Introduction to Accounting

Accounting is the systematic process of identifying, recording, classifying, summarising,

interpreting, and communicating financial information of a business to its users for effective
decision-making. It is universally called the "language of business" because it translates all
business activities into financial data that various stakeholders — investors, management,
creditors, and government — can understand and use.

Nature and Objectives

Accounting serves the following core purposes:

 Systematic record-keeping of all financial transactions

 Determining profit or loss for a given period through the Income Statement

 Ascertaining financial position of the business through the Balance Sheet

 Providing information to both internal users (management) and external users

(investors, creditors, government)

 Facilitating legal compliance with tax laws and regulatory requirements

Key Accounting Terms

A. Entity and Ownership Terms

Business Transaction: Any event that can be measured in money and that affects the financial
position of a business. Transactions can be:

 Cash-based — immediate exchange of money (e.g., paying wages)

 Credit-based — deferred payment (e.g., buying goods on credit)

Capital: The total amount of money or assets invested by the owner(s). It is treated as a liability
of the business towards the owner.

Formula: Opening Capital + Additional Capital Introduced + Net Profit − Drawings = Closing
Capital

Drawings: When the owner withdraws cash or goods for personal use. Drawings reduce the
owner's capital and are not treated as business expenses.
Proprietor/Owner: The person who owns and manages the business. Under the Business Entity
Concept, the proprietor and the business are treated as separate entities for accounting
purposes.

B. Assets

An asset is any resource owned or controlled by the business that has future economic value.

Type Definition Examples

Fixed / Non-Current Long-term assets held for use, not for

Assets resale Land, Building, Machinery, Furniture

Short-term assets convertible to cash

Current Assets within one year Cash, Stock, Debtors, Bank Balance

Tangible Assets Assets with physical existence Machinery, Vehicles, Furniture

Assets without physical form but having

Intangible Assets value Goodwill, Patents, Trademarks

Preliminary Expenses, Discount on

Fictitious Assets Losses/expenses not yet written off issue of shares

C. Liabilities

Liabilities are the legal financial obligations or debts a business owes to outsiders, settled over
time by transferring money, goods, or services.

Type Definition Examples

Non-Current Long-term obligations payable after one

Liabilities year Bank Loan, Debentures, Mortgage
 Type Definition Examples

Short-term obligations payable within Creditors, Bills Payable, Outstanding

Current Liabilities one year Expenses, Bank Overdraft

Contingent Potential obligations depending on a

Liabilities future uncertain event Pending lawsuit, Disputed tax demands

D. Revenue and Expenses

Revenue (Income): Amount earned from regular operating activities — selling goods or
rendering services. Under the Revenue Recognition Principle, revenue is recorded
when earned, not when cash is received.

 Examples: Sales, Fees Received, Commission Earned, Rent Received, Interest Received

Expenses are costs incurred to generate revenue. They reduce owner's equity:

 Direct Expenses: Directly related to production (raw materials, factory wages)

 Indirect Expenses: Overhead costs not directly tied to production (rent, salaries,
advertising)

 Outstanding/Accrued Expenses: Incurred but not yet paid (e.g., unpaid salary)

 Prepaid Expenses: Paid in advance for a future period (e.g., prepaid insurance)

Cost of Goods Sold (COGS):

COGS = Opening Stock + Purchases − Closing Stock

Term Formula

Gross Profit Net Sales − COGS

Net Profit Gross Profit − Operating & Other Expenses

E. Accounts and Books of Entry

Account: A ledger account is a summarised record of all transactions relating to a particular
item. Every account has two sides — Debit (Dr.) on the left and Credit (Cr.) on the right.

Types of Accounts — Traditional Approach:

Type Rule Examples

Personal Debtor's A/c, Creditor's A/c, Capital

Account Debit the Receiver; Credit the Giver A/c

Real Account Debit what comes in; Credit what goes out Cash A/c, Machinery A/c, Stock A/c

Nominal Debit all losses/expenses; Credit all

Account gains/income Salary A/c, Rent A/c, Sales A/c

Journal: The book of original entry where every transaction is recorded first in chronological
order using the double-entry system.

Ledger (General Ledger): The master book of accounts that classifies and summarises all journal
entries account-wise.

Subsidiary Books — to avoid recording every small transaction in one journal, businesses
maintain:

 Cash Book (all cash and bank transactions)

 Purchases Book (credit purchases of goods)

 Sales Book (credit sales of goods)

 Purchases Return Book & Sales Return Book

 Bills Receivable and Bills Payable Books

F. Debit and Credit Rules

Debit (Dr.) Credit (Cr.)

Assets Increases ↑ Decreases ↓

 Debit (Dr.) Credit (Cr.)

Liabilities Decreases ↓ Increases ↑

Capital/Equity Decreases ↓ Increases ↑

Revenue/Income Decreases ↓ Increases ↑

Expenses/Losses Increases ↑ Decreases ↓

Fundamental Accounting Concepts

1. Business Entity Concept

The business and its owner are treated as two separate and distinct entities. All transactions
are recorded from the business's perspective. Even capital contributed is treated as a liability of
the business towards the owner.

Example: If the owner deposits ₹5,00,000 into the business, it is recorded as Capital (liability of
business) — not as the owner's personal wealth.

2. Money Measurement Concept

Only those transactions expressible in terms of money are recorded in accounting. Non-
monetary factors such as employee morale, customer loyalty, or managerial skill find no place in
the books.

Limitation: Inflation or changes in purchasing power of money are ignored under this concept.
3. Dual Aspect Concept (Double Entry)

Every transaction has two aspects — a debit and an equal credit. This maintains the accounting
equation always in balance:
Assets = Liabilities + Capital

4. Going Concern Concept

The business is assumed to continue operating indefinitely into the foreseeable future. This
justifies recording fixed assets at cost and spreading depreciation over their useful life.

