Diploma in Financial Accounting
A. Answer the following questions:
1. Definition of Accounting.
Ans. Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money transactions and events which are in part at least, of a financial character, and interpreting the results thereof.
2. Define Accounting System.
Ans. There are mainly two systems for recording transactions: Single Entry System and Double Entry System.
Single Entry System is a method of maintaining and keeping the accounts similar to checkbook register and single line entry is done in the journal for each transaction. Each transaction is represented as positive or negative entry.
In double entry system every transaction has two accounts. That is each debit entry has a corresponding credit entry of same amount in another account and vise versa and hence maintains the accounting equation i.e.:
Credits = Debits
Or
Assets = Liabilities + Equity
This means that the increase in company's assets will either increase the liabilities or will increase the equity. Or decrease in company assets will either decrease the liabilities or will decrease the equity
3. What are the Accounting Rules?
Ans. There are basically three types of accounts- Personal Real, and Nominal. Accounts of DEBTORS, CREDITORS, etc. are called as Personal accounts, Real accounts relate to the accounts of real items such as fixed assets, goods, cash, bank, etc. Incomes, expenses, losses and profits represent nominal accounts.
Personal Accounts: The transactions of a business which relate to individuals, business enterprises or other organizations are classified as transactions relating to personal accounts e.g. proprietors a/c, suppliers a/c, receivers a/c limited companys a/c, any clubs a/c, salaries outstanding a/c, prepaid rent a/c, etc. Under personal accounts a person either receives something from the business or gives something to the business.
Real Accounts: It is the accounts of assets and possession like Building, Machinery, Cash < stock, Goodwill and Trade Mark. A point to be noted that goods a/c is treated as a real a/c unless it is divided into purchase a/c and sales It is a/c.
Nominal Accounts: Accounts of income expenses, gains, and losses etc. It is always transferred to the Profit & Loss a/c . e.g. Salary a/c, Rent a/c, interest Received a/c, discount Received a/c etc.
1. FOR PERSONAL A/C: i) DEBT IS THE RECEIVER
ii) CREDIT IS THE GIVER.
2. FOR REAL A/C: i) DEBIT WHAT COMES IN.
ii) CREDIT WHAT GOES OUT.
3. FOR NOMINAL A/C: i) DEBIT ALL EXPENSES & LOSSES
ii) CREDIT ALL INCOMES & GAINS.
4. What do you mean by Basic Principle of Accounts?
Ans. Basic Principle:
Personal Accounts: The transactions of a business which relate to individuals, business enterprises or other organizations are classified as transactions relating to personal accounts e.g. proprietors a/c, suppliers a/c, receivers a/c limited companys a/c, any clubs a/c, salaries outstanding a/c, prepaid rent a/c, etc. Under personal accounts a person either receives something from the business or gives something to the business.
Real Accounts: It is the accounts of assets and possession like Building, Machinery, Cash < stock, Goodwill and Trade Mark. A point to be noted that goods a/c is treated as a real a/c unless it is divided into purchase a/c and sales It is a/c.
Nominal Accounts: Accounts of income expenses, gains, and losses etc. It is always transferred to the Profit & Loss a/c . e.g. Salary a/c, Rent a/c, interest Received a/c, discount Received a/c etc.
5. State Golden Rules of Accounting.
Ans. THE GOLDEN RULES
1. FOR PERSONAL A/C: i) DEBT IS THE RECEIVER
ii) CREDIT IS THE GIVER.
2. FOR REAL A/C: i) DEBIT WHAT COMES IN.
ii) CREDIT WHAT GOES OUT.
3. FOR NOMINAL A/C: i) DEBIT ALL EXPENSES & LOSSES
ii) CREDIT ALL INCOMES & GAINS.
6. Definition of Financial Accounting.
Ans. Financial accounts are the records of the financial dealings of the business, their every day transactions.
Financial Accounting is concerned with ascertainment of profits earned or loss suffered and financial position of a business firm at the end of the accounting period which is usually a period of 12 months i.e. one year. This is done through Book-keeping (recording of financial transactions in the books of original entry and classifying them under various headings) and Accounting (presenting the classified data in a manner which is understandable and useful to the owners and other parties.
7. Definition of Financial Statement.
Ans. A written report which quantitatively describes the financial health of a company. This includes an income statement and a balance sheet, and often also includes a cash flow statement.
Financial statements are usually compiled on a quarterly and annual basis.
8. What do you mean by Mechanics of Accounting?
Ans. The Mechanics of Accounting:
All business transactions can be expressed in terms of the accounting equation and it is important to gain some mastery over describing business transactions in terms of the accounting equation. It is possible to analyze transactions (business events) in terms of their effect on the accounting equation and to subsequently prepare financial statements.
In actual practice, however, accountants do not record transactions using the accounting equation as it is impractical when thousands of transactions must be analyzed and recorded. Rather accountants (and computers) use a summary device called an account to record transactions in the company's books and records. An account can be defined as a label used by accountants to record changes in assets, liabilities, and stockholders (owners) equity. In the recording process accountants use a double entry system in which each transaction affects at least two accounts.
In displaying and explaining transactions, accountants often use a T Account which takes its name from the letter T. Note that the T Account has a heading, a left side, and a right side. The left side is known as the debit side and the right side is known as the credit side.
As we stated above, the accountant uses a double entry system in analyzing and processing transactions. Each transaction requires at least one debit and one credit entry. In making these entries the accountant uses the rules of debit and credit. These rules can be summarized as follows:
Account Category Increase Decrease Normal Balance
Assets Dr. Cr. Dr.
Liabilities Cr. Dr. Cr.
Stockholders' Equity:
Capital Stock Cr. Dr. Cr.
Retained Earnings Cr. Dr. Cr.
Dividends Dr. Cr. Dr.
Revenue Cr. Dr. Cr.
Expense Dr. Cr. Dr.
The normal balance is the side of the account used to record increases.
All business transactions fall into one of the above account categories. It is important that we have the rules of debit and credit committed to memory as we will use them time and again as we proceed through the course.
