received from B cancelled for renewal)
Cash Account Dr. 1,500
Bill Receivable Account Dr. 1,600
To B 3,000
To Interest Account 100
(Amount received on cancellation of the first bill,50% along with a new bill
for 50% of the amount plus interest `100)

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6.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

C Dr. 1,600
To Bills Receivable A/c 1,600
(A’s acceptance endorsed in favour of C)
Bank A/c Dr. 1,900
Discount A/c Dr. 100
To Bills Receivable A/c 2,000
(Second Bill for ` 2,000 discounted with the bank @ 5%)
B Dr. 2,030
To Bank A/c 2,030
(Second Bill for ` 2,000 discounted with the Bank dishonoured, noting
charges ` 30 paid by the Bank)
Bank A/c Dr. 1,000
To Bills Receivable A/c 1,000
(Amount received on maturity of the third bill)

Note: It is assumed that the bill for `1,600 has not yet fallen due for payment.
Answer 3
Books of Don
` `
(i)(a) Ray Dr. 3,040
To Bob 3,040
(Ray’s acceptance endorsed to Bob dishonoured on due date
nothing charges paid by Bob `40)
(b) Bob Dr. 3,040
Interest Dr. 51
To Cash 1,000
To Bills Payable A/c 2,091
(Amount payable to Bob ` 3,040 settled by cash payment
` 1,000 and issue of new bill for ` 2,091 including interest ` 51 for
three months on ` 2,040 @ 10% p.a.)
(c) Bills Receivable A/c Dr. 3,100.80
To Ray 3,040.00
To Interest 60.8
(Bill received from Ray for `3,040due against earlier acceptance
dishonoured plus ` 60.80 interest for two months @ 12% p.a.)
(ii) Bills Payable A/c Dr. 3,160

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31 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.31

Discount A/c Dr. 40

To James 3,200
(Cancellation of bills payable to Ralph for `3,160 in settlement of
`3,200 due from James)
(iii) Bills payable A/c Dr. 4,500
To Bills Receivable A/c 4,450
To Discount A/c 50
(Settlement of acceptance issued to Mr. Singh by endorsement of
John’s Acceptance for `4,450)
(iv) Bank A/c Dr. 3,085.30
Discount A/c Dr. 15.5
Total Bills Receivable A/c 3,100.80
(Amount received from Ray in settlement of Bills Payable, retired
one month before due date)

© The Institute of Chartered Accountants of India

6.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT – 2 SALE OF GOODS ON APPROVAL OR RETURN BASIS

LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand the nature of goods sent on approval or return basis.
 Learn the accounting treatment of sales on approval or return basis under different situations.

UNIT OVERVIEW

2.1 INTRODUCTION
Under normal course of business, goods sold to customers is treated as sale immediately when the goods are
sold, with corresponding revenue from such sale being recognized in the profit and loss account. However, when
a businessman wants to increase his sales or introduce a new product in the market, he usually faces hardship
due to competition prevailing in the market. To counter it, goods are sometimes sent to the customers on sale or
return basis. Here, goods sent on ‘approval’ or ‘on return’ basis means goods are delivered to the customers with
the option to retain or return them within a specified period. Generally, these transactions take place between a
manufacturer (or a wholesaler) and a retailer. In current scenario, this practice is prevalent in case of online

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33 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.33

sales, where the buyer is given time of few days to return the goods if the buyer believes that the specifications
of goods are different from the same mentioned on website at the time of sale. There may be certain terms and
conditions to administrate the return of goods. Following are essentially the features of sale of goods on approval
or return basis:
(a) There is a change in the possession of goods from one person to another.
(b) It does not involve transfer of ownership of goods. The ownership is passed only when the buyer gives
his approval or if the goods are not returned within that specified period.
(c) The customer does not incur any liability when the goods are merely sent to him. In case of online
transactions, sometimes customers are given choice to pay on receipt of goods and in some cases they
are required to pay in advance and then seller ships the goods to buyer. Even in case the buyer has
paid in advance, it retains the right of refund if the goods are returned as per the terms and conditions
agreed between seller and buyer.
As per the definition given under the Sale of Goods Act, 1930, in respect of such goods, the sale will take place
or the property in the goods pass to the buyer under any of the following conditions is satisfied:
(i) When he signifies his approval or acceptance to the seller;
(ii) When he does some act adopting the transaction;
(iii) If he does not signify his approval or acceptance to the seller but retains the goods without giving notice
of rejection, on the expiry of the specified time (if a time has been fixed) or on the expiry of a reasonable
time (if no time has been fixed).

2.2 ACCOUNTING RECORDS

Accounting entries depend on the fact whether the business sends goods on sale or return basis (i) casually; (ii)
frequently; and (iii) numerously.

2.2.1 WHEN THE BUSINESS SENDS GOODS CASUALLY ON SALE OR RETURN

BASIS
When the transactions are few, the seller on sending the goods, treats them as an ordinary sale. If the goods are
accepted or not returned or the business receives no intimation within the specified time limit, no extra entry is
required to be passed because the entry for sale (passed at the time of sending goods) becomes the usual entry
after the expiry of the specified period. If the goods are returned within a specified time limit, a reverse entry is
passed to cancel the previous transaction. If, at the year-end, goods are still lying with the customers and the
specified time limit is yet to expire, the entry for sales made earlier is cancelled and the value of the goods lying
with the customers must be reduced from the selling price to the cost price, and treated as part of closing
inventories for Balance Sheet purposes.
Journal Entries:
1. When goods are sent on sale or return basis:
Trade receivables / Customers Account Dr. [Invoice price]
To Sales Account

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6.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. When goods are rejected or returned within the specified time:

Sales/Return Inwards Account Dr. [Invoice price]
To Customers/Trade receivables Account
3. When goods are accepted at invoice price:
[No entry]
4. When goods are accepted at a higher price than invoice price:
Trade receivables / Customers Account Dr.
To Sales Account [Difference in price]
5. When goods are accepted at a lower price than the invoice price:
Sales Account Dr.
To Trade receivables / Customers Account [Difference in price]
6. (i) At the year-end, when goods are lying with customers and the specified time limit is yet to expire:
Sales Account Dr. [Invoice price]
To Trade receivables / Customers Account
(ii) These goods should be considered as Inventories with customers and in addition to the above,
the following adjustment entry is to be passed:
Inventories with Customers on Sale or Return Account Dr.
To Trading Account [Cost price or market price
whichever is less]
No entry is to be passed for goods returned by the customers on a subsequent date.

ILLUSTRATION 1

CE sends goods to his customers on Sale or Return basis. The following transactions took place during 2019:
Sept. 15 Sent goods to customers on sale or return basis at cost plus 33 1/3 % ` 1,00,000
Oct. 20 Goods returned by customers ` 40,000
Nov. 25 Received letters of approval from customers ` 40,000
Dec . 31 Goods with customers awaiting approval ` 20,000

CE records sale or return transactions as ordinary sales. You are required to pass the necessary Journal Entries
in the books of CE assuming that accounting year closes on 31st December, 2019.

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35 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.35

SOLUTION

In the books of CE
Journal Entries
Date Particulars L.F. Dr. (in `) Cr. (in `)
2019
Sept. 15 Trade receivables A/c Dr. 1,00,000
To Sales A/c 1,00,000
(Being the goods sent to customers on sale or return basis)
Oct. 20 Return Inward A/c (Note 1) Dr. 40,000
To Trade receivables A/c 40,000
(Being the goods returned by customers to whom goods
were sent on sale or return basis)
Dec. 31 Sales A/c Dr. 20,000
To Trade receivables A/c 20,000
(Being the cancellation of original entry of sale in respect
of goods on sale or return basis)
Dec. 31 Inventories with customers on Sale or Return A/c Dr. 15,000
To Trading A/c (Note 3) 15,000
(Being the adjustment for cost of goods lying with
customers awaiting approval)

Note: (1) Alternatively, Sales account can be debited in place of Return Inwards account.
(2) No entry is required for receiving letter of approval from customer.

(3) Cost of goods with customers = ` 20,000×100 = `15,000

133.33
ILLUSTRATION 2

Amit runs an online store where in the goods are casually sold on sale on approval basis, the following is the
information provided to you during 2020:
Date Particulars Amt (in `)
10th Feb Sale on approval basis- 25% on cost 1,20,000 (cost)
20th Feb Goods returned by customers 80,000
15th March Goods for which approval given by customers 40,000
31st March Goods with customers awaiting approval 30,000
All the above goods are sold ordinarily in the course of the online business. Considering that he closes his books
on 31st March 2020, you are required to pass entries in the books of Amit, to record the above transactions.

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6.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

Note- Additionally it has been provided that on 15th April 2020, the customers have rejected the goods for which
approval has been pending on 31st March, deal with the same accordingly.

SOLUTION

In the books of Amit

Journal Entries
Date Particulars L.F. Dr. (in ` ) Cr. (in ` )
10/2/2020 Trade receivables A/c Dr. 1,50,000
To Sales A/c 1,50,000
(Being the goods sent to customers on sale or return
basis)
Note- 1,20,000 x 25% =30,000
Sales price = 1,20,000+30,000 = 1,50,000
20/2/2020 Sales A/c Dr. 80,000
To Trade receivables A/c 80,000
(Being the goods returned by customers to whom
goods were sent on sale or return basis)
15/3/2020 There is no entry to be passed- since we have initially recorded it as sales, so when the
customer approves it, no entry to be passed once again
31/3/2020 Sales A/c Dr. 30,000
To Trade receivables A/c 30,000
(Being the cancellation of original entry of sale in
respect of goods on sale or return basis)
31/3/2020 Inventories with customers on Sale or Return A/c Dr. 24,000
To Trading A/c 24,000
(Being the adjustment for cost of goods lying with
customers awaiting approval)
Note- 30,000 x 20% = 6,000
Cost price = 30,000-6,000 = 24,000
15/4/2020 There is no need to pass the entry for the return of the goods as they have already been
reversed as on 31st March 2020.

ILLUSTRATION 3

Mr. Kumar sells goods on approval or return basis casually. He has sold goods worth ` 1,50,000, (sold at a profit
of 33 1/3% on sale) which has been awaiting approval from the customers as on the date of closing the books.
After the expiry of the period, the customers have accepted goods equivalent to 75% of the cost of the goods
and the rest considered to be rejected.
You are required to show the necessary journal entries as on the date of closing the books and the entries after
the expiry of the period and the treatment of the goods.

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37 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.37

SOLUTION

In the books of Kumar

Journal Entries

Date Particulars L.F. Dr. (in ` ) Cr. (in ` )

Closing date Sales A/c Dr. 1,50,000

To Trade receivables A/c 1,50,000

(Being the cancellation of original entry of sale in

respect of goods on sale or return basis)
Inventories with customers on Sale or Return A/c Dr. 1,00,000

To Trading A/c 1,00,000

(Being the adjustment for cost of goods lying with

customers awaiting approval)
Note- 1,50,000 x 1/3= 50,000
Cost price = 1,50,000-50,000 = 1,00,000
On expiry of Trade receivables A/c Dr. 1,12,500

approval period To Sales A/c 1,12,500

(Being the goods equal to 75% of the cost of goods

sent on approval basis, with the remaining being
rejected)
Note: 1,50,000 x 75% = 1,12,500 (accepted)
1,50,000 -1,12,500 = 37,500 (rejected)
There is no need to pass the entry for the return of the goods as they have already been
reversed as on the closing date.

ILLUSTRATION 4

S. Ltd. sends out its goods to dealers on Sale or Return basis. All such transactions are, however, treated as
actual sales and are passed through the Day Book. Just before the end of the accounting year on 31.03.2020,
200 such goods have been sent to a dealer at ` 250 each (cost ` 200 each) on sale or return basis and debited
to his account. Of these goods, on 31.03.2020, 50 were returned and 70 were sold while for the other goods,
date of return has not yet expired.

Pass necessary adjustment entries on 31.03.2020.

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6.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

In the books of S. Ltd.

Journal Entries
Date Particulars L.F. ` `
2020
March 31 Return Inwards A/c (` 250 X 50) Dr. 12,500
To Trade receivables A/c 12,500
(Being the adjustment for 50 units of goods returned by
customers to whom goods were sent on sale or return basis)
March 31 Sales A/c (` 250 X 80) (Note 1) Dr. 20,000
To Trade receivables A/c 20,000
(Being the cancellation of original entry for sale in respect
of 80 units of goods not yet returned or approved by
customers)
March 31 Inventories with Customers on Sale or Return A/c Dr. 16,000
To Trading A/c 16,000
(Being the cost of goods sent to customers on approval or
return basis not yet approved, adjusted)

Note: (1) Quantity of goods lying with dealer as on 31.3.2020 = 200 – 50 – 70 = 80

ILLUSTRATION 5

Caly Company sends out its gas containers to dealers on Sale or Return basis. All such transactions are,
however, treated as actual sales and are passed through the Day Book. Just before the end of the financial year,
100 gas containers, which cost them ` 900 each have been sent to the dealer on ‘sale or return basis’ and have
been debited to his account at `1,200 each. Out of this only 20 gas containers are sold at `1,500 each.
You are required to pass necessary adjustment entries for the purpose of Profit and Loss Account and Balance
Sheet.

SOLUTION

In the books of Caly Company

Journal Entries
Date Particulars L.F. ` `
Trade receivables A/c Dr. 6,000
To Sales A/c 6,000
(Being the adjustment for excess price of 20 gas containers
@ 300 each)

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39 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.39

Sales A/c Dr. 96,000

To Trade receivables A/c 96,000
(Being the cancellation of original entry for sale in respect of
80 gas containers @ ` 1,200 each)
Inventories with Customers on Sale or Return A/c Dr. 72,000
To Trading A/c 72,000
(Being the adjustment for cost of 80 gas container lying with
customers awaiting approval)

ILLUSTRATION 6

E Ltd. sends out its accounting machines costing ` 200 each to their customers on Sales or Return basis. All
such transactions are, however, treated like actual sales and are passed through the Day Book. Just before the
end of the financial year, i.e., on March 24, 2020, 300 such accounting machines were sent out at an invoice
price of ` 280 each, out of which only 90 accounting machines are accepted by the customers ` 250 each and
as to the rest no report is forthcoming. Show the Journal Entries in the books of the company for the purpose of
preparing Final Accounts for the year ended March 31, 2020.

SOLUTION

In the books of E Ltd.

Journal Entries
Date Particulars L.F. ` `
2020
Mar, 31 Sales A/cs (` 30x90) Dr. 2,700
To Trade receivables A/c 2,700
(Being the adjustment. for reduction in the selling price of 90
accounting machines @ ` 30 each)
Mar, 31 Sales A/c (` 280 x 210) Dr. 58,800
To Trade Receivables A/c 58,800
(Being the cancellation of original entry for sale in respect of
210 accounting machines sent to customers not yet returned
or approved)
Inventories with customers on Sale or Return A/c Dr. 42,000
To Trading A/c 42,000
(Being the cost of 210 accounting machines @ `200 each
adjusted against Trading Account)

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6.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 7

A sends out goods on approval to few customers and includes the same in the Sales Account. On 31.3.2020, the
Trade receivables balance stood at `1,00,000 which included `7,000 goods sent on approval against which no
intimation was received during the year. These goods were sent out at 25% over and above cost price and were
sent to - Mr. X - ` 4,000 and Mr. Y - ` 3,000.
Mr. X sent intimation of acceptance on 30th April and Mr. Y returned the goods on 10th April, 2020.
Make the adjustment entries and show how these items will appear in the Balance Sheet on 31st March, 2020.
Show also the entries to be made during April, 2020. Value of closing Inventories as on 31st March, 2020 was
`60,000.

SOLUTION

In the Books of A
Journal Entries
Date Particulars L.F. ` `
2020 Sales A/c Dr. 7,000
Mar, 31 To Trade receivables A/c 7,000
(Being the cancellation of original entry for sale in respect
of goods lying with customers awaiting approval)
Mar,31 Inventories with Customers on Sale or Return A/c Dr. 5,600
To Trading A/c (Note 1) 5,600
(Being the adjustment for cost of goods lying with
customers awaiting approval)
April,30 Trade receivables A/c Dr. 4,000
To Sales A/c 4,000
(Being goods costing ` 3,200 sent to Mr. X on sale or
return basis has been accepted by him)

Balance Sheet of A & Co. as on 31st March, 2020 (Extracts)

Liabilities ` Assets ` `
Trade receivables (`1,00,000 - ` 7,000) 93,000
Inventories-in-trade 60,000
Add: Inventories with customers on Sale or Return 5,600 65,600
1,58,600
Notes:
(1) Cost of goods lying with customers = 100/125 x ` 7,000 = ` 5,600
(2) No entry is required on 10th April, 2020 for goods returned by Mr. Y. Goods should be included physically
in the Inventories-in-trade.

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41 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.41

2.2.2 WHEN THE BUSINESS SENDS GOODS FREQUENTLY ON SALE OR RETURN

BASIS
When a business sends goods on sale or return on a frequent basis, an immediate sale does not take place. Only
when the customer signifies his intention to purchase the goods or takes some action whereby it is indicated that
he has decided to purchase the goods, the property in the goods passes to the buyer. So long as the property
does not pass to the buyer, the seller does not record it as a sale and, therefore, does not debit the customer
with the sales price.
Under this method, record of goods sent is maintained in a specially ruled Sale or Return Journal / Day Book
instead of passing entry for sale of goods. This Day Book is divided into 4 main columns - (1) Goods sent on
Approval; (2) Goods Returned: (3) Goods Approved; and (4) Balance.

Goods sent on approval Goods returned Goods approved Balance

1 2 3 4 5 6 7 8 9 10 11 12 13
Date Particulars Fol. Amt. Date Particulars Fol. Amt. Date Particulars Fol. Amt. Amt.

When such a Journal is kept the following procedure is adopted for recording transactions entered into on this
basis:
 When goods are sent out for sale on approval, entries are made only in column 1 to 4, the sale price of
goods being entered in column 4. The sale price is also posted to the debit of the customers’ account in
‘Goods on Approval Ledger’, and periodically total of column 4 is posted to the credit of Goods on
Approval Total Account in the same ledger.
 If goods are returned, entries are made in columns 5 to 8, the price of goods returned being entered to
column 8. The individual amounts are credited to the Customers’ Accounts, in the ‘Goods on Approval’
Ledger and the total of this column in periodically posted to the Total Goods on Approval Account.
 If the goods are retained by the customer, entries are made in columns 9 to 12. The individual amounts
are then posted to the debit of customer’s accounts in the Sales Ledger and their total is credited to
Sales Account in the General Ledger. Further the customer’s accounts in the Goods on Approval Ledger
are credited with the individual amounts of goods sold and periodically, the total of the amount is posted
to the debit of Goods on Approval Total Account.
 The value of goods sent out but not sold or returned till the close of the year is extended to column 13.
The total of this column, afterwards, will show the value of goods with customers at the sale price.
The balance amount is calculated as follows:
Balance Value of Goods Sent on Sale or Return – Value of Goods Returned – Value of Goods Approved.
Information relating to goods delivered and goods returned is kept on Memorandum basis.

