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[Link] , School of Law, SRMIST

HIGHER FINANCIAL ACCOUNTING

UNIT- I

Trading account
Trading refers to buying and selling of goods with the intention of making profit. The
trading account is a nominal account which shows the result of buying and selling of goods
for an accounting period. According to J. R. Batliboi, “The trading account shows the results
of buying and selling of goods. In preparing this account, the general establishment charges
are ignored and only the transactions in goods are included.”
Trading account is prepared to find out the difference between the revenue from sales
and cost of goods sold. Cost of goods sold refers to directly related cost. Direct cost includes
the purchase price of goods purchased and all other expenses which are incurred to bring the
goods to the business premises or godown and to make these ready for sale. All the goods
purchased during the accounting period may not be sold during the same accounting period.
Hence, it is necessary to calculate the cost of goods sold during the period. Matching principle
is applied here. Hence, the cost of stock not sold must be deducted, i.e., value of closing stock
must be deducted. But if there is any opening stock of goods that will be sold during the
accounting period, it is to be added to the cost of purchases made during the period. If there is
cost of goods manufactured, it must also be added to find out the cost of goods sold.

Cost of goods sold = Opening stock + Net purchases + Direct expenses – Closing stock of the
amount of sales exceeds the cost of goods sold, the difference is gross profit. On the other
hand, the excess of cost of goods sold over the amount of sales results in gross loss.

Sales – Cost of goods sold = Gross profit

Sales – Gross profit = Cost of goods sold

Need for preparation of trading account

Preparation of trading account serves the following purposes:
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[Link] , School of Law, SRMIST
(i) Provides information about gross profit or gross loss
It shows the gross profit or gross loss of the business for an accounting year. This helps
the business persons to find out gross profit ratio by expressing the gross profit as a
percentage of sales. It helps to compare and analyse with the ratios of the previous years.
Thus, it provides data for comparison, analysis and planning for a future period.
(ii) Provides an opportunity to safeguard against possible losses
If the ratio of gross profit has decreased in comparison to the preceding years, effective
measures can be taken to safeguard against future losses. For example, the sale price of goods
may be increased or steps may be taken to analyse and control the direct expenses.
(iii) Provides information about direct expenses and direct incomes
All the expenses incurred on the purchase of goods are direct expenses. They are
recorded in the trading account. Trading account also shows sales revenue, which is a direct
income. With the help of trading account, percentage of such expenses on sales revenue can
be calculated and compared with similar ratios of the previous years. Thus, it enables the
management to have control over the direct expenses.
Preparation of trading account
Trading account is a nominal account. The opening stock, net purchases and all expenses
relating to purchase of goods are shown on the debit side and the net sales and closing stock
are shown on the credit side of it.
A) Items shown on the debit side of the trading account
The following are the items shown on the debit side of the trading account:
(i) Opening stock
(ii) Purchases and purchases returns
(iii) Direct expenses
(a) Carriage inwards or Freight inwards
(b) Wages
(c) Dock Charges
(d) Octroi
(e) Import duty
(f) Royalty
(g) Coal, gas, fuel and power
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[Link] , School of Law, SRMIST
(iv) Cost of goods manufactured

(i) Opening stock

The stock of goods remaining unsold at the end of the previous year is the opening stock
of the current year. This item will not be there in a newly started business. It will not
appear if it is adjusted with purchases. As opening stock would have been sold during the
year, the cost of opening stock is included in trading account.
(ii) Purchases and purchases returns
Goods which have been bought for resale are termed as purchases. Goods purchased
which are returned to suppliers are termed as purchases returns or returns outward.
Purchases include both cash purchases and credit purchases. Net purchases, i.e., purchases
minus purchases returns are shown in the debit side of the trading account.
(iii) Direct expenses
All the expenses incurred on the purchase of goods and for bringing the goods to the go
down or place of business and to make them to saleable condition are known as direct
expenses. They are debited to trading account. Direct expenses include the following:
(a) Carriage inwards or Freight inwards
Amount paid for transporting the goods purchased to the godown or business premises is
called carriage inwards or carriage on purchases or freight inwards.
(b) Wages
Amount paid to workers who are directly engaged in loading, unloading and handling of
goods purchased is known as wages.
(c) Dock Charges
These are the charges levied for shipping the cargo while entering or leaving docks. When
they are paid on import of goods, they are treated as direct expenses.
(d) Octroi
This is a tax levied by the local authority when the purchased goods enter the municipal
limits.
(e) Import duty
Taxes paid on import of goods are known as import duties.
(f) Royalty
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[Link] , School of Law, SRMIST
This is the amount paid to the owner of a mine or a patent for using owner‟s right. When
the royalty is based on cost of production or output, it is treated as a direct expense.
(g) Coal, gas, fuel and power
Cost incurred towards coal, gas and fuel to make the goods saleable is also considered as
direct expenses.
(iv) Cost of goods manufactured
If the sole proprietor is also engaged in manufacture of goods, a separate account, namely,
manufacturing account is to be prepared in which expenses incurred for manufacture of
goods will be entered. Examples of such expenses are raw materials, coal, gas, fuel, water,
power, factory rent, packaging, factory lighting, royalty on manufactured goods, etc. The
total cost of goods manufactured is transferred to the debit side of trading account.