As we begin to record transactions it may be helpful to use a three-step approach. The three steps can be summarized as follows:
1. Analyze the transaction to determine its effect on asset, liability, or stockholder equity accounts
2. Apply the rules of debit and credit
3. Record the entry using double entry bookkeeping
Entries are first recorded (journalized) in chronological order in the book of original entry called the general journal. Later they are transferred (posted) to the general ledger where details of each account are maintained. The ledger is a book of accounts (one page or file for each account) in which data from transactions recorded in the journals are posted and summarized.
Note that the debit entry is listed first. The credit entry is listed second and is indented to the right. Finally the date and a brief explanation are recorded.
Periodically and at the end of each accounting period, the ending balances in the ledger are listed in a trial balance. Accounts in the trial balance are listed in the order of assets, liabilities, common stock, revenue, and expense. The trial balance provides a check before the financial statements are produced. If total debits do not equal total credits, an error has been made. Even if total debits equal total credits an error may have been made. However, for now were going to assume that if total debits equal total credits no error has been made.
9. What are the basic of Inventory Accounting?
Ans. An organization's inventory can appear a mixed blessing, since it counts as an asset on the balance sheet, but it also ties up money that could serve for other purposes and requires additional expense for its protection. Inventory may also cause significant tax expenses, depending on particular countries' laws regarding depreciation of inventory.
Inventory appears as a current asset on an organization's balance sheet because the organization can, in principle, turn it into cash by selling it. Some organizations hold larger inventories than their operations require in order inflating their apparent asset value and their perceived profitability.
Businesses that stock too little inventory cannot take advantage of large orders from customers if they cannot deliver. The conflicting objectives of cost control and customer service often pit an organization's financial and operating managers against its sales and marketing departments.
10. Describe FIFO vs. LIFO Accounting.
Ans. FIFO vs. LIFO:
When a dealer sells goods from inventory, the value of the inventory is reduced by the cost of goods sold (CoG sold). This is simple where the CoG has not varied across those held in stock; but where it has, then an agreed method must be derived to evaluate it. For commodity items that one cannot track individually, accountants must choose a method that fits the nature of the sale. Two popular methods which normally exist are: FIFO and LIFO accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in inventory as the first one sold. LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation.
11. What do you mean by Inventory Credit?
Ans. Inventory credit refers to the use of stock, or inventory, as collateral to raise finance. Where banks may be reluctant to accept traditional collateral, for example in developing countries where land title may be lacking, inventory credit is a potentially important way of overcoming financing constraints. This is not a new concept; archaeological evidence suggests that it was practiced in Ancient Rome. Obtaining finance against stocks of a wide range of products held in a bonded warehouse is common in much of the world. It is, for example, used with parmesan cheese in Italy. Inventory credit on the basis of stored agricultural produce is widely used in Latin American countries and in some Asian countries. A precondition for such credit is that banks must be confident that the stored product will be available if they need to call on the collateral; this implies the existence of a reliable network of certified warehouses. Banks also face problems in valuing the inventory. The possibility of sudden falls in commodity prices means that they are usually reluctant to lend more than about 60% of the value of the inventory at the time of the loan.
Valuation of closing inventory of raw material, work in progress, finished goods and stores material is one of the most important aspects since it directly affects profits of the business. As a general rule
(i) Inventories are valued at cost or market price whichever is less.
(ii) At the end of year all the inventories are physically counted and verified and compared with inventories available as per records.
(iii) Necessary adjustments are made for any shortage or excess observed.
(iv) The inventories physically available and verified should be valued as closing stock.
(v) Adequate provision should be made for any materials which have become old or rejected or need repairs or cannot be used in business and will have to be sold as scrap.
(vi) Old and rejected materials should be included at their realisable value since in such cases cost is generally higher than their realisable value in market.
(vii) Only inventories owned by the business which are in hand or in transit should be included, upon which the purchaser has clear title.
(viii) Materials which are received for job work or materials rejected but not yet returned to suppliers or materials sold to customers but not yet collected by them should not be included in inventories of the business.
12. Describe the methods of valuation of Inventory.
Ans. METHODS OF VALUATION OF INVENTORY
At Cost: The method of valuation of inventory at cost represent the actual price paid for the inventory:
(i) In case of raw material, cost represent the price paid to the supplier including all taxes and the expenses incurred on freight, customs duty etc. in bringing the material to its present condition and situation.
(ii) In case of work in progress, the valuation at cost represents costs of material used, wages and other manufacturing expenses spent upto the stage in which material is lying.
(iii) In case of finished goods, cost means the cost of production representing cost of materials used, wages and other expenses incurred in the manufacturing.
(iv) Expenses which represent selling or office expenses are not to be included.
(v) In case the material is lying at various places, the cost will also include its transportation charges, excise duty, if any, paid on such goods.
The problems in valuation of inventory at cost arise where materials are purchased in a number of installments at varying rates.
Market Price:
The term market price represents the current replacement cost of inventory as on the date of the balance sheet.
(i) In case of inflation, the valuation includes an element of unrealized profit also and to that extent income is overstated.
(ii) In case the market value of inventory is less than its cost this method is most proper to use since it takes into account the estimated apparent loss also.
Valuation at Cost or Market Price whichever is Lower:
Under this method
(i) If an inventory has a current replacement cost (market price) in excess of the actual cost paid for the inventory, the inventory is valued at its actual cost, but
(ii) If the current replacement cost (market price) is lower than the cost incurred on the inventory purchase, the valuation is done at market price.
(iii) The shrinkage in value of inventory is taken up as a loss of the current accounting period although the loss is not incurred as yet.
There are two possible variation of the above principle. These are:
a) The total inventory is valued at cost and also at market value and the lower of the two is taken up as value of total inventory.
b) Cost and market price of each and every time of inventory is compared and the lower of the two is taken as its value.
This method is highly conservative as it takes into consideration possibility of future loss for each item of material.
This method gives the least possible valuation of closing inventory.
13. Describe the following:
a) Receivable Accounting b) Sales Journal c) Accrued Incomes d) Provision for Bad and Doubtful Debts. e) Bad Debts.
Ans.