Significance: If this assumption is violated (business closing), assets must be revalued at

realizable prices.

5. Cost Concept (Historical Cost Concept)

Fixed assets are recorded at original purchase price and not at current market value. This
ensures objectivity in accounting — values are based on actual transactions rather than
estimates.

Example: A building bought for ₹20 lakhs in 2010 (worth ₹1 crore today) is still shown at ₹20
lakhs (minus depreciation) in the books.

6. Accounting Period Concept

The life of a business is divided into specific, equal time periods for preparing financial
statements. In India, the standard accounting year runs from 1st April to 31st March.

7. Matching Concept

Expenses must be matched against the revenues they helped generate in the same period.

Example: Salaries of ₹50,000 for March paid in April must still be shown as March's expense
(outstanding salary), since the revenue they generated belongs to March.

8. Accrual Concept

Revenues are recognised when earned and expenses when incurred, regardless of when cash is
actually received or paid.

Basis Revenue Recognition Expense Recognition

Accrual Basis When earned When incurred

 Basis Revenue Recognition Expense Recognition

Cash Basis When cash received When cash paid

Indian accounting standards (Ind AS) require the accrual basis of accounting.

9. Realisation Concept

Revenue is recognised only when earned and realisable — i.e., when goods are delivered or
services rendered.

Example: An advance received from a customer for future supply is a liability (unearned
income), not revenue.

10. Objectivity Concept

All accounting entries must be supported by verifiable source documents such as invoices,
receipts, and vouchers to eliminate personal bias.

Accounting Principles (GAAP-Based)

Full Disclosure Principle: All material information — favourable and unfavourable — must be
disclosed in financial statements. Contingent liabilities, pending lawsuits, and changes in
accounting policy must appear in notes to accounts.

Consistency Principle: Once an accounting method is adopted (e.g., depreciation method), it

should be applied consistently across all periods to enable meaningful comparisons. A change is
permissible only if required by law or a new accounting standard — and must be disclosed.

Prudence (Conservatism) Principle: When two values are available, the lower value is
recorded — anticipate losses, do not anticipate profits:

 Closing stock valued at cost or Net Realisable Value (NRV), whichever is lower

 Creating provisions for doubtful debts

 Providing for all known losses and contingencies

Materiality Principle: Only material (significant) facts need to be recorded and disclosed.

Example: A ₹50 pencil purchase need not be capitalised — it can be directly expensed. But a
₹50 lakh machinery purchase is material and must be properly capitalised.
The Accounting Equation

The foundation of double-entry bookkeeping is:

Assets = Liabilities + Capital (Owner’s Equity)

Three Rearrangements:

Form Formula Used To Find

Basic Form Assets = Liabilities + Capital Verify balance sheet balance

Finding Liabilities Liabilities = Assets − Capital Know total outside obligations

Finding Capital Capital = Assets − Liabilities Know owner's net worth in business

Expanded Accounting Equation:

Assets = Liabilities + Capital + Revenues − Expenses − Drawings

Effects of Transactions on the Equation:

Effect Example

Asset ↑, Asset ↓ (No net change) Buy machinery with cash

Asset ↑, Liability ↑ Buy goods on credit

Asset ↑, Capital ↑ Owner introduces capital or earns revenue

Asset ↓, Liability ↓ Repay a loan in cash

Numerical Illustration — Accounting Equation

Mr. Ramesh starts a new trading business. Transactions step by step:

 Transaction Assets (₹) = Liabilities (₹) + Capital (₹)

T1: Started business with ₹2,00,000 cash 2,00,000 0 2,00,000 ✅

T2: Purchased goods for cash ₹50,000 2,00,000 0 2,00,000 ✅

T3: Purchased furniture on credit ₹30,000 2,30,000 30,000 2,00,000 ✅

T4: Sold goods costing ₹20,000 for ₹28,000 (profit ₹8,000) 2,38,000 30,000 2,08,000 ✅

T5: Paid rent ₹5,000 cash 2,33,000 30,000 2,03,000 ✅

T6: Owner withdrew ₹10,000 (drawings) 2,23,000 30,000 1,93,000 ✅

T7: Paid ₹15,000 to creditor Sharma & Co. 2,08,000 15,000 1,93,000 ✅

Final Position: ₹2,08,000 (Assets) = ₹15,000 (Liabilities) + ₹1,93,000 (Capital) ✅

The Accounting Cycle — 9 Stages

The complete sequence followed during an accounting period to produce accurate financial
statements:

1. Identify and Analyse Transactions — Identify financial events supported by source

documents (invoices, receipts, vouchers)

2. Record in the Journal (Journalising) — Record in chronological order using the double-
entry system

3. Post to the General Ledger — Transfer journal entries to individual ledger accounts,
grouped by account type

4. Prepare Unadjusted Trial Balance — List all ledger balances to verify total debits = total
credits

5. Analyse the Worksheet — Prepare a working paper identifying all adjustments needed
 6. Record Adjusting Entries — Adjust for accruals, deferrals, depreciation, and other items

7. Prepare Adjusted Trial Balance — Confirm all accounts are balanced after adjustments

8. Prepare Financial Statements — Income Statement (P&L), Balance Sheet, and Cash Flow
Statement

9. Closing Entries & Post-Closing Trial Balance — Close all temporary accounts (revenues,
expenses, drawings) to Capital Account; prepare post-closing trial balance

Journal — Detailed Explanation

The Journal is the Book of Original Entry where every business transaction is recorded for the
first time, in chronological (date-wise) order. It is the starting point of the entire accounting
cycle — like a daily diary of business transactions.

