Essentials of FA - Chapter 6

ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA
Second Edition Chapter 6
Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA
Accounting Cycle: Final Phase

1/22/2014
The final phase in the accounting cycle is the preparation of the profit and loss account, and the balance sheet. The profit and loss account is prepared by matching income and expenses. The balance sheet is prepared by listing out assets and liabilities. The trial balance provides the raw data that are analysed and adjusted for preparing the profit and loss account, and the balance sheet.
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Errors
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Errors might creep in while recording transactions and other events. Errors may be classified into errors of principles and errors in book keeping. Errors of principles are those which arise due to wrong application of accounting principles in recording transactions and other events.
For example, expenditure that should be capitalised has been recorded as repair and maintenance of fixed asset. Examples of book keeping errors are: omission in recording a transaction, entering a wrong amount in subsidiary books, wrong casting of a ledger and errors of posting.
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Suspense Account
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Error in only one account head results in disagreement of the trial balance. Example
When adding up the sales day book, a mistake occurred, resulting in the total being Rs. 1,000 less than the correct total. This error resulted in short credit to the sales account, and as a consequence the credit side total of the trial balance is lower than the debit side total of the trial balance. It is assumed that individual accounts of customers are opened in the general ledger and each transaction is posted to the debit of the personal account of the concerned customer. Therefore, an error in the sales day book did not result in a mistake in the debit side of the trial balance. The suspense account will show a credit balance, because the debit side total of the trial balance is higher by Rs. 1,000 as compared to the credit side total.
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Errors Detected in A Subsequent Period

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When errors are detected in a subsequent reporting period, adjustments in nominal accounts should be debited or credited to the Prior Period Adjustment a/c. However, adjustments in assets or liabilities accounts should be debited or credited to the concerned accounts. In case, mistakes in prior periods result in disagreement in the debit side total and credit side total of the trial balance of the previous period, the suspense a/c should show a debit or credit balance carried forward from that period.
In that situation, the suspense a/c should be closed through rectification entries.
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Errors Detected In A Subsequent Period (cont.)

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Under the Indian GAAP, prior period adjustment is presented as a separate line item in the profit and loss account for the current period. If the error occurred in the previous period, the IFRS require that assets, liabilities, general reserve, income and expenses of that period should be restated after incorporating the corrections, and restated figures should be presented as comparative figures in the financial statements for the current period.
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Errors Detected in A Subsequent Period (cont.)

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If the error occurred in a period earlier to the immediately previous period, IFRS require that assets, liabilities and general reserve, at the beginning of the previous period should be restated after incorporating the cumulative effects of the corrections. Items in the balance sheet of the previous period should be restated taking into account the restated opening balances for the previous period. Restated figures for previous period should be presented as comparative figures in the financial statements for the current period.
For example, if an error occurred in the year 20062007 is detected in the year 20102011, balances in the general reserve account, assets and liabilities as at 1 April, 2009 is adjusted for the prior period adjustment.
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Adjustments
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In the accrual system of accounting, a firm recognises revenue immediately on completion of the earning process without waiting for actual receipt of cash or other assets. Similarly, it recognises expenditure when it is probable that economic benefits will outflow the enterprise, without waiting for actual cash outflow or outflow of other economic benefits.

Therefore, the accrual system of accounting requires adjustments for accrued income and outstanding expenses (accruals).
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Adjustments (cont.)
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Moreover, preparation of a profit and loss account requires matching of income and expenses.
These require adjustments for income received in advance and prepaid expenses.
Some more adjustments are required to present a true and fair view of the operating result and the financial position
Adjustment entries are passed through the journal proper and an adjusted trial balance is drawn incorporating the adjustments. The adjusted trial balance forms the basis of preparing financial statements.
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Adjustments: Closing Stock

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Initially, entities record purchase transactions as an expense under the head purchases. Therefore, assessment of the value of stock-inhand at the end of the reporting period and recognition of the same as an asset in the balance sheet is necessary to match the cost of goods sold and the revenue for the reporting period. Usually, closing stock of inventory is recorded in the books of accounts through the following entry:
Stock a/c Dr. Rs. 50,000 To profit and loss a/c
Cr. Rs. 50,000

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Adjustments: Closing Stock (cont.)

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The closing stock is an asset, and appears as such in the balance sheet. The closing stock balance is carried forward to the next reporting period as opening stock. Opening stock is added to purchases for determining the cost of goods that were available for sale, or the cost of materials that were available for consumption.