Receivable Accounting:
Accounts receivable is a current asset that reports the amount a company's customers owe the company for goods or services provided on credit. Under accrual accounting, a company credits a revenue account and debits Accounts Receivable when billing customers. When an account receivable is collected, the accountant debits Cash and credits Accounts Receivable.
A company that extends credit to a customer faces the risk of not collecting the account receivable. If a loss does occur from extending credit, it is reported as an operating expense, such as bad debt expense.
There are two ways of reporting losses from credit sales. One is the direct write-off method. Under this approach, the company does not anticipate any loss. The asset Accounts Receivable is reported at its full amount and no expense is reported until it is known with certainty that a customer will not pay the amount owed. This method is not encouraged by accountants, because it may be overstating assets and net income.
The preferred way to report losses from credit sales is to anticipate that some receivables will not be collected. This approach is the allowance method. It gets it name because of the contra account to Accounts Receivable entitled Allowance for Doubtful Accounts. The credit balance in the allowance account works to value the accounts receivable at their approximate net realizable amount. Under the allowance method, the bad debt expense and the credit to the allowance account is reported closer to the time of the sale---thus providing a better matching with revenues. Under the allowance method the accounts receivable are reported at a more realistic and conservative amount.
To assist in the managing of accounts receivables, an aging of the accounts receivable is prepared. An aging sorts the customers' balances by how long the customers have owed the open invoice amounts.
Sales on credit involve credit terms such as "net 10 days" or "net 30 days" or "2/10, net 30" and others. Net 30 days means there is no discount allowed from the amount on the sales invoice. If the credit term is "2/10, net 30" the customer can remit 2% less than the invoice amount if the customer pays within 10 days. Otherwise the full amount is due in 30 days. Receivables deal with the payments received from your customers or clients. If these payments are few, it's probably best to just record them in the General Journal. The typical transaction is , where include who paid you.
However, if you receive many payments, generally against invoices you've issued, it pays to set up a Receivables system.
Sales Journal
The transaction in the Sales Journal is , where include customer (name or number) and any other data you may wish to record, like your sales-order-number (if you use one).
Accrued Incomes
Sometimes incomes are earned but not collected. For instance, interest earned but not yet due for payment. Rent due but not yet received on premises let-out, etc. This is known as Income accrued but not received. They should be included with the income of that year. Amount so receivable would appear as a current asset in the balance sheet of the enterprise.
For the purpose of recording accrued income credit should be given to appropriate income accounts and debit may be given to either separate asset accounts like Rent Receivable, Interest Receivable or to a common account which may be called Accrued Income Receivable A/c.
Each income receivable account should be adjusted so that the balance represents the amount accrued as on the balance sheet date.
Care should be taken to include only such incomes as have become legally receivable and any income receipt of which is only contingent, should not be taken as accrued income unless it has actually become receivable.
Provision for Bad and Doubtful Debts:
Accounts Receivable (Debtors) are often considered to include some accounts which are not likely to be realized in full or in part. Accordingly, at the time of preparing Final Accounts, to ascertain fair profits for an accounting year, it is necessary adequate provision is made for such accounts, as may be difficult to realize in full.
The provision is made after a careful classification and analysis of outstanding accounts receivables as to their realisability.
Sometimes, provision is made as percentage to total credit sales or to total amount of accounts receivables outstanding as on the date of preparing profit and loss account and balance sheet.
As and when any specific debtors accounts are determined to be worthless and collection attempts abandoned, they are written off.
The amount of bad and doubtful debts so ascertained is charged to profit and loss account while provision for Bad and Doubtful Debts appears under the heading current liabilities on liabilities sides of the Balance sheet or the same may be shown as deduction from the Debtors A/c on the Asset side.
The amount of Bad Debts charged to profits for an accounting year is calculated as follows:
Bad Debts = Total provision required (Existing provision in the opening balance sheet Bad debts actually written off during the year).
Bad Debts:
Accounts receivable that will likely remain uncollectable and will be written off. Bad debts appear as an expense on the company's income statement, thus reducing net income. In general, companies make an estimate of bad debt expenses that might be incurred in the current time period based on past records as part of the process of estimating earnings. Most companies make a bad debt allowance since it is unlikely that all of their debtors will pay them in full.
14. Definition of Assets and types of Assets.
Ans. In business and accounting an asset is anything owned, whether in possession or by right to take possession, by a person or a group acting together, e.g. a company, the value of which can be expressed in monetary terms.
There are two types of Assets:
1) Fixed Assets, &
2) Current Assets.
15. What do you mean by Fixed Assets?
Ans. These are the assets which are brought for the purpose of operating the business. Tangible assets, which can be physically present like plant and machinery, land and building, furniture and fixtures, motor vehicles and intangible assets, which are not physically present but can be felt, like goodwill, patents, copyrights etc., are known as fixed assets. They help in the production of goods and services. They are not meant for re-sale.
Fixed assets are sold only in the following circumstances:
(i) When the particular asset is no longer serviceable.
(ii) When it is to be replaced by more efficient ones.
(iii) On the closure of the business.
The following information, relating to fixed assets, according to Accounting Standard issued by the Institute of Chartered Accountants of India, should be disclosed in the financial statements:
(i) Goss and net book values of fixed assets at the beginning and end of an accounting period showing additions, disposals, acquisitions and other movements;
(ii) Expenditure incurred on account of fixed assets in the course of construction or acquisition; and
(iii) Revalued amount substituted for historical costs of fixed assets, the method adopted to compute the revalued amount. The nature of indices used, the year of any appraisal made, and whether an external valuer was involved, in case where fixed assets are stated at revalued amounts.
16. Distinguish between Fixed & Current Assets.
Ans. The difference between current assets and fixed assets as follows:
Current assets are flexible in nature, easy to encashable and floating money to company whereas
Fixed assets are Fixed in nature in other words non-moving assets, not easy to encash, regularly depreciated.