B) Items shown on the credit side of the trading account

(a) Sales and Sales returns
(b) Closing stock
Following are the items shown on the credit side of the trading account:
(a) Sales and Sales returns
Both cash and credit sales of goods will be included in sales. The sales account will show
credit balance whereas the sales returns account will show debit balance. The amount of
net sales is shown on the credit side of the trading account by deducting sales returns
from sales.
(b) Closing stock
The goods remaining unsold at the end of the accounting period are known as closing
stock. They are valued at cost price or net realisable value (market price) whichever is
lower as per Accounting Standard 2 (Revised).

3. Closing of trading account

The difference between the totals of two sides of the trading account indicates either
gross profit or gross loss. If the total of the credit side is more, the difference represents gross
profit. On the other hand, if the total of the debit side is higher, the difference represents gross
loss. The gross profit or gross loss is transferred to profit and loss account.
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[Link] , School of Law, SRMIST
4. Format of trading account

Problem
From the following information, prepare trading account for the year ended 31.12.2016.

Solution
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[Link] , School of Law, SRMIST

Problem
From the following balances extracted from the books of M/s. Lavanya and sons,
prepare trading account for the year ended 31st March, 2017:

Solution
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[Link]
[Link] , School of Law, SRMIST

Profit and loss account

Profit and loss account is the second part of income statement. It is a nominal account in
nature. A business entity is interested in knowing not only the gross profit or loss but also the
net profit earned or net loss incurred during the year. Hence, profit and loss account is
prepared to ascertain the net profit or net loss during the year. Profit and loss account contains
all the items of indirect expenses and losses and indirect incomes and gains in addition to
gross profit or gross loss pertaining to the accounting period. The difference is net profit or net
loss. According to Prof. Carter, “A Profit and Loss Account is an account into which all gains
and losses are collected, in order to ascertain the excess of gains over the losses or vice-
versa”.
Need for preparing profit and loss account
Profit and loss account is prepared for the following purposes:
(i) Ascertainment of net profit or net loss
The profit and loss account discloses the net profit available to the proprietor or net loss to be
borne by him. Ascertainment of profitability helps in planning for the growth and efficiency
of a business enterprise. Inter-firm comparison and intra-firm comparison of profit and loss
account items help in assessing efficiency in comparison with other enterprises and other
departments of the same enterprise respectively.
(ii) Comparison of profit
The net profit of the current year can be compared with the profit of the previous years. It
helps to know whether the business is conducted efficiently or not.
(iii) Control on expenses
Profit and loss account helps in comparing various expenses with the expenses of the previous
years. The percentage of individual expenses to net sales can be calculated and compared with
the similar ratios of previous years. Such a comparison will be helpful in taking effective steps
for controlling unnecessary expenses.
(iv) Helpful in the preparation of balance sheet
A balance sheet can be prepared only after ascertaining the net profit or loss through profit
and loss account. Net profit or loss is shown in the balance sheet. Thus, it facilitates
preparation of balance sheet.
 Prepared By
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[Link] , School of Law, SRMIST
Preparation of profit and loss account
The amount of gross profit or gross loss brought down from the trading account is the
first item in the profit and loss account. All the indirect expenses and losses are debited to
profit and loss account. Indirect expenses include office and administrative expenses, selling
expenses, distribution expenses, etc. As the profit and loss account is a nominal account, all
the indirect expenses and losses are shown on the debit side and all the indirect incomes and
gains are shown on the credit side.
Items shown on the debit side of profit and loss account are as follows:
(i) Gross loss
If trading account discloses gross loss, it is shown on the debit side of the profit and loss
account.
(ii) Indirect expenses
Expenses which are not connected with purchase of goods are indirect expenses, i.e.,
expenses incurred in administration, office, selling and distribution of goods are indirect
expenses.
(a) Office and administrative expenses
Expenses incurred for office and administration such as salary of office employees, office
rent, lighting, postage, printing, legal charges, audit fee, depreciation and maintenance of
office equipment, etc. are classified as office and administrative expenses.
(b) Selling and distribution expenses
Expenses incurred for selling, promotion of sales and distribution of goods such as
advertisement charges, commission to salesmen, carriage outwards, bad debts, godown
rent, packing charges, etc., are classified as selling and distribution expenses.
(c) Other indirect expenses and losses
The expenses such as interest on loan, repair charges, depreciation, charity, loss on sale
of fixed assets and abnormal losses such as loss due to fire, theft, etc. not covered by