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6.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

However, information relating to goods approved and balance is duly accounted for by passing journal entries
relating to sales and Inventories on approval basis.
The amount, after eliminating the element of profit, is included in the Trading Account representing the value of
Inventories with customers at cost price. Like an ordinary closing Inventories, such goods are considered as
Inventories lying with customers on behalf of seller and are valued at cost or net realisable value whichever is
less.
(i) At the time of approval
Customer’s A/c Dr.
To Sales A/c
(ii) At the time of preparing of Final Accounts
An adjustment entry is required for balance goods which is as follow:
Goods with Customers on Sale or Return Account Dr. [Cost or net realisable value
To Trading Account whichever is less]

2.2.3 WHEN THE BUSINESS SENDS GOODS NUMEROUSLY ON SALE OR RETURN

When transactions are numerous, a business maintains the following books: (a) Sale or Return Day Book; and
(b) Sale or Return Ledger. ‘Ledger’ contains the accounts of the customers and the ‘Sale or Return’ Total account.
‘Day Book’ is the primary book which records all transactions, and from there these are entered in the ‘Sale or
Return’ Total account. It is important to remember that both are Memorandum Books, i.e., these records are
not a part of regular books of accounts.
Following procedure is adopted for recording transactions under this method:
 When goods are sent to the customers on a sale or return basis, they are first recorded in the Sale or
Return day Book. Thereafter, in the Sale or Return Ledger, all the customers are individually debited
and the Sale or Return Account is credited with the periodical total of the Sale or Return Day Book.
 When the goods are returned by the customers within the specified time, they are recorded initially in
the Sale or Return Day Book. Thereafter, in the Sale or Return Ledger, the Sale or Return Account is
debited with the periodical total of the Sale or Return Day Book and the individual customers are credited.
The above mentioned records are all memorandum and hence cannot find a place in the regular books.
 When the business receives information about the acceptance of the goods or no intimation is received
within the specified time, they are recognised as sales and are recorded in the Sales Day Book.
Periodically, the total of the Sales Day Book is credited to Sales Account and debited to the Individual
Customers Account. To cancel the earlier entries, individual customers are credited and the Sale or
Return Account is debited.
The entries for the approved goods are shown below:
In the Memorandum Sale or Return Ledger In the regular General ledger
Sale or Return Account Dr. Individual Customer’s Account Dr.
To Individual Customer’s Account To Sales Account

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43 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.43

 At the year end, in the Sale or return Ledger, the sum of the debit balances of the Individual Customers’
Account must be equal to the credit balance of the Sale or return Account. It represents Inventories with
customers waiting for approval at invoice price. To adjust the cost of such goods with customers in the
Final Accounts, the following entry is passed:
Inventories with Customers on Sale or Return Account Dr. [Cost or net realisable
To Trading Account value whichever is less]
In short, under this method, entries are passed in the regular books of account only at the time of sale or a year
end, if inventory is still lying with customers (pending approval).

SUMMARY
• As per the definition given under the Sale of Goods Act, 1930, in respect of such goods, the sale will
take place or the property in the goods pass to the buyer:
(i) When he signifies his approval or acceptance to the seller;
(ii) When he does some act adopting the transaction;
(iii) If he does not signify his approval or acceptance to the seller but retains the goods without
giving notice of rejection, on the expiry of the specified time (if a time has been fixed) or on the
expiry of a reasonable time
• Accounting entries depend on the fact whether the business sends goods on sale or approval basis (i)
casually; (ii) frequently; and (iii) numerously.

TEST YOUR KNOWLEDGE

True and False
1. Goods sold on approval or return basis are not recorded as credit sales initially when they are sent out
in case the business entity sell goods casually on sale on return basis.
2. The customer retains the goods even after the expiry of the mentioned term, but this act does not confirm
to sale of goods as there is no express consent given.
3. At the end of the year- those goods on approval basis awaiting approval from the customer are shown
as part of sales in the books of the seller.
4. No entry needs to be passed in the books of the seller, when the customer rejects the goods (awaiting
approval) after the closing of the books of the seller.
5. The period within which the customer has to reject or accept is fixed by the buyer.

Multiple Choice Questions

1. When a large number of articles are sent frequently on a sale or return basis, it is necessary to maintain
(a) Sale journal (b) Goods returned journal (c) Sale or return journal
2. Sale or Return Day Book and Sale or Return Ledger are known as
(a) principal books (b) subsidiary books (c) memorandum books

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6.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. A sent some goods costing ` 3,500 at a profit of 25% on sale to B on sale or return basis. B returned
goods costing ` 800. At the end of the accounting period i.e. on 31st December, 2020, the remaining
goods were neither returned nor were approved by him. The Inventories on approval will be shown in
the balance sheet at `
(a) 2,000. (b) 2,700 (c) 2,700 less 25% of 2,700.
4. A merchant sends out his goods casually to his dealers on approval basis. All such transactions are,
however, recorded as actual sales and are passed through the sales book. On 31-12-2020, it was found
that 100 articles at a sale price of 200 each sent on approval basis were recorded as actual sales at that
price. The sale price was made at cost plus 25%. The amount of Inventories on approval will be
amounting
(a) ` 16,000. (b) ` 20,000. (c) ` 15,000.
5. Umesh sends goods on approval basis as follows:
Date Customer’s Name Sale price of Goods Goods
January, 2020 Goods Sent Accepted Returned
` ` `
8 Anna 3,500 3,000 500
10 Babu 2,800 2,800 –
15 Chandra 3,680 – 3,680
22 Desai 1,260 1,000 260

The Inventories of goods sent on approval basis on 31st January will be

(a) ` 500. (b) Nil. (c) ` 260.
6. A company sends its cars to dealers on ‘sale or return’ basis. All such transactions are however treated
like actual sales and are passed through the sales day book. Just before the end of the financial year,
two cars which had cost ` 55,000 each have been sent on ‘sale or return’ and have been debited to
customers at ` 75,000 each, cost of goods lying with the customers will be
(a) ` 1,10,000. (b) ` 55,000. (c) ` 75,000.
7. A trader has credited certain items of sales on approval aggregating ` 60,000 to Sales Account. Of
these, goods of the value of `16,000 have been returned and taken into Inventories at cost ` 8,000
though the record of return was omitted in the accounts. In respect of another parcel of `12,000 (cost
being ` 6,000) the period of approval did not expire on the closing date. Cost of goods lying with
customers should be
(a) ` 12,000. (b) ` 54,000. (c) ` 6,000.
8. Under sales on return or approval basis, the ownership of goods is passed only
(a) when the retailer gives his approval
(b) if the goods are not returned within specified period.
(c) Both (a) and (b)

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45 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.45

9. Under sales on return or approval basis, when transactions are few, the seller, while sending the goods,
treats them as
(a) an ordinary sale but no entry is passed in the books
(b) an ordinary sale and entry for normal sale is passed in the books
(c) Approval sale and no entry is passed
10. Under sales on return or approval basis, when transactions are few and the seller at the end of the
accounting year reverse the sale entry, then what will be the accounting treatment for the goods returned
by the customers on a subsequent date?
(a) No entry will be passed for such return of goods
(b) Entry for return of goods is passed by the seller
(c) Only the Inventories account will be adjusted

Theory Questions
1. What are the features of sale of goods on approval or return basis? Explain in brief.
2. When ‘sale or return basis’ transactions are numerous, what books are maintained by the business
entity.

Practical Questions
1. A firm sends goods on sale or return basis. Customers having the choice of returning the goods within
a month. During May 2020, the following are the details of goods sent:
Date (May) 2 8 12 18 20 27
Customers P B Q D E R
Value (`) 15,000 20,000 28,000 3,000 1,000 26,000

Within the stipulated time, P and Q returned the goods and B, D, and E signified that they have accepted
the goods.
Show in the books of the firm, the Sale or Return Account and Customer- P for Sale or Return Account
on 15th June, 2020.
2. On 31st December, 2020 goods sold at a sale price of ` 3,000 were lying with customer, Ritu to whom
these goods were sold on ‘sale or return basis’ were recorded as actual sales. Since no consent has
been received from Ritu, you are required to pass adjustment entries presuming goods were sent on
approval at a profit of cost plus 20%. Present market price is 10% less than the cost price.
3. X supplied goods on sale or return basis to customers, the particulars of which are as under.
Date of dispatch Party’s name Amount Remarks
`
10.12.2019 M/s. ABC 10,000 No information till 31.12.2019
12.12.2019 M/s. DEF 15,000 Returned on 16.12.2019

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6.46 PRINCIPLES AND PRACTICE OF ACCOUNTING

15.12.2019 M/s. GHI 12,000 Goods worth ` 2,000 returned on 20.12.2019

20.12.2019 M/s. DEF 16,000 Goods Retained on 24.12.2019
25.12.2019 M/s. ABC 11,000 Good Retained on 28.12.2019
30.12.2019 M/s. GHI 13,000 No information till 31.12.2019
Goods are to be returned within 15 days from the dispatch, failing which it will be treated as sales. The
books of ‘X’ are closed on the 31st December, 2020.
Prepare the following accounts in the books of ‘X’.
(a) Goods on “sales or return, sold and returned day books”.
(b) Goods on sales or return total account.

ANSWERS/HINTS
True and False
1. False: They are recorded as sales irrespective of whether the customer might accept or reject the goods
at the end of the period given for the approval in the given case.
2. False: As per the Sale of goods Act, when the goods are retained by the customer after the given time
and no express intimation is given with regard to rejection- they are deemed sales.
3. False: At the end of the accounting period- if there are goods sold on approval or return basis, without
any information, then the accounting treatment is to reverse the same from the sales and to add it with
the existing closing stock at cost price.
4. True: At the end, already the entries pertaining to the reversal of the sale and the addition to the closing
stock would have already been passed. If subsequently the customer rejects the goods, no further entry
needs to be passed
5. False: It is the seller who fixes the terms of the period within which the customer has to get back with
the answer of rejection or accepting the goods. In some cases, mutual consent is there.

Multiple Choice Questions

1. (c) 2. (c) 3. (b) 4. (a) 5. (b) 6. (a)
7. (c) 8. (c) 9. (b) 10. (a)

Theoretical Questions
1. Features of sale of goods on approval or return basis: (i) There is a change in the possession of goods from
one person to another. (ii) It does not involve transfer of ownership of goods. The ownership is passed only
when the retailer gives his approval or if the goods are not returned within that specified period. (iii) The retailer
(customer) does not incur any liability when the goods are merely sent to him.
2. When transactions are numerous, a business maintains the following books: (a) Sale or Return Day Book; and
(b) Sale or Return Ledger. ‘Ledger’ contains the accounts of the customers and the ‘Sale or Return’ Total
account. ‘Day Book’ is the primary book which records all transactions, and from there these are entered in the

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47 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.47

‘Sale or Return’ Total account. It is important to remember that both are Memorandum Books, i.e., these
records are not a part of regular books of accounts.

Practical Questions
Answer 1
Sale or Return Account
Date Particulars ` Date Particulars `
2020 2020
31-May To Sundries: Sales 24,000 31-May By Sundries
15-Jun To Sundries: Returned 43,000 (Goods sent on sale or
return basis) 93,000
15-Jun To Balance c/d 26,000
93,000 93,000
By Balance b/d 26,000

P’s Account
Date Particulars ` Date Particulars `
2020 2020
May 31 To Sale or Return A/c 15,000 May 31 By Sale or Return A/c 15,000

Answer 2

Journal Entries
Date Particulars ` `
2020
31st Dec. Sales A/c Dr. 3,000
To Ritu’s A/c 3,000
(Being cancellation of entry for sale of goods, not yet
approved)
Inventories with customers A/c (Refer W.N.) Dr. 2,250
To Trading A/c 2,250
(Being Inventories with customers recorded at market price)

Working Note:
Calculation of cost and market price of Inventories with customer
Sale price of goods sent on approval ` 3,000
Less: Profit (3,000 x 20/120) ` 500

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6.48 PRINCIPLES AND PRACTICE OF ACCOUNTING

Cost of goods ` 2,500

Market price = 2,500 - (2,500 x 10%) = ` 2,250.

Answer 3
In the books of ‘X’
Goods on sales or return, sold and returned day book.
Date Party to whom goods sent L.F Amount Date Sold Returned
2019 ` 2019 ` `
Dec.10 M/s. ABC 10,000 Dec. 25 10,000 -
Dec.12 M/s. DEF 15,000 Dec. 16 - 15,000
Dec.15 M/s. GHI 12,000 Dec. 20 10,000 2,000
Dec.20 M/s. DEF 16,000 Dec. 24 16,000 -
Dec.25 M/s. ABC 11,000 Dec. 28 11,000 -
Dec.30 M/s. GHI 13,000 -
77,000 47,000 17,000

Goods on Sales or Return Total Account

Date Particulars Amount Date Particulars Amount
` `
2019 2019
Dec. 31 To Returns 17,000 Dec. 31 By Goods sent on
To Sales 47,000 sales or return 77,000
To Balance c/d 13,000
77,000 77,000

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49 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.49

UNIT - 3 CONSIGNMENT
LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand the special features of consignment business, meaning of the terms consignor and
consignee.
 Analyse the difference between the two transactions – sale and consignment and understand that why
consignment is termed as special transaction.
 Practice the accounting treatments for consignment transactions and events in the books of consignor
and consignee.
 Note the variations in accounting when goods are sent at cost and goods are sent above the cost.
 Learn the technique of computing value of consignment inventory lying with the consignee and also the
amount of inventory reserve in it.
 Learn the technique of computing cost of abnormal loss and treatment of insurance claim in relation to
it.
 Understand the distinction between ordinary commission, del-credere commission and over-riding
commission paid to the consignee.
 See the variation of accounting treatment for bad debts when consignee is paid ordinary commission
and when consignee is paid del-credere commission in addition to it.
 Understand the reason of including/excluding various expenditures to cost while valuing the goods
returned by the consignee.

UNIT OVERVIEW

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6.50 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.1 MEANING OF CONSIGNMENT ACCOUNT

To consign means to send. In Accounting, the term “consignment account” relates to accounts dealing with a
situation where one person (or firm) sends goods to another person (or firm) on the basis that the goods will be
sold on behalf of and at the risk of the former. The following should be noted carefully:
(i) The party which sends the goods (consignor) is called principal.
(ii) The party to whom goods are sent (consignee) is called agent.
(iii) The ownership of the goods, i.e., the property in the goods, remains with the consignor or the principal
– the agent or the consignee does not become their owner even though goods are in his possession. On
sale, of course, the buyer will become the owner.
(iv) The consignor does not send an invoice to the consignee. He sends only a proforma invoice, a
statement that looks like an invoice but is really not one. The object of the proforma invoice is only to
convey information to the consignee regarding particulars of the goods sent.
(v) Usually, the consignee recovers from the consignor all expenses incurred by him on the consignment.
This however can be changed by agreement between the two parties.
(vi) It is also usual for the consignee to give an advance to the consignor in the form of cash or a bill of
exchange. It is adjusted against the sale proceeds of the goods.
(vii) For his work, the consignee receives a commission calculated on the basis of gross sale. For ordinary
commission the consignee is not responsible for any bad debt that may arise. If the agent is to be made
responsible for bad debts, he is to be paid a commission called del-credere commission. It is calculated
on total sales, not merely on credit sales until and unless agreed.
(viii) Periodically, the consignees ends to the consignor a statement called Account Sales. It sets out the
sales made by the consignee, the expenses incurred on behalf of the consignor, the commission earned
by the consignee and the balance due to the consignor.
(ix) Firms usually like to ascertain the profit or loss on each consignment or consignments to each consignee.
Consignment Account relates to accounts dealing with such business where one person sends goods to another
person on the basis that such goods will be sold on behalf of and at the risk of the former.

3.2 DISTINCTIONS
3.2.1 CONSIGNMENT AND SALE
S.No. Consignment Sale
1. Ownership of the goods rests with the consignor The ownership of the goods transfers with the
till the time they are sold by the consignee, no transfer of goods from the seller to the buyer.
matter the goods are transferred to the
consignee.
2. The consignee can return the unsold goods to Goods sold are the property of the buyer and
the consignor. can be returned only if the seller agrees.

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51 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.51

3. Consignor bears the loss of goods held with the It is the buyer who will bear the loss if any, after
consignee. the transfer of goods.
4. The relationship between the consignor and the The relationship between the seller and the
consignee is that of a principal and agent. buyer is that of a creditor and a debtor.
5. Expenses done by the consignee to receive the Expenses incurred by the buyer are to be borne
goods and to keep it safely are borne by the by the buyer itself after the transfer of goods.
consignor unless there is any other agreement.

3.2.2 DISTINCTION BETWEEN COMMISSION AND DISCOUNT

Commission Discount
Commission may be defined as remuneration of The term discount refers to any reduction or
an employee or agent relating to services rebate allowed and is used to express one of the
performed in connection with sales, purchases, following situations:
collections or other types of business An allowance given for the settlement of a debt
transactions and is usually based on a before it is due i.e. cash discount.
percentage of the amounts involved. An allowance given to the whole sellers or bulk
Commission earned is accounted for as an buyers on the list price or retail price, known as
income in the books of accounts, and trade discount. A trade discount is not shown in
commission allowed or paid is accounted for as the books of account separately and it is shown
an expense in the books of the party availing by way of deduction from cost of purchases.
such facility or service.

3.3 ACCOUNTING FOR CONSIGNMENT TRANSACTIONS AND

EVENTS IN THE BOOKS OF THE CONSIGNOR
For ascertaining profit or loss on any transaction (or series of transactions) there is one golden rule; open an
account for the transaction (or series of transactions) and (i) put down the cost of goods and other expenses
incurred or to be incurred on the debit side; and (ii) enter the sale proceeds as also the cost of goods remaining
unsold on the right hand side or the credit side. The difference between the total of the two sides will reveal profit
or loss. There is profit if the credit side is more.
The consignor often dispatches goods to various consignees and he would be interested to ascertain the profit
or loss from each consignment separately. Therefore, a separate consignment account has to be prepared for
each consignment. Each consignment account is a nominal-cum-personal account and constitutes a profit an
loss account in respect of the transactions to which it relates.
The consignor records the following transactions in his book of accounts:
1. When goods are consigned or dispatched: it is to be reiterated that when goods are sent to the
consignee, the transaction does not result in a sale and only the possession of the goods changes.
Therefore, the personal account of consignee is not debited and also sales account is not credited. The
following entry is recorded by the consignor:
Consignment (say to Star trading) Account Dr.
To Goods Sent on Consignment Account

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6.52 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. Expenses incurred by consignor: when consignor incurs some expenses relating to the consignment
following entry is recorded:
Consignment (say to Star trading) Account Dr.
To Supplier Account/Bank/Cash
Unlike normal practice to debiting expense accounts first and then transferring to profit and loss account,
expenses are directly debited to consignment account.
3. When advance is received from the consignee: The consignee may remit some advance to consignor.
The following entry is recorded:
Bank/Cash Account Dr.
To Consignee’s Personal Account
4. On receipt of account sales from the consignee: Account sales contains details of sales made by
consignee, expenses incurred by consignee. Following entries are recorded
For sales proceeds
Consignee’s Personal Account Dr.
To Consignment Account
For expenses incurred by consignee
Consignment Account Dr.
To Consignee’s Personal Account
5. Cash or cheque or bank draft or bill of exchange/promissory note received from the consignee as
settlement:
Cash/Bank/Bills Receivable Account Dr.
To Consignee’s Personal Account
6. For bad debts: The accounting entry for bad debts will depend on whether del-credere commission is
paid to the consignee
i. When del-credere commission is not paid to the consignee
Consignment Account Dr.
To Consignee’s Personal Account
ii. When del-credere commission is paid to the consignee
No entry is recorded as bad debts is to be borne by consignee.
7. For the goods taken over by the consignee
Consignee’s Personal Account Dr.
To Consignment Account

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53 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.53

8. For unsold consignment stock: In case some of the goods sent on consignment are still unsold at the
time of preparing final accounts, the unsold inventory is recorded as consignment stock with following
entry:
Consignment Stock Account Dr.
To Consignment Account
9. For commission payable to consignee
Consignment Account Dr.
To Consignee’s Personal Account
We shall illustrate the scheme of entries on the basis of the following information:

ILLUSTRATION 1

Exe sent on 1st July, 2019 to Wye goods costing ` 50,000 and spent ` 1,000 on packing etc. On 3rd July, 2019,
Wye received the goods and sent his acceptance to Exe for ` 30,000 payable at 3 months. Wye spent ` 2,000
on freight and cartage, ` 500 on godown rent and ` 300 on insurance. On 31st December, 2019 he sent his
Account Sales (along with the amount due to Exe) showing that 4/5 of the goods had been sold for ` 55,000.
Wye is entitled to a commission of 10%. One of the customers turned insolvent and could not pay ` 600 due from
him. Show the necessary journal entries in the books of consignor. Also prepare ledger accounts.