Classification:
Current assets:
Cash - at hand and at bank
Inventories
Sundry Debtors
Advance and Deposits
Fixed Assets:
Land and Building
Furniture and Fittings
Tools and tackles
Plant and Machinery
Computer ( including assessories and UPS)
17. How you will value Fixed Assets.
Ans. Valuation of Fixed Assets:
(i) Fixed assets are initially valued on the basis of costs incurred on their acquisition/ installation including expenses incurred up to the stage of commencement of actual usage of that asset for business purposes. Any subsequent additions to the capacity or utility of the asset are added wit the cost of such assets.
(ii) Appreciation in value of fixed asset is usually not recognized in the accounts of a business on conservative consideration. However, such a conservative approach is getting obsolete and appreciation in values of assets is being recognized in accounts after proper appraisal and managerial approval.
(iii) Annual or very frequent revaluation of fixed assets is generally not considered good because these represent unrealized gains.
(iv) Any increase in value at the time of revaluation of fixed assets should be transferred to capital reserve account and shown under reserves on liabilities side of Balance Sheet.
(v) Any decrease in value at the time of revaluations should be written off against profit & loss account of the year.
(vi) Fixed assets a subject to annual depreciation and fixed assets for the purpose of balance sheet are valued on the basis of cost less adequate cumulative depreciation or depletion to date.
18. Describe the following:
a) Marketable Securities b) Definition of Depreciation c) Accounting for Royalties d) Matching Principle e) Income Statement.
Ans.
Marketable Securities:
i. Any long-term investments should normally be valued at cost including all expenses incurred on its acquisition such as brokerage, fees, taxes, stamp duty and other costs incidental to the purchase of securities. The current investments should, however be valued at lower of cost or fair value.
ii. If any Bonds were purchased at a price below par, they should be valued at cost plus discount amortized to date.
iii. If any Bonds were purchased at a price above par their valued at the balance sheet date shall be cost less premium amortized to date.
iv. It is, however, fair if current market value of securities carried as long-term investments at the date of balance sheet is shown as a Memorandum in balance sheet to reflect its true valuation. However, if current market values are significantly less than cost, a special surplus reserve may be established, as a precautionary measure.
v. In case of investments made in subsidiary companies, valuation should generally be done at cost unless the market value is lower than cost.
vi. When Stock and Bonds which may have been purchased at various prices are sold, the cost of the securities sold should be cleared from the proper stock or bond account. If a specific sale cannot be identified with a specific purchase the accounting entries should be made on the assumption that the first securities sold were the first securities purchased. (i.e., FIFO basis).
vii. Dividend, interest etc. received are generally taken directly into profit & loss account.
viii. In case of any shares, debentures, bonds etc. purchased on cum dividend or cum interest basis, that part of interest paid as a cost of purchase should be adjusted against amount of dividend or interest realized subsequently in respect of that part.
Definition of Depreciation:
Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:
"the wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced by the asset.'
A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.
In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation).
In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To calculate the depreciation charge for an accounting period, the following factors are relevant:
- the cost of the fixed asset;
- the (estimated) useful life of the asset;
- the (estimated) residual value of the asset.
Accounting for Royalties:
Publishers often consider royalties to be part of the back office operations, when in reality they are generally one of the few points of contact a publisher has with an author after his or her book is published. Authors, on the other hand, pay a lot of attention to royalty payments (although how closely they read their statement is a matter for debate!). Royalties should therefore be considered an important part of the author-publisher relationship, and clear communication and timely payment of royal ties should be a matter of concern at the highest levels of the organization. The Authors Guild and the Book Industry Systems Advisory Committee (BISAC) both publish suggested royalty statement formats, which publishers may find useful when designing their own statements. These formats may be obtained from the Authors Guild at (212) 563-5904.
Royalty Advances: Unearned advances should remain on the asset side of the balance sheet until they are earned out, at which point the book is transferred to the liability side. If returns cause the balance to become negative later, the title is not transferred back to the asset side; however, the figure that is carried on the balance sheet should be the sum of the positive amounts payable, since that is the real amount of the publisher's royalty liability. Advances that have not earned out should be written off after it reasonably appears that they are not ever going to earn out. The write- off, of course, should not be applied to the author's account in the royalty system (or on the author's statement!); if it were applied there, any sales that did trickle in would generate a royalty payment. For this reason write-offs should be tracked in a subsidiary ledger and maintained as a contra-account against advances on the asset side of the balance sheet, rather than being removed from the balance sheet altogether, in order for the royalty system to balance with the financial statements.
Monthly Royalty Expense. The monthly entry consists of a debit to royalty expense, which is part of the cost of goods sold, and a credit to the royalties payable liability. This entry can be either an estimate calculated as a percentage of sales based on historical data or an actual figure provided by the publisher's automated royalty system.
Subsidiary Rights Income: As income is received, the share belonging to the publisher is credited to the income account "Other Publishing Income," and the share belonging to the author is credited to the liability account "Royalties Payable." If your author contract calls for sub rights income to "flow through," or be paid upon receipt to the author after the advance is earned out, then Cash should be credited rather than Royalties Payable.
Author's Charge: Expenses that will be charged against an author's royalties should be credited as they occur to Cash (or Sales, in the case of book purchases) and debited to either Author Accounts Receivable or Advances. Examples of author's charges include costs of proofreading, indexing, and author's alterations.
Reserves: The author contract may permit part of the earnings payable to the author on a new book to be withheld for several royalty periods as a reserve against future returns, to ensure that the author is not paid for books that do not actually sell through. If such an overpayment were to occur, it would be highly unlikely that the author would reimburse the publisher. Although each contract is different, a 20 to 30 percent reserve held for three to four periods is not uncommon. Some publishers automatically withhold a reserve on every new book, while others make a title-by-title decision based on the type of book (a trade book being more likely to suffer high returns than a scholarly title). Since the reserve is still a liability, albeit a deferred one, it should not be netted from the total Royalties Payable liability account.
Joint Accounting: Joint accounting gives the publisher the right to offset an author's earnings on one title against unearned advances or losses on another. This almost always occurs with hardcover and paperback editions of the same book, but contracts sometimes permit this practice with different titles as well.
Royalty Statements: Although many large publishers have a fully automated process, this section assumes otherwise. The following example illustrates the process the publisher goes through semiannually, or however frequently royalties are calculated and paid to authors.