Therefore, opening stock is treated as a nominal account while preparing the profit and loss account.
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Adjustments: Closing Stock (cont.)

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Although it is not the normal practice, it is possible to pass the following entry before preparing the trial balance:
Closing stock a/c Dr. To purchase a/c Cr.
Rs. 50,000 Rs. 50,000
The result of this entry is to reduce the purchase account and to take on record the amount of closing stock.
In case this entry is passed, the trial balance will show both opening stock and closing stock. The purchase account in the trial balance will show purchases adjusted for closing stock.
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Adjustments: Accruals
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Accrual represents liabilities for which the amount is not certain, e.g. services received but not invoiced by the supplier. In this situation, the reporting enterprise estimates the liability and passes the following adjustment entry:
Appropriate expense a/c To outstanding liabilities a/c
Dr. Rs. 1,00,000 Cr. Rs. 1,00,000
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Adjustments: Accruals (cont.)

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The term accrued also signifies that an expense has been incurred or income has been earned, but the due date for payment or receipt of the same falls in the next reporting period.
Adjustments are to be made for accrued expenses and accrued income.
The following adjustment entries are required to bring these expenses and income in the books of accounts.
Appropriate expense a/c To expenses accrued a/c Income accrued a/c To appropriate income a/c
Dr. Rs. 50,000 Cr. Rs. 50,000 Dr. Rs. 70,000 Cr. Rs. 70,000
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Examples of accrued expenses are rent, interest, rates and taxes and wages outstanding at the end of the reporting period. Examples of accrued income are interest on securities, professional fees and rents earned but not received until the end of the reporting period. Expenses accrued is presented as a liability and income accrued is presented as an asset in the balance sheet.
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These adjustment entries are reversed at the commencement of the next reporting period. The following are the reversal entries:
Expenses accrued a/c To appropriate expense a/c Appropriate income a/c To income accrued a/c
Dr. Rs. 50,000 Cr. Rs. 50,000 Dr. Rs. 70,000 Cr. Rs. 70,000
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ADJUSTMENTS: PREPAID EXPENSES

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Sometimes, expenditure is incurred in the current period to receive services or goods in a subsequent period, the expenditure is classified as prepaid expenses.
An example of prepaid expenses is insurance premium.
The following adjustment entry is passed to record the prepaid amount:

Prepaid expenses a/c To appropriate expense a/c
Dr. Rs. 80,000 Cr. Rs. 80,000
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Adjustments: Prepaid Expenses (cont.)

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The result of this entry is to recognise an asset in the form of a prepaid expense and to reduce the expenditure account by the amount allocated to a subsequent reporting period.
The balance in the expenditure account represents expense for the current reporting period.
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Adjustments: Deferred Revenue

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The following accounting entry is passed for the amount of income received in advance.
Appropriate income a/c To income received in advance a/c
Dr. Rs. 60,000 Cr. Rs. 60,000
The result of this entry is to recognise a liability in the form of income received in advance and to reduce the income by the amount allocated to the next reporting period.
The reduced balance in the income account represents the amount that pertains to the current reporting period.
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These adjustment entries are reversed at the commencement of the next reporting period.
Materials Other Than Stock-in-trade

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Materials purchased for expenses such as stationery, advertisement materials and manufacturing stores are debited directly to respective expense accounts. Therefore, at the end of the reporting period, the following adjustment entry is required to bring the stock of materials in hand in the books:
Stock of materials a/c Dr. Rs. 10,000 To appropriate expense a/c Cr. Rs. 10,000 The entry is reversed at the commencement of the next reporting period.

The stock of materials is an asset recognised in the balance sheet.

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Bad Debt
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The loss due to non-recovery of amount due from customers is recorded as bad debt. Recording of bad debt reduces the balance in the trade debtors account. The entity passes the following entry to recognise the loss:
Bad debt a/c To trade debtors a/c

Dr. Rs. 50,000 Cr. Rs. 50,000
Bad debt is an expense, and it appears in the trial balance. It is taken to the profit and loss account directly from the trial balance.
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Provision for Doubtful Debts

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Entities usually recognise a provision for doubtful debts.
Provision for doubtful debts is not a liability. It is a reduction of trade receivables. An entity, based on its past experience, takes a suitable percentage on trade debtors in deciding the amount of provision required. If, a provision for doubtful debts exists, the amount of bad debt is adjusted against the provision.
The provision is recognised through the following closing entry:

Profit and loss account To provision for doubtful debts a/c
Dr. Rs. 10,000 Cr. Rs. 10,000
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Provision for Doubtful Debts (cont.)