Key Features of a Journal

 Records transactions in date-wise sequence

 Uses the double-entry system — every debit has a corresponding equal credit

 Contains a narration (brief explanation) for every entry

 Supported by source documents — invoices, receipts, vouchers

 Does not directly help in preparing the Trial Balance

 Has no opening balance — only records current transactions

Journal Format

Date Particulars L.F. Debit (₹) Credit (₹)

Date Name of A/c Dr. → To Name of A/c → (Narration) Page no. Amount Amount

Golden Rules of Debit and Credit

Type of Account Debit Credit

Personal Account Debit the Receiver Credit the Giver

 Type of Account Debit Credit

Real Account Debit what Comes In Credit what Goes Out

Nominal Account Debit all Expenses/Losses Credit all Incomes/Gains

Practical Journal Entries — M/s Priya Traders (April 2024)

T1: Started business with cash ₹3,00,000

Date Particulars L.F. Dr. (₹) Cr. (₹)

1 Cash A/c Dr. → To Capital A/c → (Being business commenced with

Apr cash) 1/2 3,00,000 3,00,000

T2: Purchased goods for cash ₹40,000

Date Particulars L.F. Dr. (₹) Cr. (₹)

3 Apr Purchases A/c Dr. → To Cash A/c → (Being goods purchased for cash) 3/1 40,000 40,000

T3: Sold goods on credit to Rahul ₹25,000

Date Particulars L.F. Dr. (₹) Cr. (₹)

5 Apr Rahul's A/c Dr. → To Sales A/c → (Being goods sold on credit to Rahul) 4/5 25,000 25,000

T4: Paid rent ₹8,000 by cash

Date Particulars L.F. Dr. (₹) Cr. (₹)

7 Apr Rent A/c Dr. → To Cash A/c → (Being rent paid for the month) 6/1 8,000 8,000

T5: Received ₹25,000 from Rahul in full settlement

 Date Particulars L.F. Dr. (₹) Cr. (₹)

10 Apr Cash A/c Dr. → To Rahul's A/c → (Being cash received from Rahul) 1/4 25,000 25,000

Important Journal Terms

Term Meaning

Journal Entry Complete record of one transaction — accounts debited, credited, and narration

Narration Brief explanation written below each journal entry in brackets

Ledger Folio (L.F.) Cross-reference number showing where the entry is posted in the ledger

Journalising The act of recording a transaction in the journal

Compound Entry A single entry involving more than two accounts

Opening Entry First journal entry of a new accounting year, recording opening balances

Closing Entry Entry passed at year-end to close all nominal accounts to P&L A/c

Rectifying Entry Corrective journal entry passed to fix errors in the books

Adjusting Entry Entry passed at year-end for accruals, prepayments, depreciation, etc.

Ledger — Detailed Explanation

The Ledger is the Principal Book of Accounts (Book of Final Entry) where all journal entries are
transferred and grouped account-wise. While the journal shows all transactions by date, the
ledger shows all transactions for a specific account.
Think of it as a filing cabinet — each drawer is a separate account, and every journal entry is
filed into the correct drawer.

Key Features of a Ledger

 Classifies transactions account-wise

 The process of transfer from journal to ledger is called Posting

 Each account shows a running/closing balance

 May show an opening balance carried forward from previous year

 Directly used to prepare the Trial Balance

 The final balances form the basis of financial statements

 Does not include narration for individual entries

How Posting Works (Journal → Ledger)

1. Account Debited in journal → enter on Debit (left) side of its ledger account

2. Account Credited in journal → enter on Credit (right) side of its ledger account

3. In "Particulars" column, write the name of the opposite account

Balancing a Ledger Account

1. Total both the Debit side and Credit side

2. Find the difference — this is the closing balance

3. Write the smaller side's total to match the larger side — this is "Balance c/d" (carried
down)

4. Write the "Balance b/d" (brought down) on the opposite side to begin the next period

 Debit total > Credit total → Debit Balance (Assets and Expenses)

 Credit total > Debit total → Credit Balance (Capital, Liabilities, Incomes)

 Both sides equal → Nil Balance (fully settled accounts)

Types of Ledger

Type Contents

General Ledger Master ledger containing all real, personal, and nominal accounts

Debtors' Ledger (Sales Ledger) Individual accounts of all customers who owe money

Creditors' Ledger (Purchase

Ledger) Individual accounts of all suppliers to whom money is owed

Special ledger acting as both journal and ledger for cash/bank

Cash Book transactions
Trial Balance

A Trial Balance is a statement listing the closing balances of all ledger accounts — both debit
and credit — at a specific point in time, to verify that total debits = total credits. It bridges the
ledger and financial statements, acting as the primary check on arithmetic accuracy.

Position in Accounting Cycle: Journal → Ledger → TRIAL BALANCE → Financial Statements

Objectives of Trial Balance

1. Verify Arithmetical Accuracy — Confirms all ledger postings are arithmetically correct
under the double-entry system

2. Detect Errors — If sides don't agree, signals errors in posting, totalling, balancing, or
extraction

3. Summarise Ledger Accounts — Provides a consolidated single-page summary of every

account's balance

4. Facilitate Preparation of Financial Statements — Nominal accounts → P&L Account;

Real and Personal accounts → Balance Sheet

5. Management Decision-Making — Periodically prepared trial balance gives management

a snapshot without waiting for year-end

6. Facilitate Audit — Provides auditors a structured, summarised view of all accounts

Which Balance Goes Where?

Account Type Normal Balance Side in Trial Balance

Assets (Cash, Machinery, Debtors) Debit Balance Debit Column

Expenses & Losses (Rent, Wages, Bad Debts) Debit Balance Debit Column

Purchases Debit Balance Debit Column

Liabilities (Creditors, Loans, Outstanding) Credit Balance Credit Column

Capital and Reserves Credit Balance Credit Column

 Account Type Normal Balance Side in Trial Balance

Income & Revenues (Sales, Commission) Credit Balance Credit Column

Methods of Preparing Trial Balance

Method 1 — Balance Method (Most Common): Only the net closing balance of each ledger
account is extracted and placed in the respective column. Most widely used and required by
Indian accounting standards.