The variance between the total of the monthly accrual and the actual Earnings from Book Sales calculated for the period should be reconciled against Royalty Expense and Royalties Payable.
Matching Principle:
Matching Principle is the basis for preparation of the two financial statements. According to this principle, all the relevant expenses incurred to earn revenue should be corelated and matched with that revenue. The implications of this principle are:
(1) Liabilities for expenses: All expenses incurred (whether paid or not) to earn an item of revenue should be debited to the Profit & Loss Account. Expenses incurred but not paid appear in the Balance Sheet as Liabilities for expenses.
(2) Prepaid expenses: When and expense has been paid for but the revenue to be derived from it will be earned in the next accounting period, the amount of expense so paid shall be carried forward to the next year as Prepaid expense appearing as an asset in the Balance Sheet. Such expenses are debited to the Profit & Loss A/c for the next year.
(3) Incomes received in advance: Any income received during the year, against which the goods are to be supplied or service is to be rendered in future, is carried forward as a liability.
Income Statement:
The income statement is generally prepared in two parts Trading Account and Profit & Loss Account. Trading Account is prepared to ascertain the gross profit earned from the trading done by the enterprise. Net profit is reflected the Profit & Loss Account, after taking into account all the expenses of the enterprise whether related to actual trading or for administration, selling, and distribution etc. In case of manufacturing concerns, a Manufacturing Account is also prepared to ascertain the cost of goods produced.
19. What are the elements of Financial Statements?
Ans. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements.
The elements directly related to financial position (balance sheet) are:
Assets
Liabilities
Equity
The elements directly related to performance (income statement) are:
Income
Expenses
The cash flow statement reflects both income statement elements and changes in balance sheet elements.
20. What do you mean by Trial Balance?
Ans. Trial Balance: - For proving the accuracy of posting in a ledger periodically balances in various accounts in the ledger are extracted, debit balances separated from credit balances, either on a sheet of paper or in a book. If the totals of the debit and credit balances agree, it is considered to be a proof of the arithmetical accuracy of posting. This is because there is always equal debit and credit entries for each transaction. Provided the postings and totals are correct, the total of debit balance should agree with the total of credit balances. The list of balances extracted for proving the accuracy of posting is called Trial Balance.
Trial Balance is not an account but a tabulation of debit credit balance of ledgers prepared in the books of accounts. It shows the arithmetic accuracy of the books of accounts. The list of balances extracted for providing the accuracy of posting is called Trial Balance.
However it must always he remembered that: -
(i) Trial Balance is always prepared on a particular date. That is why (date) is always written under the heading.
(ii) It is a comprehensive list of all the accounts in the ledger including cash account.
21. Why Trial Balance does not Tally?
Ans. When a trial balance does not tally (that is, the totals of debit and credit columns are not equal), we know that at least one error has occurred. The error (or errors) may have occurred at one of those stages in the accounting process: (1) totaling of subsidiary books, (2) posting of journal entries in the ledger, (3) calculating account balances, (4) carrying account balances to the trial balance, and (5) totaling the trial balance columns. It may be noted that the accounting accuracy is not ensured even if the totals of debit and credit balances are equal because some errors do not affect equality of debits and credits. For example, the book-keeper may debit a correct amount in the wrong account while making the journal entry or in posting a journal entry to the ledger. This error would cause two accounts to have incorrect balances but the trial balance would tally. Another error is to record an equal debit and credit of an incorrect amount. This error would give the two accounts incorrect balances but would not create unequal debits and credits. As a result, the fact that the trial balance has tallied does not imply that all entries in the books of original record (journal, cash book, etc.) have been recorded and posted correctly. However, equal totals do suggest that several types of errors probably have not occurred.
22. What is Trading Account?
Ans. The Trading Account is designed to show the gross profit on sale of goods. The trading Account contains in a summarized from the transaction of the trader relating to the commodities in which deals throughout the accounting period. It is prepared to find out Gross Profit (G.P.) or gross loss.
Trading account is prepared to know gross profit of a business resulting from excess of revenue from sales over direct manufacturing cost of goods sold or cost of purchase of goods sold.
23. What is Gross Profit (G.P) & Gross Loss (G.L)?
Ans. The excess of credit side over debit side of trading account represents gross profit of a business. Excess of debit side over credit side, however, represents, gross loss of the business. The amount of gross profit or gross loss as the case may be is carried over to profit and loss account.
From gross profit, the Gross Profit Ratio is arrived at by dividing it by sales and multiplying by 100. The Ratio is very important from income tax point of view. If there is any substantial variation in this ratio reasons and justification for the same have to be explained to the satisfaction of income tax authorities. It is, therefore, desirable, that this ratio should, as far as possible, be maintained stable (though not exactly the same) over a period of time.
For maintaining the G. P ratio, it is necessary that the expenses are properly classified. It must be ensured that only the trading expenditure are debited to the Trading A/c. Items of expenditure pertaining to selling and distribution of goods, administration and finance should obviously be debited to the Profit &Loss A/c. Proper classification of expenses assumes further importance since closing stock, which finally determines the gross ratio is very likely to dwindle every year.
Besides, the sales and purchase should kept under strict control. Monthly sales and purchase should be totaled and matched. Sales and Purchase are said to be matched if the following equation is satisfied:
Opening stock for the month +
Purchase for the month + Provision for Gross Profit (at last years G.P. rate over sales for the month) - Sales for the month = Closing stock at the end of the month
If in any month purchase have not been fully accounted for, equation not tally, and shall give a negative figure of closing stock. Such situations are looked at suspiciously by the tax authorities too and may call for a detailed scrutiny.
The above equation should hold good in quantitative terms also i.e.
Quantity of Opening stock + Quantity of Purchases - Quantity of Sales = Quantity in Closing Stock
It may, however, be difficult to establish the above equation in case of manufacturing concerns, particularly when the raw materials and the finished goods are not expressible same terms.
24. Explain Profit & Loss Account.
Ans. It is also called as Income Statement. This account determines the net profit of a firm and hence is a very important part of financial statements.