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If the opening balance in the provision for doubtful debt a/c after adjustment for bad debts, is in excess of the required provision, the excess should be credited to the profit and loss account. Enterprises that sell industrial products or provide services, scrutinise each customers account to estimate doubtful debts.

They do not apply a percentage on the amount due from customers to estimate doubtful debts.
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Provision for Cash Discount to Debtors

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Sometimes, firms create a provision for estimated amount of cash discount to be offered to trade debtors. Provision for discount is calculated with reference to good debtors, that is, the amount of trade debtors adjusted for provision for doubtful debts.
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Depreciation
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The term amortisation is used for depreciation of intangible asset. The provision for depreciation represents the reduction in the carrying amount of a depreciable asset. Depreciation is incorporated in the books through an adjustment entry or a closing entry.
Therefore, the depreciation account does not appear in the trial balance. The balance in an asset account is not disturbed, because the balance sheet should present the gross amount of the asset and accumulated depreciation separately.
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Depreciation (cont.)
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Therefore, the provision for depreciation is made by the following adjustment entry:
Depreciation a/c To provision for depreciation a/c
Dr. Rs. 1,00,000 Cr. Rs. 1,00,000
The balance in the depreciation a/c, after the adjustment entry, represents the depreciation for current period.
It is transferred to the profit and loss account through a closing entry.
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Depreciation (cont.)
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The balance in the provision for depreciation a/c, after the adjustment entry, represents depreciation accumulated at the end of the current period.
The balance represents the total of opening balance in the trial balance and depreciation for the current period, reduced by the accumulated depreciation for items disposed during the current period. It is presented in the balance sheet as a deduction from the gross amount of the asset.
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Disposal of Depreciable Assets

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On sale or disposal of an item of a depreciable asset, the cost of the asset is withdrawn from the asset account. The following is the entry:
Sale of PPE a/c Dr. To the PPE a/c Cr.
Similarly, accumulated depreciation on the item sold or disposed of is withdrawn from the provision for depreciation account. The following is the entry:
Provision for depreciation To sale of PPE
a/c Dr. a/c Cr.

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Disposal of Depreciable Assets (cont.)

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The fixed asset account and the provision for depreciation account, after these adjustments, show the cost of assets the enterprise is holding, and the amount of accumulated depreciation on those assets, respectively.
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Disposal of Depreciable Assets (cont.)

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On disposal of a depreciable asset, the difference between the net disposal proceeds and the carrying amount (net book value) of the asset represents profit (loss) on disposal. The profit (loss) on disposal is credited (debited) to the profit and loss account as income (loss).

On disposal of a previously revalued item of tangible fixed assets, the loss, if related to an increase which was previously recognised in equity as revaluation reserve, may be charged directly to the revaluation reserve, to the extent that the same has not been subsequently reversed or utilised.
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Bank Reconciliation Statement

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Ideally, a debit balance in the bank account should agree with the credit balance in the bank statement and vice versa.
However, in practice, rarely do these two balances agree.
Entities periodically reconcile the balance as per the bank statement and the balance as per the cash book. The statement which explains the differences between these two balances is known as the bank reconciliation statement.
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Bank Reconciliation Statement: Reasons for Differences

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Differences may arise on account of the following:
Cheques issued by the enterprise but not yet presented to the bank for payment. Cheques deposited with the bank but not yet collected. Interest allowed by the bank but not yet recorded in the books of the enterprise. Interest and expenses charged by the bank but not yet recorded in the books of the enterprise. Interests and dividend collected by the bank as per standing instruction of the enterprise but not yet recorded in the books of the enterprise.
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Bank Reconciliation Statement: Reasons for Differences (cont.)

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Direct payments by the bank as per the standing instructions of the enterprise but not yet recorded in the books of the enterprise. Direct payments received by the bank, for example, from a customer of the enterprise, not recorded in the books of the enterprise. Dishonouring of a bill discounted with the bank, not yet recorded in the books of the enterprise. Bills collected by the bank, not yet recorded in the books of the enterprise. An error committed by the bank. An error in writing the cash book.
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Bank Reconciliation Statement: Reasons for Differences (cont.)