Method 2 — Total Method (Gross Method): The total of the debit side and total of the credit
side of each ledger account are separately recorded. Shows gross transaction volume but does
not directly assist in preparing financial statements.

Method 3 — Total and Balance Method (Combined Method): Both totals (gross) and balances
(net) are shown simultaneously using four columns. Comprehensive but more complex.

Numerical Illustration — Trial Balance

Trial Balance of M/s Priya Traders as on 31st March 2024

Account Name Dr. (₹) Cr. (₹)

Capital A/c --- 5,00,000

Cash A/c 1,50,000 ---

Bank A/c 80,000 ---

Land & Building A/c 2,50,000 ---

Machinery A/c 1,20,000 ---

Debtors A/c 60,000 ---

 Account Name Dr. (₹) Cr. (₹)

Closing Stock A/c 40,000 ---

Creditors A/c --- 75,000

Bank Loan A/c --- 1,00,000

Sales A/c --- 3,20,000

Purchases A/c 2,00,000 ---

Wages A/c 50,000 ---

Rent A/c 30,000 ---

Salaries A/c 45,000 ---

Commission Received A/c --- 30,000

TOTAL 10,25,000 10,25,000 ✅

Errors in Trial Balance

Category A — Errors That AFFECT the Trial Balance (Disagreement):

Type Description Example

Error of Posting Amount posted to only one account, or Debit entry posted but credit entry
(One-sided) wrong side omitted
 Type Description Example

Cash A/c debit column totalled ₹5,000

Error of Totalling Wrong addition in ledger account totals instead of ₹15,000

Error of Carrying Wrong balance brought forward from Balance b/d written ₹2,000 instead of
Forward previous page ₹20,000

Correct ledger balance written wrongly

Error of Extraction in trial balance Debit balance written in credit column

Arithmetical mistake in adding up trial

Casting Error balance columns Trial balance columns added wrongly

Category B — Errors That Do NOT Affect Trial Balance (Hidden Errors):

Type Description Example

Transaction completely omitted from Credit sale of ₹10,000 to Ramesh not

Error of Omission books recorded at all

Error of Correct amount but posted to wrong

Commission person's account Sale to Ramesh posted to Suresh's A/c

Correct amount, wrong type of

Error of Principle account Machinery purchase recorded as Repairs A/c

Compensating Two or more errors that cancel each One account over-debited by ₹500 and
Errors other out another over-credited by ₹500

Error of Purchase of ₹5,000 journalised and posted

Duplication Same transaction recorded twice twice
Limitations of Trial Balance

 Does not guarantee absolute accuracy — hidden errors (Category B) go undetected

 Not conclusive proof — only proves arithmetic balance

 Errors of principle cannot be detected

 Compensating errors cancel each other and remain hidden

 It is not a financial statement — cannot replace the Balance Sheet or P&L Account

Trading Account

The Trading Account is the first stage of final accounts, prepared to calculate Gross Profit or
Gross Loss from the core buying and selling activities of the business. It deals exclusively with
direct revenues and direct expenses.

Key Formulae

Gross Profit = Net Sales − Cost of Goods Sold (COGS)

COGS = Opening Stock + Purchases + Direct Expenses − Closing Stock

Items on the DEBIT Side (Dr.) — Costs

1. Opening Stock — Unsold goods from the previous period, valued at cost or NRV,
whichever is lower

2. Purchases — Total goods purchased (cash + credit), less Purchases Returns (Returns
Outward)
Net Purchases = Gross Purchases − Purchases Returns

3. Direct Expenses (Complete List):

[Link]. Direct Expense Description

1 Wages / Factory Wages Payment to workers directly involved in production

2 Carriage Inwards / Freight Inwards Transport charges to bring purchased goods to the business

3 Octroi / Import Duty Tax on goods brought into a municipal area or imported
 [Link]. Direct Expense Description

4 Custom Duty Duty paid on imported goods

5 Dock Charges Charges at dock/port for unloading imported goods

6 Clearing Charges Charges for clearing goods from customs or port

7 Coal, Gas & Water (Factory) Fuel and utilities used directly in manufacturing

8 Factory Lighting / Power Electricity used specifically for the factory

9 Royalties on Production Payment per unit manufactured using someone's patent

10 Packing Charges (Primary) Cost of packing materials to make goods saleable

11 Manufacturing Expenses All direct costs of producing finished goods

12 Motive Power Power used to run manufacturing machinery

13 Excise Duty Tax paid on goods manufactured

14 Cost of Raw Materials Direct material costs in a manufacturing firm

Key Rule: If an expense is incurred before goods are ready for sale, it is a direct expense and
goes into the Trading Account.

Items on the CREDIT Side (Cr.)

Item Description

Sales Total revenue from selling goods (cash + credit)

Item Description

Less: Sales Returns (Returns

Inward) Goods returned by customers — deducted to get Net Sales

Unsold goods at end of period (valued at cost or NRV, whichever is

Closing Stock lower)
Trading Account Format (M/s _______ for the year ended 31st March 2024)

Dr. Particulars ₹ ₹ Cr. Particulars ₹ ₹

To Opening Stock 40,000 By Sales 3,50,000

To Purchases 2,00,000 Less: Sales Returns (10,000) 3,40,000

Less: Purchase Returns (5,000) 1,95,000 By Closing Stock 50,000

To Carriage Inwards 8,000

To Wages 22,000

To Factory Lighting 5,000

To Octroi 3,000

To Gross Profit c/d 1,17,000

TOTAL 3,90,000 TOTAL 3,90,000

Profit & Loss Account

The Profit & Loss (P&L) Account is the second stage of final accounts, beginning with Gross
Profit from the Trading Account and then accounting for all indirect expenses and other incomes
to arrive at Net Profit or Net Loss.