Credit Side
The first item is gross profit transferred from Trading Account. If the Trading Account is not prepared separately, the gross income from the major activity or operation of a business should be listed first in the same manner as in Trading Account.
Rental income: Any rent received as income from any property or asset or its part, let out by business, after deducting all expenses incurred in earning such income.
Interest of dividend income: any interest of dividend earned on investments made in shares , debentures of otherwise on loans, deposits etc . For the period covered under profit and loss account should be shown at gross amount (before deduction of tax at source) but after deducting all expenses incurred in earning and collecting it.
Commission etc: Any income as commission received in sales or otherwise is shown at gross amount before deduction of tax at source.
Others: Any other incomes of business such as service chares received for any services etc. rendered, any income arising from any job work done for others, discounts, rebates etc. received on purchases and every other income of the business should be shown in profit and loss account.
25. What Principle should be kept in view while valuing closing stock?
Ans. At the close of a period, a firm will normally have a certain quantity of goods in hand. According to matching principle, it would thus be proper, that against the sales, only the cost of goods sold is debited. Cost of goods sold can be ascertained by deducting the value of closing stock from total purchases and opening stock, or simply by crediting the value of closing stock to the Trading account. Closing stock includes stock of raw materials, spares and stores, consumables, work in process and finished goods. For valuation of closing stock refer to Chapter Valuation of Assets & Liabilities . Closing stock for a year becomes the opening stock for the next year.
Debit Side: The following items appear generally.
- Opening stock of work in progress and finished goods. It is the value of last years closing stock. A new business will have no opening stock for the first year.
- Cost of goods manufactured. If a separate manufacturing account is prepared, the Cost of goods manufactured so ascertained is debited to the Trading Account.
- Purchase of finished goods for resale. All purchase returns should also be duly adjusted against relevant purchases. Purchases of raw materials, consumable, stores etc. are also included if no separate manufacturing account is prepared.
- Wages: The amount of wages paid and payable to be shown in trading account is given as under (if manufacturing account is not prepared).
Amounts paid to workers engaged in direct manufacture of goods and services.
Wages including monthly wages with all allowances, overtime, fringe benefit, statutory liabilities such as contribution to provident fund, E. S. I .premium etc. in respect of workers,
Salaries of persons directly engaged in a manufacturing process such as foremen, supervisors, etc. excluding staff in finance, accounts, sales etc. not directly related to production.
Freight and Carriage Inwards: All expenses incurred to bring the goods purchased to the business premises such as freight, octroi, customs duty, etc. are debited to Trading account. This does not include expenses incurred to bring a capital asset such as machinery, etc.
Fuel and power such as the amount spent for coal, furnace oil or power to run boiler, drive machinery etc. (If separate manufacturing account is not maintained)
Electricity used for lighting of factory building excluding cost of electricity used for lighting etc. of office buildings. (if no separate manufacturing account is maintained).
Rent and other taxes paid for factory building such as municipal taxes, repairs and maintenance to factory building etc. (if manufacturing account is not maintained).
Rent for entire period should be charged excluding any prepaid rent and after including any rent.
Accrued but not yet paid.
Depreciation on factory building/plant and machinery. (If manufacturing is not maintained separately).
26. What is Balance Sheet?
Ans. After ascertaining the profit or loss of the business, the businessman wants to know the financial position of his business. For this purpose he prepares a statement of assets and liabilities, which is called Balance Sheet. It is prepared on a specified date because the figures shown in the Balance Sheet are true on that date only. The totals of the assets and liabilities should be equal. If it is not so it means that there is some error.
The balance sheet as distinct from other financial statements has the following characteristics:
(i) It is a statement and not on account. Although Balance Sheet is a part of the final accounts and prepared with the help of accounts. Yet it is not an account but statements.
(ii) It is always prepared on a particular date, and thus above shows the position at that date and not for a period.
(iii) It has no debit side and credit side. Nor the words To and By are used before the names of the accounts shown therein. The headings are liabilities and assets.
(iv) It shows the financial position of the business concern.
(v) It shows what the firm owners to others as also what others owe to the firm.
The totals of the liabilities and assets always are equal.
27. What is Share?
Ans. A share is the smallest unit of the total share capital of a company, having a distinctive number. A share is a movable property, transferable in the manner laid down in the articles of the company. Shares are mainly of two types Preference and Equity.
A preference share carries preferential right in respect of dividends and repayment of capital, over equity shares. Preference share may be cumulative, non-cumulative, participating redeemable and irredeemable.
Equity share capital is the share capital other than preference share capital. Ordinary, share refer to equity share, thus, they are also called ordinary shares.
Beside private companies, public companies are also permitted, w.e.f. 13.12.2000, to issue equity share capital with different rights as to dividend, voting or otherwise in accordance with prescribed rules and conditions.
28. What is Debenture?
Ans. A debenture is an acknowledgement under seal of a debt or loan, divided into uniform parts. A debenture-holder is a creditor of the company, whereas a shareholder is a joint owner of the share capital of the company. Debenture holders are paid interest at specific rates.
Debentures may be redeemable or irredeemable, secured or unsecured, convertible or non-convertible, or partly convertible.
You can raise additional capital by a debenture issue. The debenture itself is a document given by the company to the debenture holder as evidence of a mortgage or charge on company to assets for a loan with interest. The holder is a creditor of the company, but often holds one of a series of debentures with similar rights attached to them or is one of a class of debenture holders whose security is transferable (like shares) or negotiable (like warrants).
29. Difference between Share & Debenture.
Ans. Shares having voting rights, Debenture does not have voting rights. Shares holders are owners of the company, debenture holders are not owners of the company, shareholders are entitled to dividend, debenture holders are entitled to interest. Debenture is nothing but a acknowledgement of debt. Share is nothing but an ownership of a company.
30. What is annual report?
Ans. An Annual report is a comprehensive report on a company's activities throughout the preceding year. Annual reports are intended to give shareholders and other interested persons information about the company's activities and financial performance. Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry. Companies listed on a stock exchange are also required to report at more frequent intervals (depending upon the rules of the stock exchange involved).