SOLUTION

Journal Entries in the books of Consignor

` `
1 Open Consignment Account and debit it with the cost of goods
and credit it with “Goods sent on Consignment Account”.
1/7/2019 Consignment to Wye A/c Dr. 50,000
To Goods Sent on Consignment A/c 50,000
2 For the expenses incurred by the consignor, debit Consignment
Account and credit cash or Bank, as the case may be.
1/7/2019 Consignment to Wye A/c Dr. 1,000
To Bank A/c 1,000
3 If the consignee sends an advance, debit Cash (or Bank) or Bills
Receivable and credit the consignee’s personal account
3/7/2019 Bills Receivable A/c Dr. 30,000
To Wye 30,000
(Note: Wye’s account has appeared only now, in the previous two
entries his account did not figure since he is not personally
involved)

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6.54 PRINCIPLES AND PRACTICE OF ACCOUNTING

4 Wye’s acceptance will mature on 6/10/2019

Assuming it was met, the entry will be:
6/10/2019 Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(Note: If such bill is discounted by consignor with the bank before
maturity, pass usual entry for discounting a bill. The discount on
bills may either be treated as consignment expenses and charged
to Consignment A/c or it may be treated as general financial
charges and charged to Profit & Loss Account)
5 On receipt of Account sale
31/12/2019 (a) For sales made by the consignee, debit his personal account
and credit Consignment Account
Wye Dr. 55,000
To Consignment to Wye A/c 55,000
(b) For expenses incurred by the consignee as well as bad debts
suffered by him on behalf of the consignor, debit
Consignment Account and credit Consignee Account
31/12/2019 Consignment to Wye A/c (2,000+500+300+600) Dr. 3,400
To Wye 3,400
(c) For commission due to the consignee, debit Consignment
Account and credit the consignee.
31/12/2019 Consignment to Wye A/c(10% on ` 55,000) 5,500
To Wye 5,500
(d) For the remittance that may accompany the Account Sales,
debit Bank and credit the consignee.
Bank A/c Dr. 16,100
To Wye 16,100
6 For the goods that may remain unsold debit the Consignment
Stock Account and credit Consignment Account.
31/12/2019 Inventories on Consignment A/c Dr. 10,600
To Consignment to Wye A/c 10,600
Note: (i) Cost of Inventories
1/5 of Cost to consignor ` 10,000
1/5 of expense incurred by the consignor ` 200
1/5 of freight (direct exp. Of consignee) ` 400
` 10,600

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55 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.55

(ii) Inventories on Consignment Account is an asset; it will be

shown in the balance sheet of the consignor and next year it
will be transferred to the debit of the Consignment Account.
7 At this stage the Consignment Account will reveal profit or loss
(see the account given below). The profit or loss will be transferred
to the Profit and Loss Account of the consignor by debit to the
Consignment Account.
31/12/2019 Consignment to Wye A/c Dr. 5,700
To Profit and Loss A/c 5,700
8 The Goods sent on Consignment Account should be closed by
transfer to the Trading Account debit the former and credit the
latter:
31/12/2019 Goods sent on Consignment Account Dr. 50,000
To Trading Account 50,000

Important Ledger Accounts

Consignment to Wye Account
2019 Particulars ` 2019 Particulars `
1-Jul To Goods sent on Dec. 31 By Wye-sale
Consignment A/c 50,000 Proceeds 55,000
1-Jul To Bank(expenses) 1,000 Dec. 31 By Inventories on
Dec. 31 To Wye-expenses Consignment 10,600
& bad debt 3,400 Account
Dec. 31 To Wye-commission 5,500
Dec. 31 To P&L Account-transfer of profit 5,700
65,600 65,600

Goods sent on consignment account

2019 Particulars ` 2019 Particulars `
Dec. 31 To Trading A/c 50,000 July 1 By Consignment to 50,000
Wye A/c

Inventories on Consignment account

2019 Particulars ` 2019 Particulars `
Dec. 31 To Consignment to Wye A/c 10,600 Dec. 31 By Balance c/d 10,600
2020
Jan. 1 To Balance b/d 10,600

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6.56 PRINCIPLES AND PRACTICE OF ACCOUNTING

Wye’s account
2019 ` 2019 `
Dec. 31 To Consignment 3-Jul By Bills Receivable
Wye A/c 55,000 Account 30,000
By Consignment to
Wye A/c –
Expenses & bad debt 3,400
Commission 5,500
By Bank
(balance received) 16,100
55,000 55,000

3.4 VALUATION OF INVENTORIES

The principle is that inventories should be valued at cost or net realizable value whichever is lower, the same
principle as is practised for preparing final accounts. In the case of consignment, cost means not only the cost of
the goods as such to the consignor but also all expenses incurred till the goods reach the premises of the
consignee. Such expenses include packaging, freight, cartage, insurance in transit, octroi, import duty etc. But
expenses incurred after the goods have reached the consignee’s godown (such as godown rent, insurance of
godown, delivery charges, salesman salaries) are not treated as part of the cost of purchase for valuing
inventories on hand. That is why in the case given above, inventories has been valued ignoring godown rent and
insurance.
Note: Sometimes an examination problem states only that the consignor’s expenses amounted to such amount
and that consignee spent so much. If details are not available, then for valuing inventories the expenses incurred
by the consignor should be treated as part of cost while those incurred by the consignee should be ignored.
If the expected selling price of inventories on hand is lower than the cost, the inventories should be valued at
expected net selling price only, i.e. expected selling price less delivery expenses, etc.

3.5 GOODS INVOICED ABOVE COST

Sometimes the proforma invoice is made out at a value higher than the cost and entries in the books of the
consignor are made out on that basis – even the inventories remaining unsold will initially be valued on the basis
of the invoice price. It must be remembered, however, that the profit or loss can be ascertained only if sale
proceeds (plus) inventories on hand, valued on cost basis, is compared with the cost of the goods concerned
together with expenses. Hence, if entries are first made on invoice basis, the effect of the loading (i.e., amount
added to arrive at the invoice price) must be removed by additional entries. Suppose in the example given above,
if the invoice is cost plus 20%, i.e., ` 60,000 for the goods sent to Wye. The entries will be initially:
Particulars ` `
(i) Consignment to Wye A/c Dr. 60,000

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57 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.57

To Goods sent on Consignment A/c 60,000

(ii) Consignment to Wye A/c Dr. 1,000
To Bank 1,000
(iii) Bills Receivable A/c Dr. 30,000
To Wye 30,000
(iv) Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(v) Wye Dr. 55,000
To Consignment to Wye A/c 55,000
(vi) Consignment to Wye A/c Dr. 3,400
To Wye 3,400
(vii) Consignment to Wye A/c Dr. 5,500
To Wye 5,500
(viii) Bank A/c Dr. 16,100
To Wye 16,100
(ix) Inventories on Consignment A/c Dr. 12,600
To Consignment to Wye A/c 12,600
[1/5 of 60,000 + 1/5 of (1,000 + 2,000)]

[Students will see that except for difference in the amounts in entries (i) and (ix), these and other entries are the
same as those already given.]
Additional entries (before ascertaining profit) to remove the effect of loading:
(a) Goods sent on Consignment A/c Dr. 10,000
To Consignment to Wye A/c 10,000
[Entry (i) reversed to the extent of loading in order to debit the Consignment A/c on cost basis].
(b) Consignment to Wye A/c Dr. 2,000
To Inventory Reserve Account 2,000
(The amount of loading included in the value of the closing Inventories is unrealised profit – hence reserve is
created by debit to the Consignment Account).
The Consignment Account will now reveal a profit of ` 5,700 the same as before. It will be transferred to the P&L
A/c. Similarly entry given in 8 in the earlier illustration will be made to transfer the balance in the Goods sent on
Consignment Account in the earlier illustration ` 50,000) after entry in (a) above to the credit of Trading Account.
The accounts (except for Wye whose account will be the same as already shown) are given below:

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6.58 PRINCIPLES AND PRACTICE OF ACCOUNTING

Consignment to Wye Account

2019 Particulars ` 2019 Particulars `
1-Jul To Goods sent on Dec. 31 By Wye
Consignment A/c 60,000 Sales proceeds 55,000
To Bank A/c – expenses 1,000 By Inventories on Consignment A/c 12,600
Dec. 31 To Wye-expenses & bad debt 3,400 By Goods sent on Consignment 10,000
A/c(loading)
“ To Wye-commission 5,500
To Inventory Reserve A/c 2,000
“ To Profit and Loss A/c
transfer of profit 5,700
77,600 77,600

Goods sent on Consignment Account

2019 ` 2019 `
Dec. 31 To Consignment to Wye A/c – 10,000 1-Jul By Consignment to Wye A/c 60,000
loading
To Trading A/c –transfer (bal. fig.) 50,000
60,000 60,000

Inventories on Consignment Account

2019 ` 2019 `
Dec. 31 To Consignment to Wye A/c 12,600 Dec. 31 By Balance c/d 12,600

2020
Jan. 1 Balance b/d 12,600

Inventory Reserve Account

2019 ` 2019 `
Dec. 31 To Balance c/d 2,000 Dec. 31 By Consignment to Wye A/c 2,000
2019
Jan. 1, 2020 By Balance b/d 2,000

The last two accounts will be carried forward to the next year and their balance will then be transferred to the
Consignment Account – ` 12,600 on the debit side and ` 2,000 on the credit. This year in the balance sheet the
net amount of ` 10,600 will be shown on the assets side as shown below:

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59 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.59

`
Inventories on consignment 12,600
Less: Inventory Reserve 2,000
10,600

What would be the situation if the commission to Wye includes del-credere commission also?
In that case Wye would not be able to charge the bad debt of ` 600 to Exe; he will have to bear the loss himself.
The student can see that then the profit on consignment will be ` 6,300.
In this regard it is to be noted that when del – credere commission is paid to the consignee, the consignee account
is debited in the books of consignor for both cash and credit sales. But if no such del – credere commission is
paid then consignee account cannot be debited for credit sales and in that case the following entry is passed in
the books of consignor for credit sales.
Consignment Trade receivables A/c Dr.
To Consignment A/c
The difference is because in case del-credere commission is paid to consignee then consignee is responsible to
bear any loss of bad debts and he will have to pay full amount of sales to consigner. Accordingly, in the books of
consignor, whole amount (cash sales plus credit sales) is shown as receivable from consignee. On the other
hand if del-credere commission is not paid than consignor is responsible to bear loss of bad debts, therefore, till
the time consignee has not received money from customers, it is not shown as receivable from consignee.

3.6 NORMAL LOSS

If some loss is unavoidable, it would be spread over the entire consignment while valuing inventories. The total
cost plus expenses incurred should be divided by the quantity available after the normal loss to ascertain the
cost per unit. Suppose 10,000 kg of apples are consigned to a wholesaler, the cost being ` 30 per kg, plus
` 40,000 of freight. It is concluded that a loss of 15% is unavoidable. The cost per kg will be `3,40,000/8,500 or
` 40. If the unsold inventory is 1,000 kg its value will be ` 40,000.
Accordingly, no entry is recorded for normal loss and same is considered as expense which is considered for
valuation of remaining inventory.

3.7 ABNORMAL LOSS

If any accidental or unnecessary loss occurs, the proper thing to do is to find out the cost of the goods thus lost
and then to credit the Consignment Account and debit the Profit and Loss Account – this will enable the consignor
to know what profit would have been earned had the loss not taken place.
Suppose 1,000 sewing machines costing ` 2,500 each are sent on consignment basis and ` 10,000 are spent
on freight etc. 20 machines are damaged beyond repair. The amount of loss will be:
Cost = 20 × 2500 ` 50,000
Expenses = (20×10,000)/1000 ` 200
` 50,200

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6.60 PRINCIPLES AND PRACTICE OF ACCOUNTING

This amount should be credited to the Consignment Account and debited to the P&L A/c. If any amount, say,
` 40,000 is received from the insurance company, then debit to the P&L A/c will be only ` 10,200. But the credit
to the Consignment Account will still be ` 50,200. ` 40,000 will have been debited to the Bank Account.
Students shall note that abnormal loss is valued just like inventories in hand.
Students should be careful while valuing goods lost in transit and goods lost in consignee’s godown. Both are
abnormal loss but in case of former consignee’s non-recurring expenses are not to be included whereas it is to
be included in latter case.
Further, for the purpose of valuation of inventory in hand, it should be noted that while normal loss is considered
as part of cost of remaining goods, whereas abnormal loss is ignored. In the example given above assume that
10,000 Kg apples were sent in 10 different trucks and out of which one truck met an accident and 500Kg apples
were destroyed. In such case cost of remaining apples will be computed as below:
Qty. Amount (`)
Total apples shipped 10,000 3,40,000 (@ `34 per Kg including freight)
Apples lost in accident 500 17,000 (@ `34 per Kg including freight)
Remaining apples 9,500 3,23,000 (@ `34 per Kg including freight)
Normal loss (15%) 1,425 Nil
Remaining saleable apples 8,075 3,23,000 (@ `40 per Kg)

It is clear from above example that abnormal loss will not have impact on per unit cost, however, per unit cost
will change due to normal cost as the remaining quantity will absorb cost of normal loss whereas abnormal loss
will be immediately expensed off to profit or loss.
Distinctions between normal and abnormal loss

Normal loss Abnormal loss

Normal loss occurs due to inherent nature of the Abnormal loss occurs mainly because of unforeseen
goods being shipped e.g. leakage, evaporation, loss events e.g. accident or natural calamity etc.
of perishable goods etc.
Normal loss is not accounted for immediately and is Abnormal loss is accounted for immediately in profit
loaded on the remaining goods. It gets accounted for and loss account.
as cost of remaining goods as and when they are sold.
As normal loss is added to cost of remaining goods, it Abnormal loss does not impact gross profit.
impact gross profit.
Insurance companies generally do not cover normal Insurance is generally available for abnormal losses.
loss as it is expected to be incurred on each
consignment or storage of goods.
Normal loss is almost certain however it may vary Abnormal loss is because of unforeseen events and is
from time to time. not certain.

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61 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.61

Following entry is recorded for abnormal loss:

Abnormal Loss Account Dr.
To Consignment Account
If abnormal loss is recoverable from the insurance company
Insurance Company’s Account Dr.
To Abnormal Loss Account
If abnormal loss is recoverable from the consignee
Consignee’s Personal Account Dr.
To Abnormal Loss Account
If abnormal loss is not recoverable, Abnormal Loss Account is transferred to Profit & Loss Account.

3.8 COMMISSION
Commission is the remuneration paid by the consignor to the consignee for the services rendered to the former
for selling the consigned goods. Three types of commission can be provided by the consignor to the consignee,
as per the agreement, either simultaneously or in isolation. They are:

3.8.1 Ordinary Commission

The term commission simply denotes ordinary commission. It is based on fixed percentage of the gross sales
proceeds made by the consignee. It is given by the consignor regardless of whether the consignee is making
credit sales or not. This type of commission does not give any protection to the consignor from bad debts and is
provided on total sales.

3.8.2 Del-credere Commission

To increase the sale and to encourage the consignee to make credit sales, the consignor provides an
additional commission generally known as del-credere commission. This additional commission when provided
to the consignee gives a protection to the consignor against bad debts. In other words, after providing the del-
credere commission, bad debts is no more the loss of the consignor. It is calculated on total sales unless there
is any agreement between the consignor and the consignee to provide it on credit sales only.

3.8.3 Over-riding Commission

It is an extra commission allowed by the consignor to the consignee to promote sales at higher price then specified
or to encourage the consignee to put hard work in introducing new product in the market. Depending on the
agreement it is calculated on total sales or on the difference between actual sales and sales at invoice price or
any specified price. In order to encourage the consignee to earn higher margins, it can also be in the form of
share of additional profits made by consignee on sale of goods.

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3.9 RETURN OF GOODS FROM THE CONSIGNEE

Consigned goods can be returned by the consignee because of many reasons like poor quality or not upto the
specimen or destroyed in transit etc. In such a situation, the question arises what is the valuation of returned
goods. Consigned goods returned by the consignee to the consignor are valued at the price at which it was
consigned to the consignee. Expenses incurred by the consignee to send those goods back to the consignor are
not taken into consideration while valuing it because the goods were already in a salable conditions and location
and changing the location back from consignee to consignor is not a cost which must have to be incurred to sell
the goods. This is generally called secondary freight in accounting terms.

3.10 ACCOUNT SALES

An account sale is the periodical summary statement sent by the consignee to the consignor. It contains details
regarding –
(a) sales made,
(b) expenses incurred on behalf of the consignor,
(c) commission earned,
(d) unsold inventories left with the consignee,
(e) advance payment or security deposited with the consignor and the extent to which it has been adjusted,
(f) balance payment due or remitted.
It is a summary statement and is different from Sales Account.

3.11 ACCOUNTING IN THE BOOKS OF THE CONSIGNEE

The consignee is not concerned when goods are consigned to him or when the consignor incurs expenses. He
is concerned only when he sends an advance to the consignor, makes a sale, incurs expenses on the
consignment and earns his commission. He debits or credits the consignor for all these as the case may be.
Following entries are recorded in the books of consignee:
1. On making sales
Cash/Bank Account/Debtors Dr.
To Consignor’s Personal Account
2. For expenses incurred and his commission
Consignor’s Personal Account Dr.
To Bank Account
3. For advance paid to consignor
Consignor’s Personal Account Dr.
To Bank Account

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63 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.63

4. For recording bad debts

Bad Debts Account Dr.
To Customer’s Account
5. For writing off bad debts
(a) When del-credere commission is not allowed
Consignor’s Personal Account Dr.
To Bad Debts Account
(b) When del-credere commission is allowed
Commission Account Dr.
To Bad Debts Account

ILLUSTRATION 2

Exe sent on 1st July, 2019 to Wye goods costing ` 50,000 and spent ` 1,000 on packing etc. On 3rd July, 2019,
Wye received the goods and sent his acceptance to Exe for ` 30,000 payable at 3 months. Wye spent ` 2,000
on freight and cartage, ` 500 on godown rent and ` 300 on insurance. On 31st December, 2019 he sent his
Account Sales (along with the amount due to Exe) showing that 4/5 of the goods had been sold for ` 55,000.
Wye is entitled to a commission of 10%. One of the customers turned insolvent and could not pay ` 600 due from
him. Show the necessary journal entries in the consignee’s book.

SOLUTION

Journal Entries in the books of Consignee

2019 Particulars ` `
1 On sending the acceptance to Exe
July 3 Exe Dr. 30,000
To Bills Payable A/c 30,000
2 On meeting expenses on the consignment:
July 3 Exe Dr. 2,800
To Bank 2,800
3 On meeting his acceptance:
Oct. 6 Bills payable Dr. 30,000
To Bank 30,000
4 On sales being effected:
Trade receivables/Bank Dr. 55,000
To Exe 55,000

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6.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

5 On there being a bad debt:

Exe Dr. 600
To Trade receivables 600
6 On earning the commission:
Exe Dr. 5,500
To Commission Earned A/c 5,500
7 On settling the account to Exe:
Exe Dr. 16,100
To Bank 16,100

If the commission includes del-credere commission also, he would not be able to debit Exe for the bad debt. In
that case the debit should be to the Commission Earned Account whose net balance will then be `4,900 and he
will have to pay `16,700 to Exe.