insurance are shown under this category.

Items shown on the credit side of profit and loss account are as follows:
(i) Gross profit
The first item on the credit side of profit and loss account is the gross profit brought down
from the trading account if there is gross profit.
 Prepared By
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[Link] , School of Law, SRMIST
(ii) Other incomes and gains
All items of indirect incomes and gains are shown on the credit side of the profit and loss
account. Income from investments, rent earned, discount received, commission earned,
interest earned and dividend received are indirect incomes. Profit on sale of fixed assets
and investments are examples of gains.
Closing of profit and loss account
After debiting indirect expenses and losses and crediting all indirect incomes and gains, if
the total of the credit side of the profit and loss account exceeds the debit side, the difference
is termed as net profit. On the other hand, if the total in the debit side exceeds the credit side,
the difference is termed as net loss. Net profit or net loss is transferred to the capital account.
 Prepared By
[Link]
[Link] , School of Law, SRMIST
Format of profit and loss account
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[Link] , School of Law, SRMIST
Problem From the following information, prepare profit and loss account for the year ended
31st March, 2018.

Solution

Problem From the following information, prepare profit and loss account for the year ended
31st December, 2017
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[Link] , School of Law, SRMIST
Solution

Balance sheet
Balance sheet is a statement which gives the position of assets and liabilities on a
particular date. Assets are the resources owned by the business. Liabilities are the claims
against the business. After ascertaining the net profit or net loss of the business enterprise, a
business person would like to know the financial position of the business. For this purpose,
balance sheet is prepared which contains amounts of all the assets and liabilities of the
business enterprise as on a particular date. The statement so prepared is called „balance sheet‟
because it gives the balances of ledger accounts which are still there, after the closure of all
nominal accounts by transferring to the trading and profit and loss account. Balances of all the
personal and real accounts are grouped into assets and liabilities. In the balance sheet,
liabilities are shown on the left hand side and assets on the right hand side.

According to J.R. Batliboi, “A Balance Sheet is a statement prepared with a view to measure
the exact financial position of a business on a certain fixed date.”
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[Link] , School of Law, SRMIST
Need for preparing a balance sheet
The purposes of preparing a balance sheet are as follows:
i. The main purpose of preparing a balance sheet is to ascertain the true financial
position of the business at a particular point of time.
ii. It helps in comparing the cost of various assets of the business such as the amount
of closing stock, amount due from debtors, amount of fictitious assets, etc.
Moreover as assets and liabilities of similar nature are grouped and presented in
balance sheet, a comparative study of these assets and liabilities is facilitated. It
helps in comparing the various liabilities of the business.
iii. It helps in finding out the solvency position of the firm. The firm‟s solvency
position is favourable if the assets exceed the external liabilities. The firm‟s