Key Formula

Net Profit = Gross Profit + Other/Indirect Incomes − Indirect Expenses

Items on the DEBIT Side — Indirect Expenses (Complete List)

A. Office and Administrative Expenses:

 [Link]. Expense Description

Salaries paid to office/administrative staff (not factory

1 Office Salaries workers)

2 Office Rent Rent paid for office premises

3 Office Lighting/Electricity Electricity bills for the office (non-factory)

4 Printing & Stationery Cost of stationery, letterheads, printed materials

5 Postage & Telegrams Postal and communication expenses

6 Telephone Charges Landline and mobile bills

7 Legal Charges Fees paid to lawyers for business matters

8 Audit Fees Fees paid to auditors for auditing accounts

Office Expenses / General

9 Expenses Miscellaneous administrative costs

10 Insurance Premium paid on general business insurance policies

B. Selling and Distribution Expenses:

[Link]. Expense Description

11 Advertisement Cost of promoting and advertising products/services

12 Carriage Outwards / Freight Outwards Transport charges for delivering goods to customers
 [Link]. Expense Description

13 Commission (Paid) Commission paid to sales agents or middlemen

14 Discount Allowed Discount given to debtors/customers for early payment

15 Salesmen's Salaries / Travelling Expenses Costs of sales force and their travel

16 Packing Charges (Secondary/Delivery) Cost of packing for dispatching goods to customers

17 Export Duty Duty paid on goods exported

18 After-Sales Service Costs Warranty and service expenses

C. Financial Expenses:

[Link]. Expense Description

19 Interest on Loan / Capital Interest paid on borrowed funds or to the owner

20 Bank Charges / Bank Commission Charges levied by the bank for services

21 Discount on Issue of Shares/Debentures Written off each year from fictitious assets

D. Maintenance and Depreciation:

[Link]. Expense Description

22 Depreciation Systematic reduction in value of fixed assets

23 Repairs & Maintenance General upkeep of office/non-factory assets

 [Link]. Expense Description

24 Renewal Charges Cost of renewing licences, subscriptions, etc.

E. Losses and Provisions:

[Link]. Expense Description

25 Bad Debts Irrecoverable debts written off from debtors

26 Provision for Doubtful Debts Reserve created for debts that may become bad

27 Loss by Fire/Theft (not insured) Uninsured losses written off through P&L

28 Provision for Discount on Debtors Estimated future discounts to be allowed to debtors

Items on the CREDIT Side — Indirect Incomes

Item Description

Gross Profit b/d Transferred from the Trading Account

Discount Received Discount obtained from creditors/suppliers for early payment

Commission Received Commission earned from acting as an agent

Rent Received Rent earned by subletting part of business premises

Interest Received Interest earned on investments, loans given

Dividend Received Dividend on shares held as investments

 Item Description

Profit on Sale of Asset Gain made by selling a fixed asset above book value

Bad Debts Recovered Previously written-off bad debts now received

P&L Account Format (M/s _______ for year ended 31st March 2024)

Dr. Particulars ₹ Cr. Particulars ₹

To Office Salaries 20,000 By Gross Profit b/d 1,17,000

To Office Rent 12,000 By Discount Received 3,000

To Advertisement 8,000 By Commission Received 5,000

To Carriage Outwards 4,000 By Rent Received 6,000

To Discount Allowed 2,500

To Bad Debts 3,500

To Depreciation 10,000

To Insurance 4,000

To Audit Fees 3,000

To Interest on Loan 5,000

To Net Profit c/d 59,000

 Dr. Particulars ₹ Cr. Particulars ₹

TOTAL 1,31,000 TOTAL 1,31,000

Net Profit = ₹1,17,000 + ₹14,000 (other incomes) − ₹72,000 (indirect expenses) = ₹59,000

The Net Profit of ₹59,000 is then transferred to the Capital Account in the Balance Sheet.

Trading A/c vs. Profit & Loss A/c

Aspect Trading Account Profit & Loss Account

Purpose Calculate Gross Profit / Gross Loss Calculate Net Profit / Net Loss

Stage First stage of final accounts Second stage of final accounts

Opening Entry Starts with Opening Stock Starts with Gross Profit/Loss b/d

Expenses Included Direct expenses only Indirect expenses only

Income Included Sales and Closing Stock Other/non-trading incomes

Result Transferred To P&L Account Capital A/c in Balance Sheet

Focus Buying and selling efficiency Overall business performance

Important Points to Remember

 Carriage Inwards (on purchases) → Trading Account (Direct)

 Carriage Outwards (on sales) → P&L Account (Indirect)

 Factory Wages → Trading Account (Direct)

 Office Salaries → P&L Account (Indirect)

 Factory Lighting → Trading Account (Direct)

  Office Lighting → P&L Account (Indirect)

 Royalty on Production → Trading Account; Royalty on Sales → P&L Account

 If Gross Loss arises in the Trading Account, it is transferred to the Debit side of the P&L
Account

 Net Profit increases Capital; Net Loss decreases Capital in the Balance Sheet

Balance Sheet

A Balance Sheet is a financial statement showing the financial position of a business on

a specific date — what the business owns (assets), what it owes to outsiders (liabilities), and
what belongs to the owner (capital/equity). Unlike the P&L Account (which covers a period), the
Balance Sheet is a snapshot at a point in time.

Assets = Liabilities + Capital (Owner’s Equity)

Steps to Prepare a Balance Sheet

Step 1 — Determine the Reporting Date: In India, this is 31st March every year. The heading
reads: "Balance Sheet as on 31st March 20XX" — not "for the year ended".