ILLUSTRATION 3

1,000 toys consigned by Rosie & Co. of Calcutta to Sahoo of Srinagar at a cost of `150 each. Rosie & Co. paid
freight ` 10,000 and insurance ` 1,500. During the voyage 100 toys were totally damaged by fire and had to be
thrown overboard. Sahoo took delivery of the remaining toys and paid `14,400 as customs duty. Sahoo sent a
bank draft to Rosie & Co. for `50,000 as advance payment and later sent an account sales showing that 800
toys had been sold at `220 each. Expenses incurred by Sahoo on godown rent and advertisement, etc.,
amounted to `2,000. Sahoo was entitled to commission of 5 per cent. One of the credit customers could not pay
for 5 toys.
You are required to prepare the Consignment Account, Goods sent on consignment, Inventories on consignment
account and Sahoo’s a/c in the books of Rosie & Co., assuming that nothing has been recovered from the insurers
due to a defect in the policy. Sahoo settled his account immediately.

SOLUTION

In the books of M/s Rosie & Co

Dr. Consignment to Sahoo Account Cr
Particulars ` Particulars `
To Goods sent on Consignment A/c 1,50,000 By Sahoo- sale Proceeds 1,76,000
To Bank(expenses) 11,500 By Abnormal loss Ac (loss by fire) 16,150
Freight 10,000
Insurance 1,500
To Sahoo-expenses 26,300 By Inventories on consignment 17,750
Customs duty 14,400
Sundry expenses 2,000
Commission (5%) 8,800
Bad debt (220*5) 1,100
To P&L Account-transfer of profit 22,100
2,09,900 2,09,900

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65 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.65

Dr. Goods sent on consignment account Cr

Particulars ` Particulars `
To Trading A/c 1,50,000 By Consignment to Sahoo A/c 1,50,000
1,50,000 1,50,000
Dr. Inventories on Consignment account Cr
Particulars ` Particulars `
To Consignment to Wye A/c 17,750 By Balance c/d 17,750
17,750 17,750
Dr. Sahoo’s account Cr
Particulars ` Particulars `
To Consignment to Sahoo A/c 1,76,000 By bank (bank draft as advance) 50,000
By consignment to Sahoo A/c
Customs duty 14,400
Sundry expenses 2,000
Commission 8,800
Bad debts 1,100 26,300
By balance amount remitted 99,700
1,76,000 1,76,000

Working notes :
(a) Computation of the abnormal loss- 100 toys
a. Cost of 100 toys 100 x 150 15000
b. Freight charges- 100 toys 10000/1000 x 100 1000
c. Insurance- 100 toys 1500/1000 x 100 150
a. Abnormal loss 16,150
(b) Computation of the Closing stock- (1000-100-800)
a. Cost of 100 toys 100 x 150 15000
b. Freight charges- 100 toys 10000/1000 x 100 1000
c. Insurance- 100 toys 1500/1000 x 100 150
d. Customs duty-100 toys 14400/900 x 100 1600
Closing stock 17,750

ILLUSTRATION 4

Nike sports Co. of New Delhi consigned 100 shoes to Adidas Co. of Ahmedabad costing ` 1,500 each, invoiced
at ` 2,000 each. The consignor paid freight ` 10,000 and insurance in transit ` 1,500. During transit, 10 shoes
were totally damaged.

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6.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

Adidas Co took delivery of remaining shoes and paid ` 1,530 for octroi duty. Adidas co. sent a bank draft to Nike
sports Co. for ` 50,000 as advance and later on sent an account sales showing that 80 shoes had been sold @
` 2,200 each. Expenses incurred by Adidas Co. on godown rent were ` 2,000. Adidas Co. is entitled to a
commission of 5% on invoice price and 25% on any surplus of sale price over invoice price.
Prepare consignment account, consignee’s account and the related working notes account in the books of the
Nike sports Co.

SOLUTION

In the books of M/s Nike sports Co.

Dr. Consignment to Adidas Co. Account Cr
Particulars ` Particulars `
To Goods sent on Consignment A/c 2,00,000 By goods sent on consignment 50,000
To Bank (expenses) 11,500 By Adidas Co- sale Proceeds 1,76,000
Freight 10,000
Insurance 1,500
To Adidas Co.-expenses 15,530 By Abnormal loss Ac (loss in transit) 16,150
Octroi duty 1,530
Go-down rent 2,000
Commission (WN) 12,000
To Reserve on closing stock 5,000 By Inventories on consignment 21,320
To P&L Account-transfer of profit 31,440
2,63,470 2,63,470
Dr. Adidas Co. account Cr
Particulars ` Particulars `
To Consignment to Adidas A/c 1,76,000 By bank (bank draft as advance) 50,000
By consignment to Adidas A/c
Octroi duty 1,530
Go-down rent 2,000 15,530
Commission (WN) 12,000
By balance amount remitted 1,10,470
1,76,000 1,76,000
Working notes :
(a) Computation of the abnormal loss- 10 shoes
a. Cost of 100 shoes 10 x 1500 15000
b. Freight charges- 100 shoes 10000/100 x 10 1000
c. Insurance- 100 shoes 1500/100 x 10 150
Abnormal loss 16,150

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67 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.67

(b) Computation of the Closing stock- (100-10-80)

a. Invoice price of 10 shoes 10 x 2000 20,000
b. Freight charges- 10 shoes 10000/100 x 10 1000
c. Insurance- 10 shoes 1500/100 x 10 150
d. Octroi duty-10 shoes 1530/90 x 10 170
Closing stock 21,320
(c) Stock reserve on the goods sent on consignment= 100 shoes x 500 (2000-1500) = 50,000
(d) Stock reserve on the closing stock of consigned goods= 10 shoes x 500 (2000-1500) = 5000
(e) Computation of over-riding commission payable to Adidas Co.
Sales at invoice price= 80 x 2000 = 1,60,000
Commission at 5% on the above= 5% x 1,60,000 = 8000
Surplus over the invoice price= 2200-2000 = ` 200
Commission of 25% over the surplus= 200 x 80 = 16000 x 25% = 4000
Total commission = Normal + surplus commission = 8000+4000 = 12,000

3.12 ADVANCE BY THE CONSIGNEE VS SECURITY AGAINST THE

CONSIGNMENT
Generally the consignor insist the consignee for some advance payment for the goods consigned at the time of
delivery of goods. This advance payment is adjusted in full against the amount due by the consignee on account
of the goods sold.
But if the advance money deposited by the consignee is in the form of security against the goods consigned then
the full amount is not adjusted against the amount due by the consignee to the consignor on account of goods
sold if, there is any unsold inventory left with the consignee. In that case proportionate security in respect of
unsold goods is carried forward till the time the respective goods held with the consignee are sold.

ILLUSTRATION 5

Miss Rakhi consigned 1,000 radio sets costing `900 each to Miss Geeta, her agent on 1st July, 2020. Miss Rakhi
incurred the following expenditure on sending the consignment.
Freight ` 7,650
Insurance ` 3,250
Miss Geeta received the delivery of 950 radio sets. An account sale dated 30th November, 2020 showed that
750 sets were sold for `9,00,000 and Miss Geeta incurred `10,500 for carriage.
Miss Geeta was entitled to commission 6% on the sales effected by her. She incurred expenses amounting to
`2,500 for repairing the damaged radio sets remaining in the inventories.
Miss Rakhi lodged a claim with the insurance company which was admitted at `35,000. Show the Consignment
Account and Miss Geeta’s Account in the books of Miss Rakhi.

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6.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

SOLUTION

In the books of Miss Rakhi

Consignment Account
Particulars ` Particulars `
To Goods sent on By Miss Geeta 9,00,000
Consignment A/c 9,00,000 By Insurance Co. 35,000
By Profit & Loss A/c
To Cash abnormal loss(net) 10,545
Freight 7,650 By Consignment
Insurance 3,250 10,900 Inventories 1,84,391
To Miss Geeta
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
To Profit & Loss A/c 1,52,036
11,29,936 11,29,936

Miss Geeta’s Account

Particulars ` Particulars ` `
To Consignment A/c 9,00,000 By Consignment A/c
(Sales) Expenses:
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
By Bank(bal. fig.) 8,33,000
9,00,000 9,00,000
Note: It is assumed that the agent has remitted the amount due from her.
Working Notes:
1. Abnormal loss :
Cost to the consignor: 50 sets @ ` 900 45,000
50 × 10,900 545
Add: Proportionate expenses incurred by the consignor
1,000
Gross abnormal loss 45,545
Less: Insurance claim (35,000)
Net abnormal loss 10,545
2. Valuation of Inventories
200 sets @ ` 900 1,80,000

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69 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.69

Add: Proportionate expenses of the consignor 2,180

Add: Carriage paid by the consignee 2,211
1,84,391

ILLUSTRATION 6

Vikram Milk Foods Co. Ltd. of Vikrampur sent to Sunder Stores, Sonepuri 5,000 kgs of baby food packed in 2,000
tins of net weight 1 kg and 6,000 packets of net weight 1/2 kg for sale on consignment basis. The consignee’s
commission was fixed at 5% of sale proceeds. The cost price and selling price of the product were as under:
1 kg. tin 1/2 kg. packet
` `
Cost Price 10 6
Selling Price 15 7
The consignment was booked on freight “To Pay” basis, and freight charges came to 2% of selling value. One
case containing 50 (1kg. tins) was lost in transit and the transport carrier admitted a claim of `450.
At the end of the first half-year, the following information is gathered from the “Account Sales” sent by the
consignee:
(i) Sale proceeds: 1,500 1 kg. tins
4,000 1/2 kg. packets
(ii) Store rent and insurance charges ` 600.
Find out the value of closing inventory on consignment.
Show the Consignment A/c and the Consignee’s A/c in the books of Vikram Milk Food Co. Ltd. assuming that the
consignee had paid the amount due from him.

SOLUTION

Vikram Milk Foods Co. Ltd.

Consignment to Sonepuri Account
Particulars ` Particulars `
To Goods sent on By Sunder Stores
Consignment A/c
2,000 1 kg. tins @ ` 10 20,000 1,500 1 kg. tins @ ` 15 22,500
6,000 1/2 kg. pkts. @ ` 6 36,000 56,000 4,000 1/2 kg. pkts. @ ` 7 28,000 50,500
To Sunder Stores: By Insurance - Claim 450
Freight 1,440 By Profit & Loss A/c -
Rent and insurance 600 abnormal loss(Net) 65
Commission 2,525 4,565 By Inventory on 16,915
consignment A/c

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6.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

To Profit & Loss A/c – 7,365

Profit
67,930 67,930
Sunder Stores, Sonepuri
Particulars ` Particulars `
To Consignment to Sonepuri By Consignment to
Account - Sales Proceeds 50,500 Sonepuri Account -
Freight 1,440
Rent & Insurance 600
Commission 2,525
By Bank(Bal. fig) 45,935
50,500 50,500
Working Notes:
(i) Sale value of total consignment:
2,000 1 kg. tins @ ` 15 30,000
6,000 1/2 kg. pkts. @ ` 7 42,000
72,000
(ii) Freight @ 2% of above 1,440
(iii) Inventories at the end:
450 1 kg. tins @ ` 10 (Selling Price ` 6,750) 4,500
2,000 1/2 kg. pkts. @ ` 6 (Selling Price ` 14,000) 12,000
16,500
Add: Freight 2% of (Selling Price ` 20,750) 415
16,915
(iv) Loss in transit:
Cost of 50 1 kg. tins @ ` 10 500
Freight @ 2% of Selling Price ` 750 15
Gross abnormal Loss 515
Less : Claim (450)
Net abnormal Loss 65

ILLUSTRATION 7

Shri Mehta of Mumbai consigns 1,000 cases of goods costing ` 1,000 each to Shri Sundaram of Chennai. Shri
Mehta pays the following expenses in connection with consignment:
`
Carriage 10,000

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71 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.71

Freight 30,000
Loading charges 10,000
Shri Sundaram sells 700 cases at ` 1,400 per case and incurs the following expenses:
Clearing charges 8,500
Warehousing and storage 17,000
Packing and selling expenses 6,000

It is found that 50 cases have been lost in transit and 100 cases are still in transit.
Shri Sundaram is entitled to a commission of 10% on gross sales. Draw up the Consignment Account and
Sundaram’s Account in the books of Shri Mehta.

SOLUTION

In the books of Shri Mehta

Consignment to Sundaram of Chennai Account
Particulars ` Particulars `
To Goods sent on By Sundaram (Sales) 9,80,000
Consignment 10,00,000 By Loss in Transit 50 cases 52,500
@ `1,050 each
To Bank (Expenses) 50,000 By Consignment Inventories
To Sundaram (Expenses) 31,500 In hand 150 @ ` 1,060 each 1,59,000
To Sundaram (Commission) 98,000 In transit 100 @ ` 1,050 each 1,05,000 2,64,000
To Profit on Consignment to 1,17,000
Profit & Loss A/c
12,96,500 12,96,500

Sundaram’s Account
Particulars ` Particulars `
To Consignment to Chennai A/c 9,80,000 By Consignment A/c (Expenses) 31,500
By Consignment A/c (Commission) 98,000
By Balance c/d 8,50,500
9,80,000 9,80,000

Working Notes:
(i) Consignor’s expenses on 1,000 cases amounts to `50,000; it comes to `50 per case. The cost of cases
lost will be computed at `1,050 per case.
(ii) Sundaram has incurred ` 8,500 on clearing 850 cases, i.e., `10 per case; while valuing closing
inventories with the agent `10 per case has been added to cases in hand with the agent.

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6.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iii) It has been assumed that balance of `8,50,500 is not yet paid.

ILLUSTRATION 8

Ajay of Mumbai consigned to Vijay of Delhi, goods to be sold at invoice price which represents 125% of cost.
Vijay is entitled to a commission of 10% on sales at invoice price and 25% of any excess realised over invoice
price. The expenses on freight and insurance incurred by Ajay were `10,000. The account sales received by Ajay
shows that Vijay has effected sales amounting to `1,00,000 in respect of 75% of the consignment. His selling
expenses to be reimbursed were ` 8,000. 10% of consignment goods of the value of `12,500 were destroyed in
fire at the Delhi godown. Vijay remitted the balance in favour of Ajay. Prepare consignment account and the
account of Vijay in the books of Ajay along with the necessary calculations.

SOLUTION

Books of Ajay
Consignment to Vijay Account
Particulars ` Particulars `
To Goods sent on Consignment A/c 1,25,000 By Goods sent on Consignment A/c (Loading) 25,000
To Cash A/c 10,000 By Abnormal Loss 11,000
To Vijay (Expenses) 8,000 By Vijay (Sales) 1,00,000
To Vijay (Commission) 10,938 By Inventories on Consignment A/c 20,250
To Inventories Reserve A/c 3,750 By General Profit & Loss A/c 1,438
1,57,688 1,57,688

Vijay’s Account
Particulars ` Particulars `
To Consignment A/c 1,00,000 By Consignment A/c 8,000
By Consignment A/c 10,938
By Bank A/c 81,062
1,00,000 1,00,000

Working Notes:
1. Calculation of value of goods sent on consignment:
Abnormal Loss at Invoice price ` 12,500.
Abnormal Loss as a percentage of total consignment = 10%.
Hence the value of goods sent on consignment = ` 12,500 X 100/ 10 = ` 1,25,000.
Loading of goods sent on consignment = ` 1,25,000 X 25/125 = ` 25,000.
2. Calculation of abnormal loss (10%):
Abnormal Loss at Invoice price ` 12,500
Abnormal Loss at cost = ` 12,500 X 100/125 = ` 10,000

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73 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.73

Proportionate expenses of Ajay (10 % of `10,000) = ` 1,000

= ` 11,000
3. Calculation of closing Inventories (15%):
Ajay’s Basic Invoice price of consignment = ` 1,25,000
Ajay’s expenses on consignment = ` 10,000
` 1,35,000
Value of closing Inventories = 15% of ` 1,35,000 = ` 20,250
Loading in closing Inventories = `25,000 X 15/100 = ` 3,750
Where `18,750 (15% of `1,25,000) is the basic invoice price of the goods sent on consignment
remaining unsold.
4. Calculation of commission:
Invoice price of the goods sold = 75% of ` 1,25,000 = ` 93,750
Excess of selling price over invoice price = ` 6,250 (` 1,00,000- ` 93,750)
Total commission = 10% of ` 93,750 + 25% of ` 6,250
= ` 9,375 + ` 1,562.50
= ` 10,937.50 OR 10,938
Note:
1. It has been assumed that final payment received from Vijay.
2. Abnormal loss is always calculated at cost even if invoice price of goods is given.
3. Value of inventories always valued at invoice price if invoice price is given.

SUMMARY
 In Consignment one person (consignor) sends goods to another person (consignee) to be sold on behalf
of and at the risk of the former.
 In the case of consignment, cost means not only the cost of the goods as such to the consignor but also
all expenses incurred till the goods reaches the premises of the consignee. Such expenses include
packaging, freight, cartage, insurance in transit, octroi, etc.
 Expenses incurred after the goods have reached the consignee’s godown (such as godown rent,
insurance of godown, delivery charges) are not treated as part of the cost of purchase for valuing
inventories on hand.
 If the expected selling price of inventories on hand is lower than the cost, the value put on the inventories
should be expected net selling price only, i.e. expected selling price less delivery expenses, etc. i.e.
expenses necessary for sales.
 Proforma invoice is made to show the high value of goods consigned than the cost and entries in the
books of the consignor are made out on that basis. Even the inventories remaining unsold will initially
be valued on the basis of the invoice price.

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6.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

 Hence, if entries are first made on invoice basis, the effect of the loading (i.e., amount added to arrive
at the invoice price) must be removed by additional entries to ascertain profit or loss.
 Abnormal loss is valued just like inventories in hand. Students should be careful while valuing goods lost
in transit and goods lost in consignee’s godown. Both are abnormal loss but in case of former consignee’s
non-recurring expenses are not to be included whereas it is to be included in case of latter.
 Normal loss, is an unavoidable loss and be spread over the entire consignment while valuing inventories.
The total cost plus expenses incurred should be divided by the quantity available after the normal loss
to ascertain the cost per unit.
 Commission is the remuneration paid by the consignor to the consignee for the services rendered to the
former for selling the consigned goods. Three types of commission can be provided by the consignor to
the consignee, as per the agreement, either simultaneously or in isolation. They are:
 Ordinary commission
 Del-credere commission
 Over-riding commission
 For accounting of consignee, he is concerned only when he sends an advance to the consignor, makes
a sale, incurs expenses on the consignment and earns his commission. He debits or credits the
consignor for all these as the case may be.
 Abnormal loss is always calculated at cost even if invoice price of goods is given.
 Value of inventories always valued at invoice price if invoice price is given.

TEST YOUR KNOWLEDGE

True and False
1. Value of the abnormal loss is debited to the consignment account
2. Sales account and account sales are one and the same.
3. Consignor is the owner of consignment stock.
4. Normal commission is paid to the consignee to bear the risk of the bad debts on sale of the consigned
stock.
5. There is no entry passed by the consignee in his books for the remaining stock of goods lying with him.
6. Consignment account is a representative personal account.
7. Proforma invoice is sent by the consignee to the consignor giving details about the stock of goods sent
on consignment and their cost, invoice price, etc.
8. The bad debts in case of del credere commission shall be debited to the Consignment account
9. Abnormal loss is created out of uncontrollable situations and circumstances.
10. The relationship between the consignor and his consignee is that of a seller and a buyer.