solvency position is not favourable it the external liabilities exceed the assets.
Characteristics of balance sheet
The following are the characteristics of a balance sheet:
i. A balance sheet is a part of the final accounts. However, the balance sheet is a
statement and not an account. It has no debit or credit sides and as such the words „To‟
and „By‟ are not used before the names of the accounts shown therein.
ii. A balance sheet is a summary of the personal and real accounts, which have balances.
Personal and real accounts having debit balances are shown on the right hand side
known as assets side, whereas personal and real accounts having credit balances are
shown on the left hand side known as liabilities side.
iii. The totals of the two sides of the balance sheet must be equal. If the totals are not
equal, it indicates existence of error. It must satisfy the accounting equation, ie., Assets
= Capital + Liabilities, following the dual aspect concept.
iv. Balance sheet is prepared on a particular date and not for a fixed period. It discloses
the financial position of a business on a particular date. It gives the balances only for
the date on which it is prepared.
v. It shows the financial position of the business according to the going concern concept.
Methods of drafting a balance sheet
The balance sheet of business concern can be presented in the following two forms.
a. Horizontal form
b. Vertical form
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[Link] , School of Law, SRMIST
a) Horizontal form of balance sheet
In the horizontal form, assets are shown on right hand side of the balance sheet and the
liabilities are shown on the left hand side of the balance sheet.
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[Link] , School of Law, SRMIST
b) Vertical form of balance sheet
The balance sheet of a sole proprietor can be presented in a vertical statement form as given
below:
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[Link] , School of Law, SRMIST
Classification of assets and liabilities
The resources acquired by the business entity out of funds provided by owners or
creditors are called assets. These are the resources owned by the business. Assets of a business
include cash, stock, plant and machinery, etc.
A) Classification of assets
According to the nature of assets, they may be classified into the following:
a) Fixed assets
Fixed assets are those assets which are acquired or constructed for continued use in the
business and last for many years such as land and building, plant and machinery, motor
vehicles, furniture, etc. According to Finney and Miller, “Fixed assets are assets of a
relatively permanent nature used in the operations of business and not intended for sale.”
As the purpose of keeping such assets is not to sell but to use them, changes in their
realisable values are ignored and these are always shown in the balance sheet at cost less
depreciation. Fixed assets can be classified into i) Tangible fixed assets & ii)

Intangible fixed assets.

i) Tangible fixed assets
Tangible fixed assets are those which have physical existence or which can be seen and
felt.
Examples: plant and machinery, building and furniture.
ii) Intangible fixed assets
Intangible fixed assets are those which do not have any physical existence or which cannot
be seen or touched. Examples: goodwill, trade-marks, copy rights and patents. Intangible
assets are as much valuable as tangible assets because they also help the firm in earning
profits. For example, goodwill helps in attracting customers and patents represent the
know-how which helps in producing the goods.
b) Current assets
Current assets are those assets which are either in the form of cash or can be easily
converted into cash in the normal course of business or within one year. In the words of
Hovard and Upton, “The current assets are usually defined as those assets which are
convertible into cash through the normal course of business within a short time, ordinarily
in a year.” Current assets include cash in hand, cash at bank, short-term investments, bills
receivable, debtors, prepaid expenses, accrued income, closing stock, etc. Among these,
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[Link] , School of Law, SRMIST
closing stock is valued at cost or realisable value whichever is lower and debtors are
shown after deducting a reasonable provision for bad and doubtful debts.

Tutorial note
Prepaid expenses are treated as current assets. Though cash cannot be realised from
prepaid expenses, the service will be available against these without further payment.
c) Liquid assets
Liquid assets are the assets which are either in the form of cash or which can be
immediately converted into cash within a very short period of time, such as cash at bank,
bills receivable, short-term investments, debtors and accrued incomes. In other words, if
prepaid expenses and closing stock are excluded from current assets, the balance is
known as liquid assets.
d) Investments
Amount invested outside the business in shares, debentures, bonds and other securities
is called investments. If it is invested for a period more than a year they are called long-
term investments. If they are invested for a period less than a year they are short term
investments and shown under current assets.
e) Wasting assets
These are the assets which get exhausted gradually in the process of excavation.
Examples:mines and quarries.
f) Fictitious or Nominal assets
These are assets only in name but not in reality. These assets are not really assets but
are shown on the assets side only for the purpose of writing off by transferring them to
the profit and loss account gradually over a period of time in future. Such assets include
the expenditures, the benefit of which lasts for more than a year, not yet written off, such
as advertisement expenses, preliminary expenses, etc.
B) Classification of liabilities
Liabilities or equities are claims against the business entity. These are the amounts
owed by a business entity to the outsiders (outsiders equity) and owners (owners equity).
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[Link] , School of Law, SRMIST
Liabilities may be classified according to their nature as follows:

(a) Fixed or long-term liabilities

The liabilities which are to be repaid after one year or more are termed as long-term
liabilities.
Example: Long-term loans.
(b) Current or short-term liabilities
The liabilities which are expected to be paid within the normal operating cycle or one
year are termed as current or short-term liabilities. These include bank overdraft, creditors,
bills payable, outstanding expenses, etc.
(c) Contingent liabilities
These are the liabilities which are not certain at the time of preparation of balance sheet.
These liabilities may or may not occur. These are the liabilities which will become payable
only on the happening of some specific event which itself is not certain, otherwise these need
not be paid. Such liabilities are as follows:
 Liabilities for bills discounted
 In case a bill discounted with the bank is dishonoured by the acceptor on the due date,
the firm will become liable to the bank.
 Liability in respect of a suit pending in a court of law
 This would become an actual liability if the suit is decided against the firm.
 Liability in respect of a guarantee given for another person
 The firm would be liable to pay the amount if the person for whom the guarantee is

given fails to meet his obligation.