31. State limitations of the Financial Statement.
Ans. Some of the limitations of the financial statements are as follows:
As the historical costs and money measurement concepts govern the preparation of the balance sheet and income statements, hence these financial statements are essentially statements reflecting historical facts. It ignore inflationary trend and does not reflect the true current worth of the enterprise,
Certain important qualitative elements are omitted from the financial statements because they are incapable of being measured in monetary terms like the quality and reputation of the management team, employee and other,
There are still items in the assets side of the balance sheet which has no real value and are merely deferred charges to future incomes like preliminary / pre-incorporation expenses and other.
There are still the following issues or challenges in preparing the financial statements which may amount to overstatement of the accounting profit of an entity:
When to and how much to recognize revenue in the Income statement,
The constant challenge of when to expense or to capitalize the expenses. It is important to determine definitely what is revenue expenditure and capital expenditure otherwise the accounting profit will be overstated or understated - for example, capitalization of borrowing costs, etc
Method of depreciations and the rates to depreciate into the income statement are selected by management to suit their business needs. Are the rates intentionally been made lower or the depreciation rates are higher to accelerate the depreciation of the fixed assets,
Adequacy of provisions and method of providing for doubtful debts. Are the trade debtors recoverable and to what extent the accounting method for provision for doubtful debts shows the realistic picture,
Basis of valuation of assets- when can costs change to reflect current values? Using replacement or current costs?
Consolidation challenges -what to eliminates to reflects the overall group performance. Some items might be omitted to show a higher accounting profits.
32. What is a subsidiary?
Ans. Under the Companies Act 1989, a subsidiary undertaking is one in which the parent:
Has a majority of voting rights,
Is a member and can appoint or remove a majority of the board,
Is a member and controls alone a majority of voting rights by agreement with other members,
Has the right to exercise a dominant influence through the Memorandum and Articles or a control contract;
Has a participating interest and either actually exercises a dominant influence over it or manages both on a unified basis.
33. Describe current development in Financial Accounting in our country.
Ans. For about 100 years, the control of accounting rules and auditing standards rested in the hands of the accounting profession with very little input from other sources other than the SEC for rules relating to publicly-traded companies.
Following Enron, WorldCom, Satyam and other major corporate scandals, the past three years have seen substantial changes in the approach to accounting rule-making, auditing standards and regulation of accounting firms, including independence issues.
Note how the current changes came about. The numerous scandals and restatements of financial statements were caused not only by unscrupulous managers who were flagrantly falsifying the books, but also by the very complex accounting rules that evolved. Some regulations run to hundreds of pages and leave themselves open to different interpretations. In an effort to boost earnings, management uses every possible loophole to increase profits but still remain within the guidelines. This includes the use of aggressive revenue recognition, estimates and asset valuations which, when they later turn out to be incorrect, causes major restatements. The blame should not be placed only on the shoulders of accountants and rule makers. In the past two decades business has become so complex and global that transactions never contemplated previously are being concluded every day. Revenue recognition - a relatively simple concept in the past - has become a major issue as businesspeople construct very complicated deals with different types of revenue streams and conditions. For public companies, in particular, there is pressure to boost earnings and share prices. The concept of "conservatism" has disappeared in the preparation of financials.
Corporate governance has also undergone major changes. Regulators recognize that it is mainly management that perpetrates the frauds and weak controls assist in rampant abuses of accounting rules. While most of the changes affect public companies, there is a trickle-down effect to companies of all sizes. The focus is now on independent boards of directors, qualified audit committees and internal control evaluations, as well as major increases in fines for white-collar crime.
Public accountants were taken by surprise by the reaction to the scandals and audit failures. And within the past two years much of the power to regulate the profession has been taken away from them. The Sarbanes-Oxley law made substantial changes, including the creation of the Public Company Accounting Oversight Board, which now reviews firms performing audits of public entities. The American Institute of Certified Public Accountants (AICPA) and various state boards, realizing that they have lost power, are now trying to become proactive in improving controls and self-regulation, including transparent peer reviews of accounting firms.
Auditors have always maintained that the purpose of the audit was not to discover fraud. Legally, they were correct. In fact, one of the oldest judgments in auditing case law in England states that "auditors are watchdogs, not bloodhounds". The public, however, had the perception that the auditors were in fact "checking the books" and that their report was a stamp of approval on which they could rely. Auditing standards have now been changed and the auditors must now approach audits with skepticism. Auditors are required under FAS 99 to conduct a review of the possibility of fraud in engagements. The audited clients are now going through fraud questionnaires with the auditors, who also interview staff members to analyze where the possibility of fraud could exist. CPAs/FCAs are being trained to focus on the main conditions which give rise to fraud, i.e., greed/pressure to meet targets and opportunity and rationalization why the action taken was justified.
The Financial Accounting Standards Board (FASB), an independent body created by the sec, is still the main accounting rule-making body. However, for the first time, greater emphasis is being placed on user input rather than guidance only from preparers and auditors. While the major changes taking place are geared for the protection of investors in public companies, there has finally been a realization that banks, lenders and other creditors also have a vested interest in getting accurate financial statements. And these entities can provide valuable input to improve the quality.
34. What are the accounting entries for the following transactions regarding Issue of Shares:
i. On receipt of the application money.
ii. On allotment of shares.
iii. For amount due on allotment.
iv. On rejected applications, the application money is returned in full.
v. On issue of shares at a premium.
vi. Closing of Share Call.
vii. On forfeiture of shares.
viii. Issue of shares at a discount.
Ans. (i) On receipt of the application money:
Bank A/c
.. Dr.
To Share Application A/c
(ii) On allotment of shares:
Share Application A/c
Dr.
To Share Capital A/c
(Being the Application money on
Share allotted @ Rs.
per share received as per Boards resolution No.
. Dated
..)
(iii) For amount due on allotment:
Share Allotment A/c
... Dr.
To Share Capital A/c.
(Being the sum due on allotment on
..shares@ Rs.
per share allotted as per Boards resolution No.
.. dated
)
(iv) On rejected applications, the application money is returned in full:
Share Application A/c
Dr.