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75 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.75

Multiple Choice Questions

1. P of Delhi sends out 1,000 boxes of toothpaste costing ` 200 each. Each box consist of 12 packets. 600
boxes were sold by consignee at ` 20 per packet. Amount of sale value will be:
(a) `1,44,000 (b) ` 1,20,000 (c) `1,32,000
2. X of Kolkata sends out 2,000 boxes to Y of Delhi costing ` 100 each. Consignor’s expenses ` 5,000.
1/10th of the boxes were lost in consignee’s godown and treated as normal loss. 1,200 boxes were sold
by consignee. The value of consignment Inventories will be:
(a) ` 68,333 (b) ` 61,500 (c) ` 60,000
3. Which of the following statement is not true:
(a) If del-credere commission is allowed, bad debt will not be recorded in the books of consignor
(b) If del-credere commission is allowed, bad debt will be debited in consignment account
(c) Del-credere commission is provided by consignor to consignee
4. X of Kolkata sent out 2,000 boxes costing 100 each with the instruction that sales are to be made at cost
+ 45%. X draws a bill on Y for an amount equivalent to 60% of sales value. The amount of bill will be:
(a) ` 1,74,000 (b) ` 2,00,000 (c) ` 2,90,000
5. Which of the following statement is wrong:
(a) Consignor is the owner of the consignment Inventories
(b) Del-credere commission is allowed by consignor to protect himself from bad debt
(c) All proportionate consignee’s expenses will be added up for valuation of consignment
Inventories.
6. Out of the following at which point the treatment of “Sales” and “Consignment” is same:
(a) Ownership transfer. (b) Money receive. (c) Inventories outflow.
7. If del-credere commission is allowed for bad debt, consignee will debit the bad debt amount to:
(a) Commission Earned A/c
(b) Consignor’s A/c
(c) Trade receivables (Customers) A/c
8. A proforma invoice is sent by:
(a) Consignee to Consignor (b) Consignor to Consignee
(c) Customer/Debtors to Consignee
9. Which of the following statement is correct:
(a) Consignee will pass a journal entry in his books at the time of receiving goods from consignor.
(b) Consignee will not pass any journal entry in his books at the time of receiving goods from
consignor.

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6.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

(c) The ownership of goods will be transferred to consignee at the time of receiving the goods.
10. Consignment Inventories will be recorded in the balance sheet of consignor on asset side at:
(a) Invoice Value
(b) At Invoice value less Inventories reserve
(c) At lower than cost price
11. Which of the following expenses of consignee will be considered as non-selling expenses:
(a) Advertisement
(b) Insurance on freight inward
(c) Selling Expenses
12. The consignment accounting is made on the following basis:
(a) Accrual
(b) Realisation
(c) Cash Basis
13. Which of the following item is not credited to consignment account?
(a) Cash sales made by consignee
(b) Credit sales made by consignee
(c) Inventories Reserve on closing consignment Inventories

Theory Questions
1. Write short notes on:
(i) Del-credere commission.
(ii) Account sales.
(iii) Over-riding commission.
2. Distinguish between:
(i) Consignment sale and Normal sale.
(ii) Commission and Discount.

Practical Questions
1. X of Delhi purchased 10,000 metres of cloth for ` 2,00,000 of which 5,000 metres were sent on
consignment to Y of Agra at the selling price of ` 30 per metre. X paid ` 5,000 for freight and ` 500 for
packing etc.
Y sold 4,000 metre at ` 40 per metre and incurred ` 2,000 for selling expenses. Y is entitled to a
commission of 5% on total sales proceeds plus a further 20% on any surplus price realised over ` 30

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77 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.77

per metre. 3,000 metres were sold at Delhi at ` 30 per metre less ` 3,000 for expenses and commission.
Owing to fall in market price, the inventories of cloth in hand is to be reduced by 10%.
Prepare the Consignment Account and Trading and Profit & Loss Account in books of X.
2. D of Delhi appointed A of Agra as its selling agent on the following terms:
Goods to be sold at invoice price or over.
A to be entitled to a commission of 7.5% on the invoice price and 20% of any surplus price realized over
invoice price
The principals to draw on the agent a 30 days bill for 80% of the invoice price.
On 1st February, 2020, 1,000 cycles were consigned to A, each cycle costing ` 640 including freight
and invoiced at ` 800.
Before 31st March, 2020, (when the principal’s books are closed) A met his acceptance on the due date;
sold off 820 cycles at an average price of ` 930 per cycle, the sale expenses being ` 12,500; and
remitted the amount due by means of Bank draft.
Twenty of the unsold cycles were shop-spoiled and were to be valued at a depreciation of 50% of cost.
Show by means of ledger accounts how these transactions would be recorded in the books of A and find
out the value of closing inventory with A to be recorded in the books of D at cost.
3. Mr. Y consigned 800 packets of toothpaste, each packet containing 100 toothpastes. Cost price of each
packet was ` 900. Mr. Y Spent ` 100 per packet as cartage, freight, insurance and forwarding charges.
One packet was lost on the way and Mr. Y lodged claim with the insurance company and could get
` 570 as claim on average basis. Consignee took delivery of the rest of the packets and spent ` 39,950
as other non-recurring expenses and ` 22,500 as recurring expenses. He sold 740 packets at the rate
of ` 12 per toothpaste. He was entitled to 2% commission on sales plus 1% del-credere commission.
You are required to prepare Consignment Account. Calculate the cost of inventories at the end, abnormal
loss and profit or loss on consignment.
4. A of Agra sent on consignment goods valued ` 1,00,000 to B of Mumbai on 1st March, 2019. He incurred
the expenditure of ` 12,000 on freight and insurance. A’s accounting year closes on 31st December. B
was entitled to a commission of 5% on gross sales plus a del-credere commission of 3%. B took delivery
of the consignment by incurring expenses of ` 3,000 for goods consigned.
On 31.12.2019, B informed on phone that he had sold all the goods for ` 1,50,000 by incurring selling
expenses of ` 2,000. He further informed that only ` 1,48,000 had been realized and rest was considered
irrecoverable, and would be sending the cheque in a day or so for the amount due along with the
accounts sale.
On 5.1.2020, A received the cheque for the amount due from B and incurred bank charges of ` 260 for
collecting the cheque. The amount was credited by the bank on 9.1.2020.
Write up the consignment account finding out the profit/loss on the consignment, B’s account, Provision
for expenses account and Bank account in the books of the consignor, recording the transactions upto
the receipt and collection of the cheque.

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6.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWERS/HINTS
True and False
1. False: The abnormal loss is credited to the consignment account since it is a reduction in the value of
the stock.
2. False: The sales account shows the balance receivable on account of the sales- both cash and credit.
Whereas the account sales statement is given by the consignee to the consignor on a periodical basis
detailing the transactions done by the former.
3. True: The consignor is the owner of the goods sent on consignment. Consignee is a mere agent
appointed to sell the goods for a commission and the mere transfer of possession does not entitle
consignee to become the owner of the goods.
4. False: The del-credere commission is the commission paid to the consignee for bearing the loss of the
bad debts if any.
5. True: It is the consignor who has to record the closing stock of the consigned goods since he is the
owner of the goods. There is no entry passed in the books of the consignee.
6. False: It is a nominal account recording the expenses on the debit and the income on the credit side,
balance being the profit/ loss on the consignment account to the trading account.
7. False: Proforma invoice is given by the consignor to the consignee with regard to the goods sent on
consignment and their price.
8. False: If del credere commission is given to the consignee then, the bad debts are taken into the
accounts of the consignee. It will not appear in the consignment account.
9. False: Abnormal loss occurs due to unforeseen circumstances, but if necessary steps are taken they
can be controlled, it is only the natural loss which cannot be controlled since it occurs due to nature of
the product.
10. False: The relationship between the consignor and the consignee is that of a principal and agent. It is
mere arrangement for sale of goods on behalf of the consignor.

Multiple Choice Questions

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.
(a) (a) (b) (a) (c) (c) (a) (b) (b) (b) (b) (a) (c)

Theoretical Questions
1. (i) Del-credere commission is an additional commission paid by the consignor to the consignee for
undertaking responsibility of collection of debts. Generally, the consignee gets ordinary
commission for sales made by him as a percentage of gross sales, over and above, he may get
del-credere commission for the additional responsibility of debt collection. Sometimes it is
agreed that del-credere commission shall be allowed on credit sales only. However, in the
absence of any such agreement the consignor allows del-credere commission on total sales

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79 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.79

and not merely on credit sales. If the consignee is entitled to del-credere commission, he has
to bear the bad debts; if any, arising, out of credit sale of consignment goods.
(ii) Account sales is a periodic statement furnished by the consignee to the consignor stating
therein, the quantity sold, price charged, expenses incurred on behalf of the consignee and
commission payable to him in respect of a particular consignment, and the net amount due from
him and remittance received if any. It also shows the details of quantity of goods received,
destroyed, if any, and still held as stock.
(iii) Over-riding commission is an extra commission allowed to the consignee in addition to the
normal commission. Such additional commission is generally allowed:-
To provide additional incentive to the consignee for the purpose of introducing and creating a
market for a new product.
To provide incentive for supervising the performance of other agents in a particular area.
To provide incentive for ensuring that the goods are sold by the consignee at the highest
possible price.
2. (i) In case of consignment, the property in the goods remains with the consignor until the goods
are actually sold. The consignee acts only as a custodian of goods sent by consignor. In
consignment, the ownership of goods does not pass on to the consignee in any case. In case
of ordinary sale, the ownership of goods passes to the buyer immediately after sale. In case of
consignment, the risk attached to the goods remain with the consignor even after sending the
goods to the consignee. However, in case of ordinary sale, as soon as the property in the goods
passes on to the buyers, the risk attached to the goods also passes at the same time. The
relationship between consignor and consignee is that of principal and agent. In case of credit
sale, the relationship between the buyer and the seller is that of a debtor and a creditor.
(ii) Commission may be defined as remuneration of an employee or agent relating to services
performed in connection with sales, purchases, collections or other types of business
transactions and is usually based on a percentage of the amounts involved.
Commission earned is accounted for as an income in the books of accounts, and commission
allowed or paid is accounted for as an expense in the books of the party availing such facility
or service.
The term discount refers to any reduction or rebate allowed and is used to express one of the
following situations:
An allowance given for the settlement of a debt before it is due i.e. cash discount.
An allowance given to the whole sellers or bulk buyers on the list price or retail price, known as
trade discount. A trade discount is not shown in the books of account separately and it is shown
by way of deduction from cost of purchases.

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6.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
Answer 1
In the books of Mr. X
Consignment Account
Particulars Amount ` Particulars Amount `
To Goods sent on
Consignment Account 1,50,000 By Y’s account: (Sales) 1,60,000
To Bank account: Freight and 5,500 By Goods sent on consignment 50,000
packing etc. (Cancellation of loading)
To Y’s account: By Inventories on consignment (W.N.2) 28,990
Selling expenses 2,000
Commission (W.N.1) 16,000
To Inventories Reserve (W.N.3) 10,000
To Profit and loss account (profit 55,490
on consignment transferred)
2,38,990 2,38,990

Trading and Profit and Loss Account

for the year ended……..
Particulars Amount ` Particulars Amount `
To Purchases 2,00,000 By Sales 90,000
To Gross profit c/d 26,000 By Goods sent on consignment 1,00,000
By Inventories in hand Cost ` 40,000
Less: 10% 4,000 36,000
2,26,000 2,26,000
To Expenses and commission 3,000 By Gross profit b/d 26,000
To Net profit 78,490 By Consignment A/c
(profit on consignment) 55,490
81,490 81,490

Working Notes:
i. Calculation of commission payable to Y: `
Total sale proceeds of Y 1,60,000
Surplus proceeds realised over ` 30 per metre
[4,000 x ` (40-30)] 40,000

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81 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.81

Commission:
5% of total sale proceeds (5% of ` 1,60,000) 8,000
20% of surplus (20% of ` 40,000) 8,000
16,000
ii. Inventories on Consignment: `
Cost of consignment Inventories (1000 mtrs@ ` 30) 30,000
Add: Expenses of consignor (5,500X1/5) 1,100
31,100
Less: Reduction of 10% in cost due to fall in market price (20,000+1,100) x 10% 2,110
28,990
iii. Loading (`10 x 1,000 mtrs) 10,000
Answer 2

D’s Account
2020 ` 2020 `
Feb. 1 To Bills payable A/c 6,40,000 Mar. 31 By Cash/Bank A/c (820x `930) 7,62,600
(80% of ` 8,00,000)
Mar. 31 To Cash A/c (expenses) 12,500
To Commission earned A/c 70,520
To Bank A/c 39,580
7,62,600 7,62,600

Bills Payable Account

2020 ` 2020 `
Mar. 5 To Cash/Bank A/c 6,40,000 Feb. 1 By D’s A/c 6,40,000
6,40,000 6,40,000

Value of closing inventory with A

`
160 cycles at ` 640 (cost price including freight) 1,02,400
20 cycles (shop-spoiled) at 50% of the cost i.e. at ` 320 each 6,400
Value of closing inventory with A i.e. the amount (net effect of the loading) at which D will
account for in his books on 31st March, 2020
1,08,800

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6.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

Working Note:
1. Calculation of commission:
`
7.5 % on the invoice price amount (820x ` 800) i.e. ` 6,56,000 49,200
20% on the surplus price amount (820 x ` 130) ` 1,06,600 21,320
70,520
2.
`
Abnormal loss:
Cost of packet lost during transit 900
Add: Expenses incurred by Y 100
Gross Abnormal loss 1,000
Less: Insurance claim received (570)
Net Abnormal loss 430

3. Cost of inventories at the end:

`
59 packets @ ` 900 53,100
Add: Expenses incurred by Y (59x `100) 5,900
Add: Proportionate (non-recurring) expenses incurred by the consignee
(59/799x `39,950) 2,950
61,950
4.
Closing inventories No. of packets
Packets consigned 800
Less: Packet lost in transit (1)
799
Less: Packets sold 740
59

Answer 3
Consignment Account
` `
To Goods sent on consignment A/c 7,20,000 By Consignee’s A/c-Sales 8,88,000
(800 x ` 900) (740 x100x ` 12)
To Cash A/c 80,000

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83 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.83

(expenses 800 x `100) By Abnormal Loss Cash A/c 570

(insurance claim)
To Consignee’s A/c: By Profit and loss account 430
Recurring expenses 22,500 (abnormal loss)
Non-recurring expenses 39,950 By Consignment stock A/c 61,950
Commission @ 2% on ` 8,88,000 17,760
Del-credere commission @ 1% on 8,880
` 8,88,000
To Profit and loss A/c 61,860
(profit on consignment)
9,50,950 9,50,950

Answer 4
In the books of Mr. A
Consignment to Mumbai Account
2019 ` 2019 `
March 1 To Goods sent on consignment A/c 1,00,000 Dec. 31 By B’s A/cs 1,50,000
To Cash A/c (freight and insurance) 12,000
To B’s A/c:
Clearance expenses 3,000
Selling expenses 2,000
Commission
@ 5% on ` 1,50,000 = 7,500
Del-credere commission @3% on 17,000
` 1,50,000 = 4,500
Dec. 31 To Provision for expenses (bank 260
charges)
To Profit and loss A/c (profit on 20,740
consignment)
1,50,000 1,50,000

B’s Account

2019 ` 2019 `
Dec. 31 To Consignment A/c 1,50,000 Dec. 31 By Consignment A/c-
Clearance expenses 3,000
Selling expenses 2,000

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6.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

Commission 7,500
Del-credere commission 4,500 17,000
By Balance c/d 1,33,000
1,50,000 1,50,000
2020 2020
Jan. 1 To Balance b/d 1,33,000 Jan. 5 By Bank A/c 1,33,000

Bank Account

2020 ` 2020 `
Jan. 5 To B’s account 1,33,000 Jan. 5 By Bank charges 260
Jan. 5 By Balance c/d 1,32,740
1,33,000 1,33,000

Provision for Expenses Account

2020 ` 2020 `
Jan. 5 To Bank charges 260 Jan. 1 By Balance b/d 260
260 260

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85 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.85

UNIT – 4 AVERAGE DUE DATE

LEARNING OUTCOMES
After studying this unit, you would be able to:
 Understand what is average due date and how to choose 0 (zero) day for calculating average due date.
 Learn the technique of calculating due date
 Learn calculation of average due date where amount is lent in various instalments.
 Calculate average due date for determining interest on drawings.
 Familiarize with the steps involved in calculation of average due date where amount is lent in one
instalment but repayment is done in various instalments. Also understand days of grace and learn the
technique of maturity date by counting the days of grace.

UNIT OVERVIEW USES OF AVERAGE DUE DATE

For calculatyion of Where amount is Where amount is

Interest on drawings lent in various lent in one
of partners Instalments Instalments

CALCULATION OF DUE DATE

If Bill/Invoice is
payable

at a stated no. of
on a specific date months(s)/days after
date

Due date will be on tat date

Due date will be on which comes after adding
that specific date stated number of months/days
to the date of invoice/bill+3
days of grace

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6.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.1 INTRODUCTION
In business enterprises, a large number of receipts and payments by and from a single party may occur at
different points of time. To simplify the calculation of interest involved for such transactions, the idea of average
due date has been developed. Where a person owing several amounts due on different dates, desires to pay the
total amount payable by him/her on a particular date, so that neither the debtor nor the creditor stands to lose or
gain anything by way of interest, that date is known as average due date. Average Due Date is weighted average
of due dates of various transactions where amount of each transaction is used as weight. The unique feature of
this approach is that the party making payment neither suffers any loss nor gains anything by this arrangement
of making a single payment. Average due date is generally used in following circumstances:
(i) For calculating interest on drawings of partners;
(ii) For settling accounts between principle and agent;
(iii) For settling contra accounts e.g. where parties sell goods to each other;
(iv) For making lump sum payment against various bills drawn on different dates with different due dates;
In this unit, we shall elaborate the underlying principle of determining average due date covering the cases where the
amount is lent in various instalments but repayment is made in a single instalment as well as where the amount is lent
in one instalment but repayment is made by various instalments. The technique of average due date is also useful for
calculating interest on drawings made by the proprietors or partners of a business firm at several points of time.
Average due date: It is the mean or equated date on which a single total payment may be made in lieu of different
payments on different dates without any loss to either party.
Where payment is not made on the average due date, the party receiving the amount charges interest for as
many days as the payment is delayed from the average due date.
The formula for calculating average due date is as follows:
Total of the products
Average due date = Base date ±
Total of the amounts
Points to be noted:
1. Selection of base date/ zero date: Such a date may be the due date of the first transaction or the due
date of the last transaction or any other due date between the first and the last but preferably earlier due
date may be taken.
2. While ascertaining the number of intervening days (plus or minus) between the base date and the due
date of each transaction ignore the first date and include the last day.
3. If due date is in fraction, round it off.
4. If amount is paid before due date, rebate is given.
5. If amount is paid after due date, then interest is charged.
6. Whenever there is a sale of goods by two persons to each other on different dates, the formula for
calculating average due date becomes:
Difference in products
Base date ±
Difference in amounts

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87 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.87

4.2 CONCEPT OF DUE DATE (DATE OF MATURITY)

The due date of a bill of exchange/invoice is the date when the amount of a bill/invoice is payable by the drawee/
creditor to drawer/ debtor.

4.2.1 Calculation of Due Date after Taking into Consideration Days of Grace
A Bill of exchange or promissory note matures on the date on which it falls due. And every promissory note or
bill of exchange (other than those payable on demand or at sight or on presentment) falls due on the third day
after on which it is expressed to be payable.
Examples
(i) A bill dated 30th September is made payable three months after date. It falls due on 2nd January.
(ii) Due Date=30 Dec
(iii) Maturity date= 30 Dec +3 =2 Jan
(ii) A note dated 1st January is payable one month after sight. It falls due on 4th February.