Step 2 — Extract Balances from Trial Balance:

 Nominal accounts (income/expense) → Closed in Trading/P&L Account

 Real accounts (assets) → Appear on Assets side

 Personal accounts (debtors, creditors, capital) → Appear on respective sides

Step 3 — Make Year-End Adjustments:

 Add Outstanding Expenses → Current Liabilities

 Add Prepaid Expenses → Current Assets

 Add Accrued Income → Current Assets

 Add Income Received in Advance → Current Liabilities

 Deduct Depreciation from respective fixed assets

 Deduct Provision for Doubtful Debts from Debtors

 Add Net Profit to Capital; deduct Net Loss and Drawings

Step 4 — Classify Assets and Liabilities under proper heads.

Step 5 — Verify: Total Assets = Total Liabilities + Capital ✅

Components of the Balance Sheet

Liabilities Side:

A. Capital / Owner's Equity:

Closing Capital = Opening Capital + Additional Capital + Net Profit − Drawings − Net Loss

B. Non-Current (Long-Term) Liabilities:

Item Example

Long-Term Loans Bank term loan, mortgage loan

Debentures Bonds issued by the company

Loan from Partners/Directors Funds lent by insiders for long-term

C. Current Liabilities (Payable within 1 year):

Item Example

Creditors (Accounts Payable) Amounts owed to suppliers

Bills Payable Written promises to pay creditors

Bank Overdraft Overdrawn bank balance

Outstanding Expenses Expenses incurred but unpaid

Income Received in Advance Rent received in advance, unearned income

Short-Term Loans Loans repayable within one year

Assets Side:

A. Fixed / Non-Current Assets:

Item Treatment

Land & Building Cost − Depreciation = Book Value

Plant & Machinery Cost − Accumulated Depreciation

Furniture & Fixtures Cost − Depreciation

Vehicles Cost − Depreciation

Goodwill Shown at cost or valuation

Patents, Trademarks Shown at written-down value

Key Rule: Fixed assets are shown at Book Value = Cost − Accumulated Depreciation

B. Current Assets (Convertible to cash within 1 year):

Item Example

Closing Stock Unsold goods valued at cost or NRV, whichever is lower

Debtors (Accounts Receivable) Less: Provision for Doubtful Debts

Bills Receivable Amounts due from debtors via bills

Cash in Hand Physical cash balance

Cash at Bank Bank account balance

 Item Example

Prepaid Expenses Expenses paid in advance

Accrued Income Income earned but not yet received

C. Fictitious Assets — Not real assets but losses/expenses not yet fully written off:

 Preliminary Expenses

 Discount on Issue of Shares/Debentures

 Deferred Revenue Expenditure

Important Points to Remember

 Balance Sheet is prepared as on a date (position statement, not a period statement)

 Net Profit → Added to Capital; Net Loss and Drawings → Deducted from Capital

 Debtors always shown after deducting Provision for Doubtful Debts

 Fixed Assets always shown at Net Book Value (Cost − Accumulated Depreciation)

 Closing Stock always appears on the Assets side

 Balance Sheet has no debit/credit sides — it has Liabilities + Capital on one side and
Assets on the other

 Working Capital = Current Assets − Current Liabilities → key measure of short-term

financial health

Marshalling of Assets and Liabilities

Marshalling refers to the process of arranging assets and liabilities in a specific, logical order
on the Balance Sheet. It is not about changing values — only about the sequence of
presentation.

Why is Marshalling Important?

 Clarity and Transparency — Logical arrangement makes financial statements easier to

read
  Better Decision-Making — Investors, creditors, and lenders can quickly assess liquidity
and solvency

 Comparability — Uniform arrangement allows comparison across periods and

businesses

 Audit Convenience — Systematic presentation simplifies verification for auditors

 Legal Compliance — Companies Act, 2013 prescribes a specific order (Schedule III)

Grouping vs. Marshalling

Concept Meaning Example

Combining similar items under one common All fixed assets clubbed under "Fixed
Grouping heading Assets"

Arranging groups and items in a specific Fixed Assets placed before or after Current
Marshalling sequence Assets

Method 1 — Order of Liquidity

Assets (Most to Least Liquid):

Order Asset Reason

1st Cash in Hand Already cash — 100% liquid

2nd Cash at Bank Easily withdrawable

3rd Bills Receivable Collectible on due date

4th Debtors Collectible within weeks/months

5th Short-term Investments Easily saleable in market

 Order Asset Reason

6th Stock/Inventory Needs to be sold first

7th Prepaid Expenses Not convertible to cash

8th Furniture & Fixtures Fixed asset, takes time to sell

9th Vehicles Fixed asset

10th Plant & Machinery Fixed asset, harder to liquidate

11th Land & Building Very difficult and time-consuming to sell

12th Goodwill Least liquid — realisable only on dissolution

Liabilities (Most Urgent to Least Urgent):

Order Liability Reason

1st Bank Overdraft Repayable on demand — most urgent

2nd Creditors Short-term trade obligations

3rd Bills Payable Payable on due dates

4th Outstanding Expenses Due for payment immediately

5th Short-term Loans Payable within one year

6th Long-term Loans / Debentures Payable after many years

 Order Liability Reason

7th Capital / Owner's Equity Repaid only at dissolution — last obligation

Method 2 — Order of Permanence

Assets (Most to Least Permanent):

Order Asset Reason

1st Goodwill Remains with business throughout its life

2nd Land & Building Very long-lived — rarely sold

3rd Plant & Machinery Long-lived productive asset

4th Furniture & Fixtures Long-lived but less than machinery

5th Vehicles Medium-term asset

6th Long-term Investments Held for many years

7th Stock/Inventory Held temporarily — sold each cycle

8th Debtors Collected within months

9th Bills Receivable Short-term receivable

10th Prepaid Expenses Consumed in next period

11th Cash at Bank Highly transient

 Order Asset Reason

12th Cash in Hand Least permanent — constantly flowing out

Liabilities (Most to Least Permanent):