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The final bank reconciliation statement, prepared after incorporating all transactions and correcting errors in the cash book, should exhibit only the following:
Cheques issued by the enterprise but not yet presented to the bank for payment. Cheques deposited with the bank but not yet collected. An error committed by the bank.
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Bank Reconciliation Statement: Advantages

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The chief advantages of preparing a bank reconciliation statement at short intervals, say fortnightly, are:
It brings out any error in the banks records or in the cash book. It brings out any undue delay in collection of cheques and other instruments deposited with the bank. It is a control against embezzlement. It summarises information that is available from the bank statement only.
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Bank Reconciliation Statement: Presentation

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Example: Bank reconciliation statement before adjustments

BANK RECON CILIATION STATEMENT OF A & CO. As on 31st December, 2010 Balance as per cash book Add: Cheques issued not yet presented cash book Dividend collected not yet recorded in the Less: Cheques deposited not yet collected Cheque dishonoured not yet recorded in the cash book Bank charges not yet recorded in the cash book Cheque wrongly debited by bank Balance as per bank statement Rs. 5,000 Rs. 3,000 200 Rs. 2,000 500 50 800 3,200 8,200
Rs. 3,350 Rs. 4,850
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Bank Reconciliation Statement: Presentation (cont.)

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Example (cont.): Final bank reconciliation statement before adjustments

BANK RECONCILIATION STATEMENT OF A & CO. As on 31st December. 2010 Balance as per cash book Add: Cheques issued not yet presented Less: Cheques deposited not yet collected Cheque wrongly debited by bank Balance as per bank statement Rs. 2,000 800 Rs. 4,650 3,000 7,650 2,800 Rs. 4,850
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Deferred Tax
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Tax expense for a period is the total of current tax and deferred tax. Current tax is the amount of income tax determined to be payable (recoverable) in respect of the taxable income (tax loss) for a period. Taxable income or tax loss is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined.
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Deferred Tax (cont.)

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Deferred tax liability arises because of taxable temporary differences. Similarly, deferred tax asset arises because of deductible temporary differences. Deferred tax is the difference between the closing net deferred tax liability (net of deferred tax asset) and the opening net deferred tax liability (net of deferred tax asset).
Income tax law allows deduction of past losses and unabsorbed depreciation in computing taxable income. Therefore, deferred tax asset arises from carriedforward losses and unabsorbed depreciation.
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Deferred Tax (cont.)

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Deferred tax liability is presented separately in the balance sheet. The Indian GAAP require that the deferred tax liability be presented after the head unsecured loans. Deferred tax liability may be viewed as an interest free credit to the entity and the management is expected to use this credit to earn return for equity share holders.

Therefore, for the purpose of financial analysis, deferred tax liability is considered as quasi-equity and is included in equity to calculate accounting ratios.
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Deferred Tax
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On 1st January 2010 Rangachari Limited (RL) purchased equipment for use in research activities. The cost of the equipment is Rs. 1,00,000. RL estimates the useful life of the equipment at 5 years and its residual value at zero. RL uses the straight line method of depreciation. The tax law allows 100% depreciation in the first year for equipment being used for research. The current tax rate is 40%. Assume that there is no temporary difference other than depreciation. Further assume that the taxable income before depreciation and accounting income before depreciation are same at Rs. 1,00,000 from year 1 to 5.
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Deferred Tax: Example (cont.)

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Solution
Table showing computation of current tax and deferred tax Particulars
Accounting income before depreciation Depreciation Accounting income after depreciation Taxable inc ome before depreciation Depreciation Taxable income after depreciation Tax expense as per accounting income @0.40 Tax expense as per taxable income (Current tax) @0.40 Deferred tax Tax expense: Current tax Deferred tax Total Deferred tax liability: Opening balance New/(Reversal) Closing balance (to be recognised in the balance sheet) Amount in Rs.
Year 1
Year 2
Year 3
Year 4
Year 5
Total
1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 5,00,000 20,000 20,000 20,000 20,000 20,000 1,00,000 80,000 80,000 80,000 80,000 80,000 4,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 5,00,000 1,00,000 Nil Nil Nil Nil 1,00,000 Nil 1,00,000 1,00,000 1,00,000 1,00,000 4,00,000 32,000 Nil 32,000 Nil 32,000 32,000 32,000 40,000 (8,000) 40,000 (8,000) 32,000 32,000 40,000 (8,000) 40,000 (8,000) 32,000 32,000 40,000 (8,000) 40,000 (8,000) 32,000 32,000 1,60,000 40,000 1,60,000 (8,000) Nil 40,000 1,60,000 (8,000) Nil 32,000 1,60,000
Nil 32,000
32,000
32,000 (8,000)
24,000
24,000 (8,000)
16,000
16,000 (8,000)
8,000
8,000 (8,000)
Nil
343