4.2.2 Calculating Due Date of Bill or Note Payable Few Months after Date or Sight
When the bill is made payable at a stated number of months after date or after sight or after certain events, then
the period stated shall be held to terminate on the date of the month which corresponds with the day on which
the instrument is dated. If the month in which the period would terminate has no corresponding day, the period
shall be held to terminate on the last day of such month.
Example: A Bill due on 29th January, 2015 is made payable at one month after date. The due date of instrument
is 3rd day after 28th February, i.e., 3rd March (in 2015, February is of 28 days only).

4.2.3 Calculation of Due Date when the Maturity Day is a Holiday

When the day on which a promissory note or bill of exchange is at maturity (after including days of grace) is a
public holiday, the instrument shall be deemed to be due on the preceding business day. The expression “public
holiday” includes Sundays and other days declared by the Central Government by notification in the official
gazette, to be a public holiday. And now if the preceding day is also a public holiday, it will fall on the day
preceding the previous day. But if the holiday happens to be emergency or unforeseen holiday then the date shall
be the next following day.(Ref: Negotiable Instruments Act 1881).

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6.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

If Maturity Day is holiday (after including days of grace)

Public Holiday (including Sundays & other

days declared by Central Government by Emergency or unforeseen holiday
notification in the official gazette

Due date = Preceding Business day Due date = Next following day

If Preceding day is also Public Holiday

Due date =Day Preceding the previous day

4.3 TYPES OF PROBLEMS

Case 1: Learn calculation of average due date where one Party is involved
Case 2: Learn calculation of average due date where inter transactions between 2 Parties are involved
Case 3: Learn calculation of average due date where amount is repaid in Instalments
Case 4: Learn calculation of average due date for determining interest on drawings.
Case 1: Learn calculation of average due date where one Party is involved
Calculation of average due date
Under this type of problem, average due date is calculated as follows :
a. Take the earliest due date as starting day or base date or “O” day for convenience. Any date whatsoever,
may also be taken as “O” day.
b. Consider the number of days from base date up to each due date. Calculations may also be made in
month.
c. Multiply the number of days by the corresponding amounts.
d. Add up the amount and products.
e. Divide the “Product total” by “Amount total” and get result approximately upto a whole number.
f. This number is added in the base date to find the average due date.

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89 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.89

Thus the formula for the average due date can be under.
Total of products
Average due date = Base date ±
Total amounts
Note: For calculation of no. of days, no. of days in each respective month involved are to be considered
individually.

ILLUSTRATION 1

The followings are the amounts due on different dates in between the same parties:
Amount Due Date
`
500 3rd July
800 2nd August
1,000 11th September

Suggest a date on which all the bills may be paid out without any loss of interest to either party.

SOLUTION

Considering 3rd July as the starting day the following table is prepared:
Due Dates Amount No. of Days from 3rd July Products
3rd July 500 0 0
2nd August 800 30 24,000
11th September 1,000 70 70,000
2,300 94,000

94,000
Average Due Date = 3rd July
2,300
= 3rd July + 41 days = 13th August
Loss of Interest: 13th August to 11th September
Assuming 5% is interest rate, the debtor loses interest due to early payment of ` 1,000 for 29 days (from 13th
August to 11th September) i.e., ` 4. 1000 × 29/365 × 5/100
Gain of Interest: 3rd July to 13th August and 2 August to 13th August
He however, gains interest, due to late payment on ` 500 for 41 days from 3rd July to 13th August and on
` 800 for 11 days i.e. ` 2.80 + ` 1.20, i.e., ` 4.
Thus, the debtor neither loses nor gains by payment of all the amounts on 13th August.
It should be noted that in calculating the number of days only one of the dates, either the starting date or the due
date is to be counted.

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6.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

In the same manner, bill due to one party may be cancelled as against bills of same amount due from the same
party after adjustment of interest for the period elapsing between the two average due dates. Instead of payment
of several bills on the same date as above, other bill starting from the average due date for agreed period together
with interest for the period may be accepted.

ILLUSTRATION 2

The following amounts are due to X by Y. Y wants to pay off (a) on 18th March or (b) on 14th July. Interest rate
of 8% p.a. is taken into consideration.
Due Dates `
10th January 500
26th January (Republic Day) 1,000
23rd March 3,000
18th August (Sunday) 4,000

Determine the amount to be paid in (a) and in (b).

SOLUTION

Taking 10th January as the base date

Due Date Due Date No. of days Amount Product

(Normal) (Actual) from 10th January…. `
10th January 10th January 0 500 0
26th January 25th January 15 1,000 15,000
23rd March 23rd March 72 3,000 2,16,000
18th August 17th August 219 4,000 8,76,000
8,500 11,07,000

11,07,000
Average Due Date = 10th Jan.+ = 10th Jan + 130 days = 20th May
8,500

January 21
February 28
March 31
April 30
110

(a) If the payment is made on 18th March rebate will be allowed for unexpired time from 18th March to
20th May i.e., 13 + 30 + 20 i.e. for 63 days. He has to pay the discounted value of the total amount.

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91 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.91

8 63
Discount =8,500 x x = `117.37
100 365
Amount to be paid on 18th March= ` (8,500 – 117.37) = ` 8,382.63
(b) If the payment is deferred to 14th July, interest is to be paid from 20th May to 14th July i.e., for
11 + 30 + 14 = 55 days.
8 55
Interest =8,500 x x = `102.47
100 365
The amount to be paid on 14th July.
` 8,500 + 102.47 = 8602.47

ILLUSTRATION 3

Calculate Average Due date from the following information:

Date of the bill Term Amount `
August 10, 2019 3 months 6,000
October 22, 2019 60 days 5,000
December 4, 2019 2 months 4,000
January 14, 2020 60 days 2,000
March 14, 2020 2 months 3,000
(Assume February of 28 days)

SOLUTION

Calculation of Average Due Date

Taking 10th August 2019 as the base date
Date of bill Term Due date- No. of days from Amount Product
Maturity Date 10th August 2019 ` `
August 10, 2019 3 months Nov. 13, 2019 95 6,000 5,70,000
October 22, 2019 60 days Dec. 24, 2019 137 5,000 6,85,000
December 04, 2019 2 months Feb. 07, 2020 181 4,000 7,24,000
January 14, 2020 60 days Mar. 18, 2020 220 2,000 4,40,000
March 14, 2020 2 months May 17, 2020 280 3,000 8,40,000
20,000 32,59,000

Total of product 32,59,000

Average Due Date = = = 162.95 = 163 days
Total of amount 20,000

= 163 days after August 10, 2019 i.e. January 20, 2020.
Days of Grace added as it is case of Bills and it is Negotiable Instrument.

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6.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 4

A trader having accepted the following several bills falling due on different dates, now desires to have these bills
cancelled and to accept a new bill for the whole amount payable on the average due date :
Sl. No. Date of bill Amount Usance of the bill
1 1st March 2020 400 2 months
2 10th March 2020 300 3 months
3 5th April 2020 200 2 months
4 20th April 2020 375 1 month
5 11th May 2020 500 2 months

You are required to find the said average due date.

SOLUTION

Calculation of the average due date

Taking 4th May as the base date
Sl. Date of bill Due Date of Amount No. of days Product
No. Maturity ` from starting date (4th May)
1 1st March 2020 4th May 400 0 0
2 10th March 2020 13th June 300 40 12,000
3 5th April 2020 8th June 200 35 7,000
4 20th April 2020 23rd May 375 19 7,125
5 11th May 2020 14th July 500 71 35,500
Total : 1,775 61,625

Average Due Date is 61,625/1,775=34.71 i.e., 35 days after the assumed due date, 4th May, 2020. The new bill
should be for ` 1,775 payable on June 8th, 2020.
Case 2: Learn calculation of average due date Where inter transactions between 2 Parties are involved
When more than one party is involved where one party purchase and also sells to other party like JK Tyres and
Maruti where Maruti sells car to JK Tyres for their employees and purchases Tyres from them. In such a case
instead of paying gross amount they may go for new amount i.e. Purchase amount and sales amount will be set
off and thus here we take difference of amount and produce as Net Amount. In such cases, earliest date of both
parties is taken as the base date.

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93 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.93

ILLUSTRATION 5

Two traders X and Y buy goods from one another, each allowing the other one month’s credit. At the end of 3
months the accounts rendered are as follows:
Goods sold by X to Y Goods sold by Y to X
` `
April 18 60.00 April 23 52.00
May 15 70.00 May 24 50.00
June 17 80.00

Calculate the date upon which the balance should be paid so that no interest is due either to X or Y.

SOLUTION

Taking May 18th as the zero or base date (April 18 + One month Credit = 18 May)
For Y’s payments:
Date of Due Date Amount No. of days from the base date Products
Transactions
(1) (2) (3) (4) (5)
April 18 May 18 60 0 0
May 15 June 15 70 28 1,960
June 17 July 17 80 60 4,800
Amount Due to X 210 Sum of products 6,760

For X’s payments

The students should note that the same base date should be taken. Therefore, the base date will be May 18th in
this case also.
Date of Transactions Due Date Amount No. of days from the base date Products
(1) (2) (3) (4) (5)
April 23 May 23 52 5 260
May 24 June 24 50 37 1,850
Amount Due to Y 102 Total products 2,110

Excess of Y’s products over X’s = 6,760 – 2,110

= 4,650
Excess amount due to X ` 210 – 102 = ` 108.
Number of days from the base date to the date of settlement is
4,650
= 43 days
108

Hence the date of settlement of the balance is 43 days after May 18 i.e., on June 30. On June 30, Y has to pay
X, ` 108 to clear the account.

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6.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 6

Manoj had the following bills receivables and bills payable against Sohan. Calculate the average due date, when
the payment can be received or made without any loss of interest.
Date Bills Receivable Tenure Date Bills Payable Tenure
` `
01/06/2020 3,000 3 month 29/05/2020 2,000 2 month
05/06/2020 2,500 3 month 03/06/2020 3,000 3 month
09/06/2020 6,000 1 month 9/06/2020 6,000 1 month
12/06/2020 1,000 2 month
20/06/2020 1,500 3 month

15 August, 2020 was a Public holiday. However, 6 September, 2020 was also declared as sudden holiday.

SOLUTION

Let us take 12.07.2020 as Base date.

Bills receivable
Due date No. of days from 12.07.2020 Amount Product
04/09/2020 54 3,000 1,62,000
08/09/2020 58 2,500 1,45,000
12/07/2020 0 6,000 0
14/08/2020 33 1,000 33,000
23/09/2020 73 1,500 1,09,500
14,000 4,49,500

Bills payable
Due date No. of days from 12.07.2020 Amount Product
01/08/2020 20 2,000 40,000
07/09/2020 57 3,000 1,71,000
12/07/2020 0 6,000 0
11,000 2,11,000

Excess of products of bills receivable over bills payable = 4,49,500 – 2,11,000 = 2,38,500
Excess of bills receivable over bills payable = 14,000 – 11,000 = 3,000
Number of days from the base date to the date of settlement is 2,38,500/3,000 = 79.5 (appox.)
Hence date of settlement of the balance amount is 80 days after 12th July i.e. 30th September.
On 30th September, 2020 Sohan has to pay Manoj ` 3,000 to settle the account.

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95 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.95

ILLUSTRATION 7

Mr. Kapoor had the following Bills receivable and Bills payable against Mr. Khan, the details of which has been
given as follows-
Bills receivable Bills payable
Date Amount Tenure Date Amount Tenure
1.5.2020 400 3 months 11.5.2020 800 60 days
19.6.2020 750 2 months 21.6.2020 950 30 days
25.6.2020 1,000 1 month 28.6.2020 1,150 45 days
7.7.2020 1,250 2 months 10.7.2020 1,800 50 days
14.7.2020 800 2 month 16.7.2020 1,250 55 days

Gazetted holidays in the intervening period

15th August (Independence day), 24th July (Emergency holiday), 10th September (Sunday)

SOLUTION

Base date-The date of the first transaction - 13.07.2020

Payment to be made by Mr. Khan to Mr. Kapoor
Due date No. of days from base Amount Product
date
04.08.2020 22 400 8,800
22.08.2020 40 750 30,000
28.07.2020 15 1000 15,000
09.09.2020 58 1250 72,500
17.09.2020 66 800 52,800
Total 4,200 1,79,100

Payment to be made by Mr. Kapoor to Mr. Khan

Due date No. of days from base Amount Product
date
13.07.2020 0 800 0
25.07.2020 12 950 11,400
14.08.2020 32 1,150 36,800
01.09.2020 50 1,800 90,000
12.09.2020 61 1,250 76,250
Total 5,950 2,14,450

Difference in products = Mr. Kapoor to pay to Mr. Khan = 2, 14, 450-1,79,100 = 35350.

© The Institute of Chartered Accountants of India

6.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

Difference in amounts = 5,950-4,200 = 1,750

Difference in products
Average due date = Base date ±
Difference in amounts
35,350
13th July + = 13th July + 20.2 days = 20 days
1,750
Average due date = 2nd August, 2020

ILLUSTRATION 8

Mr. Green and Mr. Red had the following mutual dealings and desire to settle their account on the average due
date:
Purchases by Green from Red: `
6th January, 2020 6,000
2nd February, 2020 2,800
31st March, 2020 2,000
Sales by Green to Red:
6th January, 2020 6,600
9th March, 2020 2,400
20th March, 2020 500
You are asked to ascertain the average due date. (28 days in February)

SOLUTION

Calculation of Average Due Date

Taking 6th January, 2020 as base date
For Green’s payments
Due date Amount No. of days from the base date i.e. Product
6th Jan. 2020
2020 `
6th January 6,000 0 0
2nd February 2,800 27 75,600
31st March 2,000 84 1,68,000
Total 10,800 2,43,600
For Red’s payment
2020
6th January 6,600 0 0
9th March 2,400 62 1,48,800
20th March 500 73 36,500
Total 9,500 1,85,300

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97 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.97

Excess of Green’s products over Red’s = ` 2,43,600 – ` 1,85,300 = ` 58,300

= ` 10,800 – ` 9,500 = ` 1,300
Number of days from the base date to the date of settlement is 58,300/1,300 = 45 days (approx.)
Hence, the date of settlement of the balance amount is 45 days after 6 th January i.e. on 20th February.
On 20th February, 2020, Green has to pay Red ` 1,300 to settle the account.
Case 3: Learn calculation of average due date where amount is repaid in Instalments
Calculation of average due date in a case where the amount is lent in one instalment and repayment is done in
various instalments (opposite to what we have done in the first case). The problem takes a different shape. The
procedure for calculating average due date can be summarized as under:
Step 1: Calculate number of days/monthly/years from the date of lending money to the date of each repayment.
Step 2: Find the total of such days/months/years.
Step 3: Quotient will be the number of days/months/years by which average due date falls away from date of
commencement of loan.
As explained earlier, if instalment are same, we can use Simple mean concept i. Divide days by number of items
and no need for product.
Thus, the formula for the average due date can be written as under:
Sum of days/months/years from the date of Lending
Average due date = Date of Loan + to the date of repayment of each instalment
Number of instalments

ILLUSTRATION 9

` 10,000 lent by Dass Bros. to Kumar & Sons on 1st January, 2015 is repayable in 5 equal annual instalments
commencing on 1st January, 2016. Find the average due date and calculate interest at 5% per annum, which
Dass Bros. will recover from Kumar & Sons.

SOLUTION

Due date No. of years from 1 Jan 2015

1 Jan 2015 0
1 Jan 2016 1
1 Jan 2017 2
1 Jan 2018 3
1 Jan 2019 4
1 Jan 2020 5

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6.98 PRINCIPLES AND PRACTICE OF ACCOUNTING

Average=5+4+3+2+1/5=3 years
Sum of days/months/years from the date of Lending
Average due date = Date of Loan + to the date of repayment of each instalment
Number of instalments
1+ 2 + 3 + 4 + 5
= Jan. 1, 2015 +
5
= Jan. 1, 2015 + 3 years
= 1st Jan., 2018
Interest at a certain rate on the instalments paid from the date of payment to any fixed date will be the same as
on ` 10,000 (if lent on 1st Jan., 2018 to that fixed date). There will be no loss to either party. Supposing rate of
interest is 5% p.a. and date of settlement is 31st Dec., 2016 then calculation of interest by product method from
both parties’ point of view will be as follows:
Dass Bros. pays interest as follows:
Amount Paid on Money used by Dass Bros upto 31st Dec. 2020 Product
` `
2,000 1st Jan. 2016 5 Years 10,000
2,000 1st Jan. 2017 4 Years 8,000
2,000 1st Jan. 2018 3 Years 6,000
2,000 1st Jan. 2019 2 Years 4,000
2,000 1st Jan. 2020 1 Year 2,000
30,000
` 30,000 × 5
Interest at 5% p.a. on ` 30,000 for one year. = = ` 1,500
100
Dass Bros. will receive interest (if given on 1st Jan., 2018 on ` 10,000 from average due date to 31st Dec.,
5 × 3 ×` 10,000
2020, i.e., for 3 years at 5% p.a. = = ` 1,500
100
From the above, it can be concluded that if the borrower pays ` 2,000 yearly from 1st Jan., 2016 for 5 years and
if the lender gives ` 10,000 on 1st Jan., 2018 then both will charge same interest from each other. There is no
loss to any of the parties. But actually lender gives ` 10,000 on 1st Jan., 2015, therefore, he has given loan 3
years in advance and will charge interest on ` 10,000 for 3 years.
` 10,000 × 5 × 3
Interest = = ` 1,500 (to be charged by Dass Bros.)
100

ILLUSTRATION 10

` 20,000 lent on 1st January 2015, is repaid as follows-

` 2500 on 1st January 2016
` 5500 on 1st January 2017

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99 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.99

` 3000 on 1st January 2018

` 5000 on 1st January 2019
` 4000 on 1st January 2020
Determine the average due date for settling all the above instalments by a single payment and compute interest
at the rate of 10% per annum

SOLUTION

Due date Amount No. of months from Products

(in `) 1.1.2015
1st January 2016 2500 12 30,000
1st January 2017 5500 24 1,32,000
1st January 2018 3000 36 1,08,000
1st January 2019 5000 48 2,40,000
1st January 2020 4000 60 2,40,000
20,000 7,50,000
Total of Product
Average due date = Base date +
Total of amount
1st January 2015 + = 37.5 months~ 38 months
Average due date= 1st January 2015+ 38 months = 1st March 2018.
20,000 × 10 × 3.17
Interest for the 38 months = = 6,340.
100
Case 4: Learn Calculation of average due date for determining interest on drawings
In the case of drawings also, amount is drawn by the owners of business on various dates but it may settled on
one day. It should be noted that, when different amounts are due on different dates, but they are ultimately settled
on one day the interest may be calculated by means of Average Due Date. When interest is chargeable on
drawings, and drawings are on different dates, interest may be calculated on the basis of Average Due Date of
drawings determined on the basis given above. An illustration is given below to help in understanding the same:

ILLUSTRATION 11

A and B, two partners of a firm, have drawn the following amounts from the firm in the year ending
31st March, 2020:
Date A Date B
` `
1st July 500 12th June 1,000
30th September 800 11th August 500
1st November 1,000 9th February 400
28th February 400 7th March 900

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6.100 PRINCIPLES AND PRACTICE OF ACCOUNTING

Interest at 6% p.a. is charged on all drawings. Calculate interest chargeable by using (i) ordinary system
(ii) Average due date system. (assume 1 year = 365 days) any fraction of day should be ignored.

