Financial Accounting

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Financial Accounting (Mgt-101)
VU
Lesson-12
THE ACCOUNTING EQUATION
Resources in the business = Resources supplied by the owner
In accounting, terms are used to describe things. The amount of resources supplied by the owner is called
capital. The actual resources which are in the business are called assets. This means that the accounting
equation above, when the owner has supplied all the resources, can be shown as:
Assets=Capital
Usually, people, other than the owner has supplied some of the assets. Liabilities are the name given to the
amounts owing to these people for these assets. The equation has now changed to:
Assets=Capital + Liabilities
It can be seen that two sides of the equation will have the same totals. This is because we are dealing with
the same thing with two different points of view. It is:
Resources in the business = Resources: who supplied them
Assets = Capital + Liabilities
It is a fact that total of each side will always equal one another, and this will always be true no matter how
many transactions there may be. The actual assets, capital and liabilities may change, but the total of the
assets will always equal to the total of capital and liabilities.
Assets consist of property of all kinds, such as buildings, machinery, stocks of goods and motor vehicles.
Also benefits such as debts owned by customers and the amount of money in the bank accounts are
included.
Liabilities consist of money owing for goods supplied to the business and for expenses. Also loans made to
the firm are included.
Capital is often called the owner's net worth.
Working capital
Working capital of the business is the net value of current assets & current liabilities.
Current assets are the resources of the business that are expected to be received within 12 months in an
accounting period.
Current liabilities are the amount owing to the business that is expected to be paid within one year in a
financial year.
So, working capital is the net of what is receivable in an accounting year & what is payable in that year or:
Working Capital = Current Assets ­ Current Liabilities
For instance, current assets of the business worth Rs.100,000 & current liabilities of the business has the
value of Rs. 75,000. Then working capital is Rs. 25,000.
i.e., (100,000-75,000).
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STOCK
Stock is termed as "value of goods available to the business that are ready for sale". For accounting
purposes, stock is of two types:
·  Opening stock
·  Closing stock
Opening stock is the value of goods available for sale in the beginning of an accounting year. For purpose
of financial reporting, opening stock is added to the purchases for the year to become a part of cost of
goods sold. As this is available in the beginning of the year, it is assumed that it will be consumed in the
accounting year. That is why; it becomes a part of cost of goods sold. Stock of previous year is the opening
stock in present year.
Closing stock is the value of goods unsold at the end of accounting year. For purposes of making financial
statements, it is deducted from cost of goods sold & is shown as an asset in the balance sheet. As this is the
value of goods that are yet to be sold, so it cannot be included in cost of goods sold. That is why it is
deducted from cost of good sold. On the other hand, its benefit will be received in the next accounting year,
so it is shown as an asset in the balance sheet.
Now, the contents of cost of goods sold are:
Opening stock
Plus: purchases
Plus: Freight/ carriage paid on purchases
Less: closing stock
For instance, opening stock of a business worth Rs. 15,000, business purchased goods of Rs. 12,000 for the
year & also paid Rs. 1,500 as carriage on purchases. The value of closing stock at the end of the year is Rs.
10,000. Then, value of closing stock is calculated as under:
Opening stock
15,000
12,000
1,500
Less: closing stock
(10,000)
Cost of goods sold
18,500
Trial Balance As On January 31, 20--
Title of Account
Code
Dr. Rs.
Cr. Rs.
Cash Account
01
35,000
Bank Account
02
130,000
Capital Account
03
200,000
Furniture Account
04
15,000
Vehicle Account
05
50,000
Purchases Account
06
60,000
Mr. A (Creditor)
07
15,000
Sales
08
95,000
Mr. B (Debtor)
09
15,000
Salaries
10
5,000
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Expenses
11
20,000
Expenses Payable
12
20,000
Total
330,000
330,000
The Accounting Equation.
Assets = Capital + Liabilities
Assets = 35,000+130,000+15,000+50,000+15,000= 245,000
Capital = 200,000
Liabilities = 15,000 + 20,000 = 35,000
Capital + Liabilities = 235,000
We ignore the Net Profit Rs.10000 (Net profit is added in capital account)
When we added Net profit in capital then;
Assets = Capital + Liabilities
245000 = 210000+35000
245000 = 245000
Account form Balance Sheet
Name of the Entity (Ali traders)
Balance Sheet As At (January 31, 20--)
Liabilities
Assets
Particulars
Amount Rs.
Particulars
Amount
Rs.
Capital
200.000 Fixed Assets
65,000
Profit and Loss Account
10,000
Furniture
15,000
50000
210,000 Vehicle
Current Liabilities
Current Assets
Mr. A
15,000
Mr. B
15,000
Exp. payable
20,000
35,000
Bank  130,000
180,000
Cash
35,000
Total
245,000 Total
245,000
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Report form Balance Sheet
Balance Sheet As At January 31, 20--
Particulars
Amount Rs.