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[Link] , School of Law, SRMIST

Differences between trial balance and balance sheet

The following are the differences between trial balance and balance sheet:

Problem : From the following balances of Niruban, prepare balance sheet as on 31st
December, 2017.
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[Link] , School of Law, SRMIST
Solution

Problem :
From the following information, prepare trading and profit and loss account of Abdul
Rahuman for the year ending 31st December, 2016 and balance sheet as on that date. The
closing stock on 31st December, 2016 was valued at Rs. 2,000.

Solution
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[Link] , School of Law, SRMIST

Problem :From the following trial balance of Sharan, prepare trading and profit and loss
account for the year ending 31st December, 2017 and balance sheet as on that date. The
closing stock on 31st December, 2017 was valued at Rs. 2,50,000.

Solution
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[Link] , School of Law, SRMIST

Adjustment entries and accounting treatment of adjustments

1. Meaning of adjustment entries

Adjustment entries are the journal entries made at the end of the accounting period to
account for items which are omitted in trial balance and to make adjustments for outstanding
and prepaid expenses and revenues accrued and received in advance.

2. Purpose of adjustment entries

The main purpose of adjustment entries are to match current year revenue with the
expenses incurred to earn these revenues. Other purposes are:

i. To exhibit true and fair view of profitability

ii. To exhibit true and fair view of financial status.

3. Need for adjustment entries

The need arises to pass adjusting entries for the following reasons:
i. To record omissions in trial balance such as closing stock, interest on capital,
interest on drawings, etc.
ii. To bring into account outstanding and prepaid expenses.
iii. To bring into account income accrued and received in advance.
iv. To create reserves and provisions.
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[Link] , School of Law, SRMIST
4. Adjustments and adjustment entries
The following are the common adjustments and adjustment entries which are made while
preparing the final accounts.
 Closing stock
 Outstanding expenses
 Prepaid expenses
 Accrued income
 Income received in advance
 Interest on capital
 Interest on drawings
 Interest on loan
 Interest on investment
 Depreciation
 Bad debts
 Provision for bad and doubtful debts
 Provision for discount on debtors
 Income tax paid
 Manager‟s commission

Problem :Prepare trading account from the following ledger balances presented by P. Sen as
on 31st March, 2016.

Additional information:
i. Stock on 31st March, 2016 Rs. 20,000
ii. Outstanding wages amounted to Rs. 4,000
iii. Gas and fuel was paid in advance for Rs. 1,000
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[Link]
[Link] , School of Law, SRMIST

Problem :From the following particulars presented by Thilak for the year ended 31st March,
2017, prepare profit and loss account.

Adjustments:
i. Outstanding salaries amounted to Rs. 4,000
ii. Rent paid for 11 months
iii. Interest due but not received amounted to Rs. 2,000
iv. Prepaid insurance amounted to Rs. 2,000
v. Depreciate buildings by 10%
vi. Further bad debts amounted to Rs. 3,000 and make a provision for bad debts @
5% on sundry debtors
vii. Commission received in advance amounted to Rs. 2,000
 Prepared By
[Link]
[Link] , School of Law, SRMIST
Solution

Working Note:

Debtors : 40,000
Less: Further bad debts : 2,000
38000

Provision for bad and doubtful debts at 5% : 38,000 x 5% = Rs. 1,900

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[Link] , School of Law, SRMIST

Summary of adjusting entries and accounting treatment of adjustments

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[Link] , School of Law, SRMIST
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[Link] , School of Law, SRMIST

Problem The following balances were extracted from the books of Thomas as on 31st March,
2018

Additional information:

i. Closing stock Rs. 9,000

ii. Provide depreciation @ 10% on machinery
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[Link] , School of Law, SRMIST
iii. Interest accrued on investment Rs. 2,000

Prepare trading account, profit and loss account and balance sheet.

Solution
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[Link] , School of Law, SRMIST

Given below are the balances extracted from the books of Nagarajan as on 31st March, 2016.

Prepare the trading and profit and loss account for the year ended 31st March, 2016 and the
balance sheet as on that date after adjusting the following:
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[Link] , School of Law, SRMIST
i. Commission received in advance Rs. 400
ii. Advertisement paid in advance Rs. 150
iii. Wages outstanding Rs. 200

iv. Closing stock on 31st March 2016, Rs. 2,100

Solution