SOLUTION

(i) Ordinary System :

A 500 for 9 months = 4,500 for 1 month
800 for 6 months = 4,800 for 1 month
1,000 for 5 months = 5,000 for 1 month
400 for 1 month = 400 for 1 month
14,700 for 1 month
14,700 @ 6% for 1 month = 1/2% of 14,700
= ` 73.50
B 1,000 for 292 days = 2,92,000
500 for 232 days = 1,16,000
400 for 50 days = 20,000
900 for 24 days = 21,600
4,49,600
6 1
4,49,600 x × = ` 73.91
100 365
(ii) Average Due Date System:
(a) Taking 1st July as the base date (O-day)
Dates ` Months from O-day Products
1st July 500 0 0
30th September 800 3 2,400
A 1st November 1,000 4 4,000
28th February 400 8 3,200
2,700 9,600
9,600
Average Due Date = months from 1st July. i.e., 3.556 months i.e. October 17th.
2,700
6 5,444
Interest is chargeable from October 17 to March 31 i.e. 5.444 months 2,700 × × = ` 73.49
100 12
Or,
Taking 1st April as the base date (O-day):
Dates ` Months from O-day Products
A 1st July 500 3 1,500
30th September 800 6 4,800

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101 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.101

1st November 1,000 7 7,000

28th February 400 11 4,400
2,700 17,700
17,700
Average Due Date = months from 1st April. i.e. 6.556 months i.e. 17th October.
2,700

6 5444
Interest is chargeable from October 17 to March 31 i.e. 5.444 months. 2,700 × × = ` 73.49
100 12
(b) Taking 12th June as the base date (Zero-day)
Dates ` Days from O-day Products
B 12th June 1,000 0 0
11th August 500 60 30,000
9th February 400 242 96,800
7th March 900 268 2,41,200
2,800 3,68,000
3,68,000
Average Due Date = days from 12th June. i.e. 131 days.
2,800

June 18
July 31
Aug. 31
Sept. 30
110
131 days -110 days i.e. 21st October
So, interest is chargeable from 21st October to 31st March i.e. for 161 days.
6 161
2,800 × × = ` 74.10
100 365
The Differences in amounts in the two systems (1) and (2) are due to approximation.

ILLUSTRATION 12

A partner in a firm has drawn the following amounts for the half year ended on 31st March 2020 :
Date Amount
9th Sep, 2019 9,000
10th Oct, 2019 10,000
11th Nov, 2019 11,000
12th Dec, 2019 12,000
13th Jan, 2020 13,000

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6.102 PRINCIPLES AND PRACTICE OF ACCOUNTING

14th Feb, 2020 14,000

15th Mar, 2020 15,000

Assume February has 28 days

SOLUTION

Base date = 9th September

Calculation of average due date
Due date Amount No of days from base date Product
9th Sep, 2019 900 0 0
10th Oct, 2019 1,000 31 31,000
11th Nov, 2019 1,100 63 69,300
12th Dec, 2019 1,200 94 1,12,800
13th Jan, 2020 1,300 126 1,63,800
14th Feb, 2020 1,400 158 2,21,200
15th Mar, 2020 1,500 187 2,80,500
8,400 8,78,600

Total of Product
Average due date = Base date +
Total of amount
8,78,600
9th September, 2019 + = 104.60 days = 105 days
8,400

Average due date=9th September, 2019 + 105 days = 23rd December, 2019.

SUMMARY
 Average Due Date is one on which the net amount payable can be settled without causing loss of interest
either to the borrower or the lender.
 It is used in various cases like:
(i) Calculation of interest on drawings of partners.
(ii) Cancellation of various bills of exchange due on different dates and issuance of a Single bill.
(iii) Amount lent in one instalment and repayable in various instalments.
 When the amount is lent in various instalments then average due date can be calculated as :
Total Amount × No. of days from base date to due date
Average due date = Base date ±
Total Amounts
 When interest is chargeable on drawings, and drawings are on different dates, interest may be calculated
on the basis of Average Due Date of drawings.

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103 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.103

 Average due date in a case where the amount is lent in one instalment and repayment is done in various
instalments will be:
Sum of days/months/years from the date of lending to
Average due date = Date of Loan + the date of repayment of each instalments
Total Amounts
Every promissory note or bill of exchange (other than those payable on demand or at sight or on
presentment) falls due on the third day after on which it is expressed to be payable. This exempted
period of three days is called days of grace.

TEST YOUR KNOWLEDGE

True and False
1. The specific due date excludes the addition of grace days to arrive at the due date.
2. Payment made before the average due date entitles rebate to the customer.
3. Average due date results in loss to the party making the payment.
4. Interest has to be paid by the party making payment exactly on the average due date.
5. Where the due date is a Public holiday and the preceding day is Sunday (holiday), then the due date
falls on the day preceding Sunday.

Multiple Choice Questions

1. If payment is made on the average due date it results in-
(a) Loss of interest to the creditor.
(b) Loss of interest to the debtor.
(c) No loss of interest to either of them.
2. A mean date is calculated
(a) In connection with the settlement of contra accounts.
(b) For a lump sum payment.
(c) For several payments on different dates.
3. If payment is made after average due date, the party entitled to interest is
(a) Creditor (b) Debtor (c) Bank
4. When due date is a public holiday, then the due date will be.
(a) Succeeding business day
(b) Preceding business day
(c) Due date will not change and will remain same.
5. A Bill due on 29th January, 2020 is made payable at one month after date. The due date of instrument

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6.104 PRINCIPLES AND PRACTICE OF ACCOUNTING

(a) 28th February, 2020

(b) 29th February, 2020
(c) 3rd March, 2020

Theoretical Questions
1. Define Average Due Date.
2. List out the various instances when Average Due Date can be used.

Practical Questions
1. Mr. Yash and Mr. Harsh are partners in a firm. They had drawn the following amounts from the firm
during the year ended 31.03.2020:
Date Amount Drawn by
` `
01.05.2019 75,000 Mr. Yash
02.07.2019 20,000 Mr. Yash
15.08.2019 60,000 Mr. Harsh
31.12.2019 50,000 Mr. Harsh
04.03.2020 75,000 Mr. Harsh
31.03.2020 15,000 Mr. Yash

Interest is charged @ 10% p.a. on all drawings. Calculate interest chargeable from each partner by using
Average due date system. (Consider 1st May as base date) (1 year = 365 days)
Anand purchased goods from Amirtha, the average due date for payment in cash is 10.08.2020 and the
total amount due is ` 67,500. How much amount should be paid by Anand to Amirtha, if total payment
is made on following dates and interest is to be considered at the rate of 12% p.a.
(i) On average due date.
(ii) On 25th August, 2020.
(iii) On 30th July, 2020.

ANSWERS/HINTS
True and False
1. True: Where the due date is specifically given, then there is no need of further addition of 3 days grace
to it.
2. True: The rebate is given to the customers who make payment early to the average due date calculate.
3. False: It is single weighted average date calculated in such a way that it does not create any profit / loss
to both the parties involved.

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105 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.105

4. False: If payment made on the average due date, then there is no need to pay interest or provide rebate
as it is a date resulting in no profit/loss to either parties.
5. True: This can be understood from the following example- where August 15th is the due date, then the
revised due date is 14th- which is Sunday (holiday), then the due date becomes 13 th (preceding working
day).

Multiple Choice Questions

1. (c) 2. (c) 3. (a) 4. (b) 5. (c)

Theoretical Questions
1. In business enterprises, many receipts and payments by and from a single party may occur at different
points of time. To simplify the calculation of interest involved for such transactions, the idea of average
due date has been developed. Average Due Date is a break-even date on which the net amount payable
can be settled without causing loss of interest either to the borrower or the lender.
2. Few instances where average due date can be used:
(i) Calculation of interest on drawings made by the proprietors or partners of a business firm at
several points of time.
(ii) Settlement of accounts between a principal and an agent.
(iii) Settlement of contra accounts, that is, A and B sell goods to each other on different dates.

Practical Questions
Answer 1
Calculation of Interest chargeable from Partners
Taking 1st May as the base date
Dates Amount (`) Days from 1st May Products (` )
Yash 1.5.2019 75,000 0 0
2.7.2019 20,000 62 12,40,000
31.3.2020 15,000 334 50,10,000
1,10,000 62,50,000

62,50,000
Average Due Date = days from 1st May. i.e. 57 days = 27th June
1,10,000
Interest is chargeable for Yash from 27th June to March 31 i.e. 277 days
` 1,10,000 x 10% x 277/365 = ` 8,348
Dates (`) Days from 1 May Products (` )
Harsh 15.8.2019 60,000 106 63,60,000
31.12.2019 50,000 244 1,22,00,000

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6.106 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.3.2020 75,000 307 2,30,25,000

1,85,000 4,15,85,000

4,15,85,000
Average Due Date = days from 1st May = 225 days.
1,85,000
= 12th Dec.
Interest is chargeable for Harsh from 12th December to 31st March i.e. for 109 days.
10 109
` 1,85,000 x x = ` 5,525
100 365
Thus, interest amounting ` 8,348 will be charged from Yash and amount of ` 5,525 will be charged from Harsh.
Answer 2

A B C D=BC
Principal Interest from Average Due Date to Actual date of Payment Total amount
Amount to be paid

(i) Payment on average due date

12 0
` 67,500 ` 67,500 x × =0 ` 67,500
100 365

(ii) Payment on 25th Aug. 2020

` 67,500 12 15
` 67,500 x × = 333
100 365
` 67,833
Interest to be charged for period of 15 days from 10.8.2020 to
25th Aug. 2020

(iii) Payment on 30th July, 2020

` 67,500 12 (11)
` 67,500 x × = (244)
100 365
` 67,256
Rebate has been allowed for unexpired credit period of 11 days
from 30.7.2020 to 10.8.2020

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107 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.107

UNIT – 5 ACCOUNT CURRENT

LEARNING OUTCOMES
After studying this unit, you would be able to:
♦ Understand the meaning of Account Current.
♦ Learn the methods of preparing Account Current, namely preparation of Account Current with
the help of interest tables, by means of product and by means of balances.
♦ Understand the calculation procedure involved in the preparation of Account Current.

UNIT OVERVIEW

WAY OF PREPARING ACCOUNT CURRENT

By means of
With the help of By means of
products of
Interest tables products
balances

5.1 INTRODUCTION
An Account Current is a running statement of transactions between parties for a given period of time and includes
interest allowed or charged on various items. It takes the form of an ledger account.
Some of the situations when account current is prepared are:
1. It is prepared when frequent transactions regularly take place between two parties. For example it is
prepared by a manufacturer who sells goods frequently to a merchant on credit and receives payments
from him in instalments at different intervals and charges interest on the amount which remains
outstanding.
2. A consignee of goods can also prepare an Account Current, if the latter is to settle the account at the
end of the consignment & interest is chargeable on outstanding balance.
3. An Account Current also is frequently prepared to set out the transactions taking place between a banker
and his customer.
4. It is prepared when two or more persons are in joint venture and each co-venture is entitled to interest
on their investment. Also, no separate set of book is maintained for it.
An Account Current has two parties - one who renders the account and the other to whom the account is rendered.
This is indicated in the heading of an Account Current, which is like the following: “A in Account Current with B”.
It implies that A is the customer, and the account is being rendered and prepared to him by B.

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6.108 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.2 PREPARATION OF ACCOUNT CURRENT

There are three ways of preparing an Account Current:
(i) With help of interest table
(ii) By means of products
(iii) By means of products of balances

5.2.1 Method 1: Preparation of Account Current with the help of Interest Tables-
Individual Method
According to this method, all the transactions are arranged in the form of an account. There are two additional
columns on both the sides of such an account.
(a) One column is meant to indicate the number of days counted from the due date of each transaction to
the date of rendering the account. If no specific date is mentioned as the date on which payment is due,
the date of the transactions is presumed to be the due date.
(b) The other column is meant for writing interest.
With the help of ready made tables, interest due on different amounts at given rates for different periods of time
is found out and this is entered against each item separately.
The interest columns of both the sides are totalled up and the balance is drawn.

ILLUSTRATION 1

Prepare Account Current for Nath Brothers in respect of the following transactions with Shyam:
2019 `
September 16 Goods sold to Shyam 200 due 1st Oct.
October 1 Cash received from Shyam 90
October 21 Good purchased from Shyam 500 due 1st Dec.
November 1 Paid to Shyam 330
December 1 Paid to Shyam 330
December 5 Goods purchased from Shyam 500 due 1st Jan.
December 10 Goods purchased from Shyam 200 due 1st Jan.
2020
January 1 Paid to Shyam 600
January 9 Goods sold to Shyam 20 due 1st Feb.

The account is to be prepared upto 1st February. Calculate interest @ 6% per annum. (1 year = 365 days)

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109 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.109

SOLUTION

Shyam in Account Current with Nath Brothers

(Interest to 1st February, 2020 @ 6% p.a.)
Date. Particulars Due Amount Days Interest Date Particulars Due Amount Days Interest
2019 date ` 2019 date `
Sept.16 To Sales 1st Oct. 200 123 4.04 Oct. 1 By Cash A/c 1st 90 123 1.82
A/c Oct.
Nov.1 To Cash A/c 1st Nov. 330 92 5 Oct. By Purchase 1st 500 62 5.1
21 A/c Dec.
Dec. 1 To Cash A/c 1st Dec. 330 62 3.36 Dec. 5 By Purchase 1st 500 31 2.55
A/c Jan.
Dec.1 By Purchase 1st 200 31 1.02
0 A/c Jan.
2020 2020
Jan. 1 To Cash A/c 1st Jan. 600 31 3.06 Feb. 1 By Balance of 4.97
Interest
Jan. 9 To sales A/c 1st Feb. 20 Feb.1 By Balance c/d 194.97 -
Feb. 1 To Interest 4.97
1,484.97 15.46 1,484.97 15.46

Tutorial Notes:
(1) While counting the number of days, the date of due date is ignored and the date upto which the account
is prepared, is included.
(2) While counting the number of days, for opening balances, the opening date as well as date upto which
the account is prepared, is counted.
Calculation of days:
Transaction Due Date Oct. Nov. Dec. Jan. Feb. Total Days
2019
16th Sept. 1st Oct. 30+ 30+ 31+ 31+ 1= 123
1st Oct. 1st Oct. 30+ 30+ 31+ 31+ 1= 123
21st Oct. 1st Dec. - - 30+ 31+ 1= 62
1st Nov. 1st Nov. - 29+ 31+ 31+ 1= 92
1st Dec. 1st Dec. - - 30+ 31+ 1= 62
5th Dec. 1st Jan. - - - 30+ 1= 31
10th Dec. 2020 1st Jan. - - - 30+ 1= 31
1st Jan. 1st Feb. - - - 30+ 1= 31
9th Jan. 1st Feb. - - - - -= 0

© The Institute of Chartered Accountants of India

6.110 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.2.2 Method 2: Preparation of Account Current by means of Products; Product

Method
When this method is followed, the way of preparing the Account Current remains the same. In this method is only
the method of calculating interest is different.
Under the previous method, interest columns are provided on both the sides of the Account Current, and interest
in respect of each item is found out from the ready-made interest tables. In this method, interest columns are
replaced by “product” columns. Product in this case is the amount multiplied by the number of days for which it
has been outstanding. Interest on a certain sum of money for a certain number of days is the same thing as
interest on the product for one day. In other words, with a view to reduce the period of each transaction to one
day, the amount of each transaction is multiplied by the number of days. This product is entered against each
transaction the product column.
The remaining steps are as follows:
(a) Find out the balance of the products on the two sides.
(b) Calculate interest at the given rate on the balance of the products for a single day.
(c) Enter interest on the appropriate side in the amount column. This entry is made on the side other than
that on which the balance of products appears.
Taking Illustration 1 Account Current by means of Product is explained below :
Shyam in Account Current with Nath Brothers
(Interest to 1st February, 2020 @ 6% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
date date
2019 ` ` ` 2019 ` ` `
Sept. 16 To Sales A/c 1st Oct 200 123 24,600 Oct. 1 By Cash A/c Oct.1 90 123 11,070
1 Nov. To Cash A/c 1st Nov 330 92 30,360 Oct.21 By Purchase A/c Dec.1 500 62 31,000
1 Dec. To Cash A/c 1st Dec 330 62 20,460 Dec.5 By Purchase A/c Jan. 1 500 31 15,500
Dec.10 By Purchase A/c 1-Jan 200 31 6,200
2020 2020
Jan.1 To Cash A/c 1-Jan 600 31 18,600 Feb.1 By Balance of 30,250
products
Jan.9 To Sales A/c 1-Feb 20 Feb.1 By Balance c/d 194.97
Feb.1 To Interest 4.97
(30,250x6%)/365
1,484.97 94,020 1,484.97 94,020
2020
Feb To Balance b/d 194.97

5.2.3 Method of Computing the numbers of Days

Usually any of the following two methods is used for calculating the number of days.

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111 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.111

1. Forward Method- Under this method the number of days are calculated from the due date of the
transaction to the date of closing the account.
2. Backward (or Epoque Method)- Under this method, the number of the days are calculated from the
opening date of statement to the due date of transaction.
Example
From the following particulars, make up an Account Current to be rendered by Mr. X to Mr. Y on 31st December,
2020 taking interest into account at the rate of 18% p.a.

01.07. 2020 Balance owing by Mr. Y ` 600

30.07. 2020 Goods sold to Mr. Y (Credit Period allowed 1 month) ` 300

01.08. 2020 Good purchased from Mr. Y (Credit Period received 1 month) ` 200

01.09. 2020 Cash received from Mr. Y ` 100

01.09. 2020 Mr. Y accepted Mr. X’s Draft at 3 Months date ` 400

You are required to prepare the Account Current according to interest on individual transaction under the Forward
and Backward methods. (1 year = 365 days)

SOLUTION

(a) Product of individual Transaction Method (Forward Method)

Mr. Y in Account Current with Mr. X (interest to 31st Dec. 2020 @ 18% p.a.)
Date Particulars Due Amt. Days Product Date Particulars Due Amt. Days Product
date ` ` date ` `

01.07.2020 To Balance b/d 600 184 1,10,400 01.08.2020 By Purchase Sep. 1 200 121 24,200
A/c
30.07. 2020 To Sales A/c Aug 30 300 123 36,900 01.09.2020 By Cash A/c Sep. 1 100 121 12,100
31.12. 2020 To Interest on 49 01.09.2020 By B/R A/c Dec. 4 400 27 10,800
Balance for
1 day @
18%
 1, 00, 200 × 18 × 1 
 100 × 365 

31.12.2020 By Balance 1,00,200

of Products
31.12.2020 By Balance 249
c/d
949 1,47,300 949 1,47,300

© The Institute of Chartered Accountants of India

6.112 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) Product of individual Transaction Method (Epoque Method)

Mr. Y in Account Current with Mr. X (interest to 31st Dec. 2020 @ 18% p.a.)
Date Particulars Due Amt. Days Product Date Particulars Due Amt. Days Product
date ` date ` `
`
01.07.2020 To Balance b/d 600 01.08.2020 By Purchase Sep. 1 200 63 12,600
A/c
30.07.2020 To Sales A/c 30-Aug 300 61 18,300 01.09. 2020 By Cash A/c Sep. 1 100 63 6,300
31.12.2020 To Balance of 1,00,200 01.09. 2020 By B/R A/c Dec. 4 400 157 62,800
Product
31.12.2020 To Interest on 49 31.12. 2020 By Balance of 36,800
Balance for 1 Products
day @ 18% [200 x
184]
 1, 00, 200 × 18 × 1 
 100 × 365 
31.12. 2020 By Balance 249
c/d
949 - 1,18,500 949 1,18,500

ILLUSTRATION 2

From the following particulars prepare the account current to be rendered by Mr. Singh to Mr. Paul as on 31st
August, 2020. Interest must be calculated @ 10% p.a. (1 year = 365 days)
2020 `
June 11 Goods sent to Mr. Paul 1,020
June 15 Cash received from Mr. Paul 500
June 20 Goods sent to Mr. Paul 650
July 7 Goods sent to Mr. Paul 700
Aug 8 Cash received from Mr. Paul 1,100

SOLUTION

Mr. Paul in Account Current with Mr. Singh

(Interest to 31st August, 2020 @ 10% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
2020 Date ` 2020 Date `
June 11 To Sales A/c June 11 1,020 81 82,620 June 15 By Cash A/c June 15 500 77 38,500
June 20 To Sales A/c June 20 650 72 46,800 Aug.8 By Cash A/c Aug.8 1,100 23 25,300
July 7 To Sales A/c July 7 700 55 38,500 Aug.31 By Balance of 1,04,120
product
Aug.31 To Interest A/c 28.53 Aug. 31 Balance 798.53
1, 04,120 10 c/d
×
365 100
2,398.53 1,67,920 2,398.53 1,67,920
Sept. To Balance b/d 798.53

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113 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.113

ILLUSTRATION 3

Following running transactions took place between Me and You during the month of February, 2020.
Feb 2020 Particulars `
1 Amount payable by You to Me 5,000
5 Sales made by Me to You (invoice dated 07.04.2020) 8,250
8 Received acceptance of You by Me for 3 months 10,000
10 You sold goods to Me (invoice dated 10.3.2020) 11,000
12 Me received cheque from You dated (12.04.2020) 7,500
16 Cash paid by Me to You 2,500
24 Bills receivable accepted by Me from You on account of sale (due date- 24.03.20) 5,000
28 Cash paid by you to me 2500
Prepare account current to be rendered by me to you as on 31 March, 2020 charging interest @ 12% p.a.
st

SOLUTION

‘You’ In Account Current with ‘Me’

(Interest to 31st March, 2020 @ 12% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
2020 Date ` 2020 Date `
Feb 1 To Balance b/d 5,000 59 2,95,000 Feb 08 By Bills May 11 10,000 - -
Receivable
Feb 5 To Sales A/c Apr 07 8,250 - - Feb 10 By Purchases Mar 10 11,000 21 2,31,000
A/c
Feb 16 To Cash A/c Feb 16 2,500 43 1,07,500 Feb 12 By Bank A/c Apr 12 7,500 - -
Feb 24 To Bills Mar 24 5,000 7 35,000 Feb 28 By cash A/c Feb 28 2,500 31 77,500
payable
Mar 31 To Red ink May 11 - 41 4,10,000 Mar 31 By Red ink Apr 07 - 7 57,750
Product as per Product as
contra per contra
Mar 31 To Red ink Apr 12 - 12 90,000 Mar 31 By balance of 5,71,250
product as per product
contra
Mar 31 To Interest 187.3
(5,71,250x12%
× 1/366)
Mar 31 To balance C/d 10,062.7
31,000 9,37,500 31,000 9,37,500

Balance of ` 10,062.7 to be paid by Me to You.