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Insights:
a. Temporary difference is one that is capable of reversal. b. Every year the deferred tax and deferred tax liability should be computed using the latest tax rate. c. In practice, deferred tax for the year is calculated by deducting the opening balance of deferred tax liability from the closing balance of the same. This obviates the necessity to track all reversals.
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Tax liability for year 1 is calculated as follows:

Carrying amount of the equipment in the balance sheet: Rs. 80,000 Tax base (Carrying amount as per tax law): Nil Difference Rs. 80,000 Therefore, a deferred tax liability of 0.40 Rs. 80,000 or Rs. 32,000 should be recognised in the balance sheet. Deferred tax expense is recognised at (Rs. 32,000 0) or Rs. 32,000.
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Year 2:
Carrying amount of the equipment in the balance sheet: Rs. 60,000 Tax base (Carrying amount as per tax law): Nil Difference: Rs. 60,000 Therefore, a deferred tax liability of 0.40 Rs. 60,000 or Rs. 24,000 should be recognised in the balance sheet. In year 2, deferred tax expense will be recognised at (Rs. 24,000 32,000) orRs. 8,000.
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Preparation of Profit and Loss Account

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Usually, regulators do not require segmentation of profit and loss account into manufacturing account, trading account and profit and loss account. However, entities often prefer this segmentation.
The manufacturing account shows the cost of goods manufactured: The trading account shows the gross profit earned during the reporting period The profit and loss account shows the net profit/loss for the period.
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Preparation of Profit and Loss Account (cont.)

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Manufacturing Account
The manufacturing account is debited with the cost of raw materials and components consumed, manufacturing wages and other manufacturing expenses, including depreciation on factory assets.
Trading Account
The trading account is debited with the opening stock of finished goods, cost of goods manufactured, purchases of finished goods and all other expenses attributable to bringing the finished goods to the condition and location of sale. The trading account is credited with the amount of sales and the closing stock.
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Preparation of Profit and Loss Account (cont.)

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The Profit and Loss Account
The profit and loss account is credited with the gross profit, other operating income and extraordinary income. It is debited with operating expenses, financing charges, tax expenses and losses incurred during the reporting period.
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Closing Entries
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Closing entries refer to those entries that are passed to transfer balances in nominal accounts appearing in the adjusted trial balance to the manufacturing account, trading account and profit and loss account. The closing entries close nominal accounts in the general ledger. The remaining account balances represent either assets or liabilities that appear in the balance sheet.
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ESSENTIALS OF FINANCIAL ACCOUNTING BY ASISH K BHATTACHARYYA

Second Edition Chapter 6

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Accounting Cycle: Final Phase

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Errors Detected in A Subsequent Period

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Errors Detected In A Subsequent Period (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Errors Detected in A Subsequent Period (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Closing Stock

Stock a/c Dr. Rs. 50,000 To profit and loss a/c

Cr. Rs. 50,000

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Closing Stock (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Closing Stock (cont.)

Rs. 50,000 Rs. 50,000

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Appropriate expense a/c To outstanding liabilities a/c

Dr. Rs. 1,00,000 Cr. Rs. 1,00,000

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Accruals (cont.)

Adjustments are to be made for accrued expenses and accrued income.

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Accruals (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Accruals (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

ADJUSTMENTS: PREPAID EXPENSES

An example of prepaid expenses is insurance premium.

The following adjustment entry is passed to record the prepaid amount:

Dr. Rs. 80,000 Cr. Rs. 80,000

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Prepaid Expenses (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Adjustments: Deferred Revenue

Dr. Rs. 60,000 Cr. Rs. 60,000

Materials Other Than Stock-in-trade

The stock of materials is an asset recognised in the balance sheet.

Bad debt a/c To trade debtors a/c

Dr. Rs. 50,000 Cr. Rs. 50,000

Provision for Doubtful Debts

Entities usually recognise a provision for doubtful debts.

The provision is recognised through the following closing entry:

Dr. Rs. 10,000 Cr. Rs. 10,000

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Provision for Doubtful Debts (cont.)

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Provision for Cash Discount to Debtors

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

Dr. Rs. 1,00,000 Cr. Rs. 1,00,000

It is transferred to the profit and loss account through a closing entry.