Order Liability Reason

1st Capital / Owner's Equity Remains as long as business exists

2nd Long-term Loans / Debentures Outstanding for many years

3rd Bills Payable Short/medium-term obligations

4th Creditors Settled within weeks/months

5th Outstanding Expenses Cleared very soon

6th Bank Overdraft Repaid on demand — least permanent

Liquidity vs. Permanence — Comparison

Aspect Order of Liquidity Order of Permanence

Starting Asset Cash in Hand (most liquid) Goodwill (most permanent)

Ending Asset Goodwill (least liquid) Cash in Hand (least permanent)

Starting Liability Bank Overdraft (most urgent) Capital (most permanent)

Ending Liability Capital (least urgent) Bank Overdraft (least permanent)

Focus Short-term paying ability Long-term financial stability

Used By Sole traders, partnership firms Companies (Schedule III)

Preferred By Creditors, short-term lenders Shareholders, long-term investors

Comparative Financial Statements

A Comparative Financial Statement presents financial data for two or more accounting periods
side by side, showing both absolute change (₹) and percentage change (%) between periods. It
is also called Horizontal Analysis — we compare across time horizontally.

Objectives

 Identify Trends — Reveal direction of change in financial items over time

 Performance Evaluation — Assess whether business performance is improving or

deteriorating

 Highlight Strengths and Weaknesses — Pinpoint strong-performing and weak areas

 Forecasting — Historical trends help predict future financial performance

 Intra-firm Comparison — Compare the same firm across different periods

 Inter-firm Comparison — Compare with competitors or industry benchmarks

How to Prepare Comparative Statements

Column Contents

Column 1 Item names (Sales, Expenses, Assets, etc.)

Column 2 Previous Year figures (₹) — Base Year

Column 3 Current Year figures (₹)

Column 4 Absolute Change = Current Year − Previous Year (₹)

Column 5 Percentage Change = (Absolute Change ÷ Previous Year) × 100

Absolute Change = Current Year Amount − Previous Year Amount

Absolute Change
Percentage Change = × 100
Previous Year Amount
Comparative Income Statement — M/s Sharma Traders
 Particulars 2022-23 (₹) 2023-24 (₹) Absolute Change (₹) % Change

Revenue from Operations (Sales) 8,00,000 10,00,000 +2,00,000 +25.00%

Less: Cost of Goods Sold 5,00,000 6,00,000 +1,00,000 +20.00%

Gross Profit 3,00,000 4,00,000 +1,00,000 +33.33%

Office Salaries 60,000 70,000 +10,000 +16.67%

Rent 24,000 24,000 Nil 0.00%

Advertisement 16,000 30,000 +14,000 +87.50%

Depreciation 20,000 25,000 +5,000 +25.00%

Bad Debts 10,000 5,000 −5,000 −50.00%

Total Operating Expenses 1,30,000 1,54,000 +24,000 +18.46%

Operating Profit (EBIT) 1,70,000 2,46,000 +76,000 +44.71%

Less: Interest on Loan 20,000 20,000 Nil 0.00%

Net Profit Before Tax 1,50,000 2,26,000 +76,000 +50.67%

Interpretations:

 Sales grew by 25% — positive sign of business expansion

 COGS grew by only 20% — less than sales growth, indicating improved cost efficiency

 Advertisement surged by 87.5% — aggressive marketing push

  Net Profit jumped by 50.67% — excellent overall profitability improvement

Comparative Balance Sheet — M/s Sharma Traders

Particulars 31.03.2023 (₹) 31.03.2024 (₹) Absolute Change (₹) % Change

Capital 5,00,000 6,50,000 +1,50,000 +30.00%

Long-term Loan 2,00,000 1,50,000 −50,000 −25.00%

Creditors 80,000 90,000 +10,000 +12.50%

Outstanding Expenses 20,000 10,000 −10,000 −50.00%

Land & Building 3,00,000 3,00,000 Nil 0.00%

Machinery 2,00,000 2,50,000 +50,000 +25.00%

Closing Stock 1,00,000 1,20,000 +20,000 +20.00%

Debtors 80,000 70,000 −10,000 −12.50%

Cash & Bank 1,20,000 1,60,000 +40,000 +33.33%

Interpretations:

 Capital increased by 30% → Owner reinvested profits, strengthening equity base

 Long-term Loan reduced by 25% → Business is repaying debt — improving solvency

 Debtors decreased by 12.5% → Better collections, improved debtor management

 Cash & Bank rose by 33.33% → Strong improvement in liquidity position

Ratio Analysis

Category 1: Liquidity Ratios

1.1 Current Ratio:

Current Assets
Current Ratio = (Ideal: 2:1)
Current Liabilities
1.2 Quick Ratio (Acid Test Ratio):
Quick Assets
Quick Ratio = (Ideal: 1:1)
Current Liabilities
1.3 Cash Ratio:
Cash + Bank
Cash Ratio = (Ideal: 0.5:1)
Current Liabilities

Category 2: Solvency Ratios

2.1 Debt-Equity Ratio:

Long-term Debt
Debt-Equity Ratio = (Ideal: 2:1)
Equity (Shareholders’ Funds)

2.2 Total Assets to Debt Ratio:

Total Assets
Total Assets to Debt Ratio =
Long-term Debt
Higher ratio (e.g., 3:1) means assets are 3 times the debt — firm can comfortably repay long-
term obligations.