ILLUSTRATION 4

From the following prepare an account current, to be rendered by Ali to Bali on 31st December, 2020 by means
of products method charging interest @ 8% p.a: (Assume 1 year = 365 days)

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6.114 PRINCIPLES AND PRACTICE OF ACCOUNTING

2020 Particulars `
Oct. 1 Balance due from Bali 2,000
Oct 19 Purchased goods from Bali 3,200
Oct 25 Returned goods to Bali 800
Nov 3 Sold goods to Bali 5,400
Nov 15 Bali accepted a bill drawn by Ali for one month 2,400
Nov. 30 Bills accepted by Bali earlier dishonoured on the due date 3,000
Dec 15 Received cash from Bali 2,000

SOLUTION

Bali in Account Current with Ali

(Interest to 31st Dec 2020, @ 8% p.a.)
Date Particulars Amount Days Product Date Particulars Amount Days Product
2020 ` 2020 `

Oct.1 To Balance b/d 2,000 92 1,84000 Oct.19 By Purchases A/c 3,200 73 2,33,600
Oct. 25 To Purchase 800 67 53,600 Dec. 18 By Bills receivable 2,400 13 31,200
returns A/c A/c (drawn for a
month)
Nov. 3 To Sales A/c 5,400 58 3,13,200 Dec 15 By cash A/c 2,000 16 32,000
Nov 30 To bills receivable 3,000 31 93,000 Dec. 31 By Balance of 3,47,000
(dishonoured) products
Dec. 31 To Interest Ac 76.05 Dec 31 By Balance c/d 3676.05

11,276.05 6,43,800 11,276.05 6,43,800

Calculation of interest: 3,47,000* 8%* 1/365= 76.05

ILLUSTRATION 5

From the following particulars make up an Account Current to be rendered by S. Dasgupta to A. Halder at
31st Dec. reckoning interest at 5% p.a. (assume 1 year = 365 days)
2019 `
June 30 Balance owing by A. Halder 520
July 17 Goods sold to A. Halder 40
Aug. 1 Cash received from A. Halder 500
Aug. 19 Goods sold to A. Halder 720
Aug. 30 Goods sold to A. Halder 50
Sept. 1 Cash received from A. Halder 400
Sept. 1 A. Halder accepted Dasgupta’s Bill at 3 month date for 300
Oct. 22 Goods bought from A. Halder 20
Nov. 12 Goods sold to A. Halder 14
Dec. 14 Cash received from A. Halder 50

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115 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.115

SOLUTION

A. Halder in Current Account with Mr. S. Dasgupta

(Interest to 31st December, 2019 @ 5% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
2019 Date ` 2019 Date `

June 30 To Balance b/d 520 185 96,200 Aug.1 By Cash A/c Aug.1 500 152 76,000
July 17 To Sales A/c July 17 40 167 6,680 Sep.1 By Cash A/c Sep.1 400 121 48,400
Aug.19 To Sales A/c Aug.19 720 134 96,480 Sep.1 By Bills Dec.4 300 27 8,100
Receivable
A/c (Note : 1)
Aug. 30 To Sales A/c Aug.30 50 123 6,150 Oct.22 By Purchases Oct.22 20 70 1,400
A/c
Nov.12 To Sales A/c Nov.12 14 49 686 Dec.14 By Cash A/c Dec.14 50 17 850
Dec.31 By Balance of 71,446
product
31 Dec. To Interest A/c 9.79 Dec.31 By Balance b/d
83.79 -------
71, 446 × 5%
365
1,353.79 2,06,196 1,353.79 2,06,196

Note: It is assumed that the bill was honoured on due date. The due date of the bill should be treated as date of
payment and days to be calculated from the due date of account.
Workings:
Calculation of Days
Date of Transactions : Due June July Aug. Sept. Oct. Nov. Dec. Total
date
Opening Balance 1 +31 +31 +30 +31 +30 +31 = 185
July 17 July 17 - 14 +31 +30 +31 +30 +31 = 167
Aug. 1 Aug. 1 - - 30 +30 +31 +30 +31 = 152
Aug. 19 Aug. 19 - - 12 +30 +31 +30 +31 = 134
Aug. 30 Aug. 30 - - 1 +30 +31 +30 +31 = 123
Sep. 1 Sep. 1 - - - 29 +31 +30 +31 = 121
Sep. 1 Dec. 4 - - - - - - 27 = 27
Oct. 22 Oct. 22 - - - - 9 +30 +31 = 70
Nov. 12 Nov. 12 - - - - - 18 +31 = 49
Dec. 14 Dec. 14 - - - - - - 17 = 17

Note: While counting the number of days, for opening balances, the opening date as well as date upto which the
account is prepared, is counted.

© The Institute of Chartered Accountants of India

6.116 PRINCIPLES AND PRACTICE OF ACCOUNTING

ILLUSTRATION 6

From the following prepare an account current, as sent by A to B on 30th June, 2020 by means of products method
charging interest @ 6% p.a:
2020 `
Jan. 1 Balance due from B 600
Jan.11 Sold goods to B 520
Jan. 18 B returns Goods 125
Feb 11 B Paid by cheque 400
Feb 14 B accepted a bill drawn by A for one month 300
Apr. 29 Goods sold to B 615
May 15 Received cash from B 700

SOLUTION

B in Account Current with A

(Interest to 30th June 2020, @ 6% p.a.)
Date Particulars Amount Days Products Date Particulars Amount Days Products
2020 ` 2020 `
Jan.1 To Balance b/d 600 182 1,09,200 Jan.18 By Sales Returns 125 164 20,500
Jan. 11 To Sales A/c 520 171 88,920 Feb. 11 By Bank A/c 400 140 56,000
Apr. 29 To Sales A/c 615 62 38,130 Feb. 14 By B/R A/c (due 300 105 31,500
June 30 To Interest A/c 15.75 date: March 17)
May 15 By Cash A/c 700 46 32,200
June 30 By Balance of 96,050
products
By Balance c/d 225.75
1,750.75 2,36,250 1,750.75 2,36,250

Calculation of interest:
96,050 6
Interest = × = ` 15.75
366 100
Red - Ink Interest: In case the due date of a bill falls after the date of closing the account, then no interest is allowed
for that. However, interest from the date of closing to such due date is written in “Red-Ink” in the appropriate side of
the ‘Account current’. This interest is called Red-Ink interest. This Red Ink interest is treated as negative interest. In
actual practice, however the product of such bill [value of bill X (due date-closing date) is written in ordinary ink in the
opposite side on which the bill is entered]. It means interest from future date from date of account current i.e., present
date. In earlier periods, it was written in red ink; hence it got the name of red ink interest. It implies that rebate will be
allowed on interest paid/ received, if settlement of future due transaction is done on account current date
This can also be understood in a different way. In an account current, interest is calculated on the amount of a bill from
the date of transaction to the closing date of the period concerned. In case the due date of the bill falls after the closing
date of the accounts, then no interest is allowed for that period. Such interest is customarily written in red ink in the
appropriate side of the account current. The interest is called Red-Ink interest and is treated as negative interest.

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117 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.117

ILLUSTRATION 7

Following transaction took place between X and Y during the month of April, 2020.
April `
1 Amount payable by X to Y 10,000
7 Received acceptance of X to Y for 2 months 5,000
10 Bills receivable (accepted by Y) on 7.2.2020 is honoured on this due date
10 X sold goods to Y (invoice dated 10.5.2020) 15,000
12 X received cheque form Y dated 15.5.2020 7,500
15 Y sold goods to X (invoice dated 15.5.2020) 6,000
20 X returned goods sold by Y on 15.4.2020 1,000
20 Bill accepted by Y is dishonoured on this due date 5,000
You are required to make out an account current by products method to be rendered by X to Y as on 30.4.2020,
taking interest into account @ 10% p.a. (assume 1 year = 365 days)

SOLUTION

‘Y’ In Account Current with ‘X’

(Interest to 30th April, 2020 @ 10% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
Date ` Date `
2020 2020 2020 2020
April 7 To Bills Payable June 10 5,000 - - April 1 By Balance b/d 10,000 30 3,00,000
April 10 To Sales A/c May 10 15,000 - - April 12 By Bank A/c May 15 7,500 - -
(Cheque received
dated 15.5.2020)
April 20 To Purchase May 15 1,000 - - April 15 By Purchase A/c May 15 6,000 - -
Returns (invoice dated
15.5.2020)
April 20 To Bill April 20 5,000 10 50,000
Receivable
A/c
April 30 To Red Ink May 15 15 1,12,500 April 30 By Red Ink Product as June10 - 41 2,05,000
Product per contra
(` 7,500 x15) (5,000 x 41)
as per contra
April 30 To Red Ink May 15 15 90,000 April 30 By Red Ink Product May 10 - 10 1,50,000
Product
(` 6,000 x15) as per contra
as per contra (15,000 x 10)
April 30 To Balance of 4,17,500 April 30 By Red Ink Product May 15 - - 15,000
product as per contra
(1,000 x 15)
April 30 By Interest A/c 114.38

April 30 By Balance c/d 2,385.62

26,000 6,70,000 26,000 6,70,000

No entry is required for matured bill on 10th April since party is not contracted.

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6.118 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.2.4 Method 3: Preparation of Account Current by Means of Product of Balances

in case of Banks.
This method, also known as periodic balance method, is usually adopted in the case of banks where the balance
of account is taken out after every transaction. In this case, the number of days written against each transaction
are the days counted from its date or due date to the date of the following transaction. In the case of the last
transaction, the number of days is counted to the close of the period.
Each amount is multiplied with the number of days. If the amount represents a debit balance, the product is
entered in the Dr. Product column; and if it represents a credit balance, the product is written in the Cr. Product
column. The Dr. Product and Cr. Product columns are then totalled up. Interest is calculated on each total at the
given rate of interest; and the net interest is ascertained. If net interest is payable to the customer, it will appear
as “By Interest A/c”, and if it is due from the customer, it will appear as “To Interest A/c”.

ILLUSTRATION 8

On 2nd January, 2020 Vinod opened a current account with the Allahabad Bank Limited; and deposited a sum of
` 30,000.
He further deposited the following amounts: `
15th January 12,000
12th March 8,000
10thMay 16,000
His withdrawals were as follows :
15th February 26,000
10th April 30,000
15th June 14,000

Show Vinod’s a/c in the ledger of the Allahabad Bank. Interest is to be calculated at 5% on the debit balance and
2% on credit balance. The account to be prepared as on 30 th June, 2020. Calculation may be made correct to
the nearest rupee. (assume 1 year = 365 days)

SOLUTION

Vinod Current Account with Allahabad Bank Ltd.

Date Particular Dr. Cr. Dr. or Cr. Balance Days Dr. Product Cr. Product
2020
Jan. 2 By Cash Account - 30,000 Cr. 30,000 13 - 3,90,000
Jan. 15 By Cash Account - 12,000 Cr. 42,000 31 - 13,02,000
Feb. 15 To Self 26,000 - Cr. 16,000 25 - 4,00,000
Mar. 12 By Cash Account - 8,000 Cr. 24,000 29 - 6,96,000
April 10 To Self 30,000 - Dr. 6,000 30 1,80,000 -
May 10 By Cash Account - 16,000 Cr. 10,000 36 - 3,60,000
June 15 To Self 14,000 - Dr. 4,000 15 60,000 -

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119 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.119

June 30 By Interest A/c - 140 Dr. 3,860 - -

June 30 By Balance c/d 3,860 -

70,000 70,000 2,40,000 31,48,000

July 1 To Balance b/d 3,860

* Interest is calculated as follows:

On ` 31,48,000 @ 2% for 1 day = ` 172.49
On ` 2,40,000 @ 5% for 1 day = ` 32.88
Net Interest = ` 139.61 (` 172.49- ` 32.88)

SUMMARY
 When interest calculation becomes an integral part of the account. The account maintained is called
“Account Current”.
Some examples where it is maintained are:
(i) Frequent transactions between two parties.
(ii) Goods sent on consignment
(iii) Frequent transactions between a banker and his customers
(iv) In case of Joint venture when no separate set of books is maintained for joint venture
 There are three ways of preparing an Account Current:
(i) With the help of interest tables
(ii) By means of products
(iii) By means of products of balances

TEST YOUR KNOWLEDGE

True and False
1. Current account and account current are one and the same.
2. The account current is an extension of the average due date concept.
3. Date of transaction or the due date whichever is earlier is considered for computation of the number of
days.
4. A is in account current with B- The person rendering the account current is Mr. A.
5. The honored bills of exchange will not be recorded in the account current.

Multiple Choice Questions

1. Red ink interest is
(a) really not interest

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6.120 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) negative interest

(c) used in connection with average due date.
2. An account current is a statement of mutual transactions
(a) between two parties
(b) in lieu of average due date
(c) prepared for a particular accounting period.
3. In account current, while counting the number of days, the due date is ignored and date up to which
the accounts are prepared, is
(a) included (b) excluded (c) ignored

Theoretical Questions
1. Define Account Current. Explain ways of preparing an Account Current
2. Write short note on Red-ink interest.

Practical Questions
1. Roshan has a current account with partnership firm. It has debit balance of ` 75,000 as on 01-07-2020.
He has further deposited the following amounts:
Date Amount (`)
14-07-2020 1,38,000
18-08-2020 22,000
He withdrew the following amounts :
Date Amount (`)
29-07-2020 97,000
09-09-2020 11,000
Show Roshan’s A/c in the ledger of the firm. Interest is to be calculated at 10% on debit balance and 8%
on credit balance. You are required to prepare current account as on 30 th September, 2020 by means of
product of balances method. (1 year = 365 days)
2. From the following particulars prepare a account current, as sent by Mr. Ram to Mr. Siva as on
31st October 2019 by means of product method charging interest @ 5% p.a.
2019 Particulars `
1st July Balance due from Siva 750
15th August Sold goods to Siva 1250
20th August Goods returned by Siva 200
22nd Sep Siva paid by cheque 800
15th Oct Received cash from Siva 500

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121 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.121

ANSWERS/HINTS
True and False
1. False: Account current statement of running transaction between two parties to ascertain the amount
along with interest payable. Current account is an account type to be maintained with the bank. In both
the interest is calculated, but then different methods to calculate the interest.
2. True: An extension of the counter transactions between two parties type under the average due date-
where in the date of the initial transaction is considered as the base date from which the no. of days to
the date of rendering the account is calculated.
3. False: The due date is considered for the purpose of calculation of number of days and not the date of
transaction.
4. False: It is B who is preparing and rendering the account current to Mr. A.
5. True: The bills of exchange which is honored will not appear in the account current, only in case of
dishonor, it will be appearing in the account current.

Multiple Choice Questions

1. (b) 2. (a) 3. (a)

Theoretical Questions
1. An Account Current is a running statement of transactions between parties for a given period of time and
includes interest allowed or charged on various items. It takes the form of an ledger account.
There are three ways of preparing an Account Current:
(i) With help of interest table.
(ii) By means of products.
(iii) By means of products of balances.
2. In case the due date of a bill falls after the date of closing the account, then no interest is allowed for
that. However, interest from the date of closing to such due date is written in “Red-Ink” in the appropriate
side of the ‘Account current’. This interest is called Red-Ink interest. This Red Ink interest is treated as
negative interest. In actual practice, however the product of such bill [value of bill X (due date-closing
date) is written in ordinary ink in the opposite side on which the bill is entered]. It means interest from
future date from date of account current i.e., present date. In earlier periods, it was written in red ink;
hence it got the name of red ink interest. It implies that rebate will be allowed on interest paid/ received,
if settlement of future due transaction is done on account current date.

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6.122 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
Answers 1
Roshan’s Current Account with Partnership firm (as on 30.9.2020)
Date Particulars Dr Cr Balance Dr. Days Dr Cr
or Product Product
(` ) (` ) (` ) Cr. (` ) (` )
01.07.20 To Bal b/d 75,000 75,000 Dr. 14 10,50,000
14.07.20 By Cash A/c 1,38,000 63,000 Cr. 15 9,45,000
29.07.20 To Self 97,000 34,000 Dr. 20 6,80,000
18.08.20 By Cash A/c 22,000 12,000 Dr. 22 2,64,000
09.09.20 To Self 11,000 23,000 Dr. 21 4,83,000
30.09.20 To Interest A/c 472 23,457 Dr.
30.09.20 By Bal. c/d 23,472
1,83,472 1,83,472 24,77,000 9,45,000
Interest Calculation:
On ` 24,77,000x 10% x 1/365 = 679
On ` 9,45,000 x 8% x 1/365 = (` 207)
Net interest to be debited = (` 472)
Answers 2
Siva in Account Current with Ram as on 31st Oct, 2019
Days Product Days Product
(`) (`) (`) (`)
01.07.19 To Bal. b/d 750 123 92,250 20.08.19 By Sales 200 72 14,400
Returns
15.08.19 To Sales 1,250 77 96,250 22.09.19 By Bank 800 39 31,200
31.10.19 To Interest 18.48 15.10.19 By Cash 500 16 8,000
By Balance of 1,34,900
Products
31.10.19 By Bal. c/d 518.48
2018.48 1,88,500 2018.48 1,88,500

5 1
Interest = ` 1,34,900 x × = ` 18.48
100 365

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