To Bank A/c.
(v) On issue of shares at a premium (share premium may be payable along with application or at allotment or with calls):
Share Allotment A/c
.. Dr.
To Share Capital A/c
To Share Premium A/c.
(Being the amount due on allotment of
.. shares @......... per share on account of capital and @
.. per share on account of premium, per Boards resolution No.
. Dated
..
Bank A/c
Dr.
To Share Allotment A/c.
(Being the amount actually received on allotment of shares (including premium))
(vi) Closing of Share Calls Account:
Calls in Arrear A/c
. Dr.
To Share (First/Second/Final) Call A/c.
(Being the amount still due on
.. shares @
by the way of first call etc.)
When the amount is received, it is credited to Calls in Arrear A/c.
(VII) On forfeiture of shares:
Share Capital A/c
. Dr.
To Calls in Arrear A/c (Unpaid amount)
To Shares forfeited A/c.(amount already received)
(Being the amount called up on
. shares @
.. per share and paid up @
. per share forfeited.)
(VIII) Issue of shares at a discount :
Share Application & Allotment a/c
.. Dr.
Discount on Shares A/c
. Dr.
To Share Capital A/c.
(Being the amount due on allotment of shares @ Rs. .. .
. per share debited to Discount on Shares A/c.
35. What are the accounting entry for the following transactions regarding Issue of Debentures:
i. When debentures are issued at par and are also redeemable at par
ii. When debentures are issued at a discount but are redeemable at par:
iii. When debentures are issued at premium but are redeemable at par.
iv. When debentures issued at par but are redeemable at a premium.
v. Redemption at par.
vi. Redemption at Premium.
vii. Redemption at discount.
Ans. (i) When debentures are issued at par and are also redeemable at par:
Bank A/c
.. Dr.
To Debenture A/c.
(ii) When debentures are issued at a discount but are redeemable at par:
Bank A/c
.. Dr.
Discount on Debentures A/c
Dr.
To Debentures A/c
(iii) When debentures are issued at premium but are redeemable at par:
Bank A/c
Dr.
To Debentures A/c
To Premium on Debentures A/c
(iv) When debentures issued at par but are redeemable at a premium:
Bank A/c
. Dr.
Loss on Issue of Debentures A/c
Dr.
To Debentures A/c
To Premium on Redemption of Debentures A/c.
(v) Redemption at par:
Debentures A/c
.. Dr.
To Bank A/c.
(vi) Redemption at Premium:
Debentures A/c
. Dr.
Premium on Redemption of Debentures A/c
. Dr.
To Bank A/c.
(vii) Redemption at discount:
Debentures A/c
. Dr.
To Bank A/c,
To Profit on Redemption of Debentures A/c.
36. What are the Financial Statements of Limited Companies?
Ans. The accounting statements of companies comprise:
1. An income statement, which may include a manufacturing account (if appropriate, depending on the organisations activities dealt with in Chapter 12) and a trading account;
2. A statement of changes in equity;
3. Balance Sheet;
4. Cash Flow Statement.
Select the appropriate answer:
37. Which of the following is not a Fixed Assets?
a. Building
b. Bank Balance
c. Plant
d. Patents
e. Goodwill
Ans. b) Bank Balance, d) Patents, e) Goodwill
38. Gross Profit is the difference between
a. Net sales and cost of goods sold
b. PAT and dividends
c. Net sales and cost of production
d. Net sales and direct costs of production
e. Net sales and net purchase
Ans. a) Net sales and cost of goods sold
39. As per the double entry concept
a. Assets + Liability = Capital
b. Capital = Assets Liability
c. Capital Liability = Assets
d. Capital + Assets = Liability
e. None of the above
Ans. b) Capital = Assets Liability
40. Stock is
a. Included in the category of Fixed Assets.
b. An Investment.
c. An intangible Fixed Asset.
d. A part of Current Asset.
Ans. d) A part of Current Asset.
41. Which of the following is an example of personal accounts:
a. Machinery
b. Rent
c. Cash
d. Creditor
e. Salary
Ans. d) Creditor
42. From the accounting point of view, loss means
a. Increase in liability
b. Decrease in assets
c. Increase in owners equity
d. Decrease in owners equity
e. Increase in assets
Ans.
Select the correct answer from the alternatives given in the brackets: -
43. Capital account is a __________ account (Personal/ Real/ Nominal)
44. Amount invested in business by its owner is known as _______ account. (Asset/ Cash/ Capital)
45. Drawings account is a ____________ account. (Real/ Personal / Nominal)
46. Short description of a transaction is called __________. (Journal / Voucher/ Narration)
47. The amount brought in by the proprietor in the business should be credited to_________ [a) Proprietors Account, b) Drawings Account, c) Capital Account.]
48. Every transaction is recorded first in the _______ [Voucher, Cash Book, Bank Book, and Journal Book.]
49. Bank account is a _________ [a) Personal Account b) Company Account, c) Debtors Account.]
50. Personal expenses of the proprietors are debited to _______ [a) Capital a/c, b) Drawings a/c, c) Personal a/c.]
51. The difference between two sides of account is called ______ [a) Balance b) Debit, c) Credit.]
52. Nominal accounts are transferred to _________ at the end of the year. [a) P/L a/c b) Balance Sheet c) Trading a/c.]
53. Cash account always shows a ______ (Debit Balance, Credit Balance).
54. Outstanding income is ______ (Assets / Liability).
55. Accrued Income and Prepaid Expenses are ______ of business (Assets / Liability).
56. Goodwill is a ______ (Fixed Asset, Current Asset, Fictitious Asset, Intangible Assets).
57. Trial Balance is a statement showing ___ and _____ balance taken from ____. (Debit/Credit/ Overdraft/ Journal/ Ledger/ Cash Book)
Ans. 43) Personal, 44) Capital, 45) Personal, 46) Narration, 47) Capital Account, 48) Journal Book,
49) Personal Account, 50) Drawings Account, 51) Balance, 52) P/L A/c, 53) Debit Balance,
54) Assets, 55) Assets, 56) Intangible Assets, 57) Debit, Credit, Ledger.