2.3 Proprietary Ratio:

Shareholders’ Funds
Proprietary Ratio = (Ideal: 0.5:1 or higher)
Total Assets
2.4 Interest Coverage Ratio:
EBIT
Interest Coverage Ratio = (Minimum: 6-7 times)
Interest on Long-term Debt

2.5 Capital Gearing Ratio:

Fixed Interest Bearing Capital
Capital Gearing Ratio =
Equity Shareholders’ Funds

 High Gearing → More fixed interest capital → higher financial risk

 Low Gearing → More equity capital → lower financial risk

Category 3: Activity / Turnover Ratios

3.1 Stock Turnover Ratio:

COGS
Stock Turnover Ratio =
Average Stock
Opening Stock + Closing Stock
Average Stock =
2
365
Stock Holding Period = days
Stock Turnover Ratio
3.2 Debtors Turnover Ratio:
Net Credit Sales
Debtors Turnover Ratio =
Average Trade Receivables
365
Debtors Collection Period = days
Debtors Turnover Ratio
3.3 Creditors Turnover Ratio:
Net Credit Purchases
Creditors Turnover Ratio =
Average Trade Payables

3.4 Working Capital Turnover Ratio:

Net Sales
Working Capital Turnover =
Working Capital

3.5 Fixed Assets Turnover Ratio:

Net Sales
Fixed Assets Turnover =
Net Fixed Assets

Category 4: Profitability Ratios

4.1 Gross Profit Ratio:

Gross Profit
Gross Profit Ratio = × 100
Net Sales
4.2 Net Profit Ratio:
Net Profit
Net Profit Ratio = × 100
Net Sales
4.3 Operating Profit Ratio:
Operating Profit
Operating Profit Ratio = × 100
Net Sales
4.4 Operating Cost Ratio:
COGS + Operating Expenses
Operating Cost Ratio = × 100
Net Sales
Or: Operating Cost Ratio = 100 − Operating Profit Ratio.

4.5 Return on Investment (ROI) / ROCE:

Net Profit Before Interest and Tax
ROCE = × 100
Capital Employed
Capital Employed = Shareholders’ Funds + Long-term Debt

4.6 Return on Equity (ROE):

Net Profit After Tax (less Preference Dividend)
ROE = × 100
Equity Shareholders’ Funds

4.7 Earnings Per Share (EPS):

Net Profit After Tax − Preference Dividend
EPS =
Number of Equity Shares Outstanding

4.8 Dividend Per Share (DPS):

Total Dividend Paid to Equity Shareholders
DPS =
Number of Equity Shares Outstanding

4.9 Dividend Payout Ratio:

DPS
Dividend Payout Ratio = × 100
EPS
4.10 Price Earnings (P/E) Ratio:
Market Price per Share
P/E Ratio =
EPS
 High P/E = Investors expect high future growth

 Low P/E = Stock may be undervalued or firm not performing well

All Ratios — Quick Reference Table

Category Ratio Formula Ideal

Liquidity Current Ratio CA / CL 2:1

Liquidity Quick Ratio Quick Assets / CL 1:1

Category Ratio Formula Ideal

Liquidity Cash Ratio Cash + Bank / CL 0.5:1

Solvency Debt-Equity Ratio Long-term Debt / Equity 2:1

Solvency Total Assets to Debt Total Assets / Long-term Debt Higher better

Solvency Proprietary Ratio Shareholders' Funds / Total Assets 0.5:1

Solvency Interest Coverage EBIT / Interest Higher better

Activity Stock Turnover COGS / Avg. Stock Higher better

Activity Debtors Turnover Net Credit Sales / Avg. Debtors Higher better

Activity Creditors Turnover Net Credit Purchases / Avg. Creditors Moderate

Activity Working Capital Turnover Net Sales / Working Capital Higher better

Activity Fixed Assets Turnover Net Sales / Net Fixed Assets Higher better

Profitability Gross Profit Ratio GP / Net Sales × 100 Higher better

Profitability Net Profit Ratio NP / Net Sales × 100 Higher better

Profitability Operating Profit Ratio Operating Profit / Net Sales × 100 Higher better

Profitability Return on Investment EBIT / Capital Employed × 100 Higher better

Category Ratio Formula Ideal

Profitability Return on Equity Net Profit / Equity Funds × 100 Higher better

Profitability EPS (Net Profit − Pref. Dividend) / No. of Shares Higher better

Profitability P/E Ratio Market Price / EPS Context-based

Cash Flow Statement

A Cash Flow Statement shows the inflows (receipts) and outflows (payments) of cash and cash
equivalents during a specific accounting period, classified under three activities — Operating,
Investing, and Financing. It bridges the gap between the Income Statement (profit-based) and
the Balance Sheet (position-based) by focusing exclusively on actual cash movement.

The Cash Flow Statement is mandatory for companies under AS-3 (Revised) issued by ICAI
and Ind AS-7.

Objectives

 Assess Liquidity — Determine whether the firm has enough cash for day-to-day
obligations

 Evaluate Cash Generation — Know how much cash core business operations generate

 Investment Planning — Understand where cash is being invested in long-term assets

 Financing Decisions — Analyse how the business is funding its operations

 Predict Future Cash Flows — Historical patterns help forecast future cash requirements

 Reconcile Profit and Cash — Explain why net profit and net cash may differ

Cash vs. Profit — Why They Differ

 Non-cash expenses like depreciation reduce profit but involve no cash outflow

 Credit transactions affect profit but not immediate cash

 Capital expenditure does not affect profit directly but uses cash

 Loan repayments use cash but do not affect profit

Methods of Preparing Cash Flow from Operating Activities

Method Approach Used By

Direct
Method Shows actual cash receipts and payments Preferred by ICAI/AS-3

Indirect Starts with Net Profit; adjusts for non-cash items and More commonly used in
Method working capital changes practice
Investing and Financing Activities are always prepared using the Direct Method only.

Cash Flow from Operating Activities

Cash Inflows:

 Cash received from customers (cash sales + collections from debtors)

 Interest received (in trading/financial companies)

 Dividend received (in investment companies)

 Commission and fees received in cash

 Income tax refunds received

Cash Outflows:

 Cash paid to suppliers (payments for purchases, raw materials)

 Cash paid to employees (salaries, wages, PF contributions)

 Cash paid for operating expenses (rent, electricity, telephone, insurance)

 Income tax paid