Amount Rs.
Assets
Fixed Assets
65,000
Current Assets
180,000
Total
245,000
Liabilities
Capital
200,000
Profit and Loss Account
10,000
210,000
Current Liabilities
35,000
Total
245,000
Treatment of closing stock
If closing stock is Rs.10000 then;
Name of the Entity (Ali Traders)
Profit and Loss Account for the Month Ending January 31, 20--
Particulars
Amount
Amount
Rs.
Rs.
Income / Sales / Revenue
95,000
Less: Cost of Goods Sold ( 60,000 - 1,000 )
(59,000)
(59,000)
Gross Profit
36,000
(25,000)
(25,000)
Net Profit
11,000
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Balance Sheet As At January 31, 20--
Particulars
Amount Rs.
Amount Rs.
Assets
Fixed Assets
65,000
Current Assets (180,000 + 1,000)
181,000
Total
246,000
Liabilities
Capital
200,000
Profit and Loss Account
11,000
210,000
Current Liabilities
35,000
Total
246,000
Treatment of Depreciation
In Profit and Loss Account it is considered as expense and in Balance Sheet it is deducted from the
concerned asset.
If useful life of an asset is 50 month and considered that there is no residual value then,
·
Dividing total cost by life of the asset.
·
Rs.65,000 / 50 months = Rs.1,300 monthly charge
Name of the Entity (Ali Traders)
Profit and Loss Account for the Month Ending January 31, 20--
Particulars
Amount
Amount
Rs.
Rs.
Income / Sales / Revenue
95,000
Less: Cost of Goods Sold ( 60,000-1,000 )
59,000
(59,000)
Gross Profit
36,000
25,000
Depreciation
1,300
(26,300)
Net Profit
9,700
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Balance Sheet As At January 31, 20--
Particulars
Amount Rs.
Amount Rs.
Assets
Fixed Assets (65,000 ­ 1,300)
63,700
Current Assets (180,000 + 1,000)
181,000
Total
244,700
Liabilities
Capital
200,000
Profit and Loss Account
9,700
209,700
Current Liabilities
35,000
Total
244,700
Distribution of Profits / Drawing
Balance Sheet As At January 31, 20--
Particulars
Amount Rs.
Amount Rs.
Assets
Fixed Assets (65,000 ­ 1300)
63,700
Current Assets (181,000 - 5,000)
176,000
Total
239,700
Liabilities
Capital
200,000
Profit and Loss Account
9,700
Drawing
(5,000)
204,700
Current Liabilities
35,000
Total
239,700
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Illustration
Consider the trial balance given hereunder:
Saeed & co.
Trial Balance As On ( January 31, 2002)
Title of Account
Code
Dr. Rs.
Cr. Rs.
Cash Account
01
161,250
Capital Account
02
150,000
Furniture Account
03
2,000
Purchases Account
04
16,000
Carriage on purchase account
05
250
Salim& co. (Creditor)
06
0
Sales
07
37,000
Usman & co. (Debtor)
08
0
Salaries
09
2,500
sRent
10
3,000
Stationery
11
2,000
Utility billst
12
5,000
Accrued expenses
13
5,000
Total
192,000
192,000
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Financial Accounting (Mgt-101)
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(This trial balance is extracted from the solved illustration, in lecture 11)
Let's say, the value of closing stock at the end of the period is Rs. 2,000. Then profit & loss account will bear
the following change.
Saeed & Co.
Profit & Loss Account for the period ended January 31, 2002
Particulars
Amount
Amount
Rs.
Rs.
37,000.
Income / Sales / Revenue (See Note
16,250 ­ 2,000
(14,250)
#1)
Less: Cost of Goods Sold ­ Closing
stock
Gross Profit
22,750.
(12,500)
(See Note # 2)
Net Profit/ (Loss)
10,250
Its effect in the balance sheet is as follows:
Saeed & Co.
Balance Sheet As At January 31, 2002
Liabilities
Assets
Particulars
Amount
Particulars
Amount
Rs.
Rs.
Capital
150,000 Fixed Assets
Profit and Loss Account
10,250 Furniture Account
2,000
160,250
Current Liabilities
Current Assets
Accrued Expenses
5,000 Cash
161,250
Closing Stock
2,000
Total
165,250 Total
165,250
This is a practical demonstration of the treatment of closing stock. But, we are not mentioning the journal
entry of closing stock at this stage. It will be discussed in detail, when we will study the topic of fixed assets.
DEPRECIATION
Depreciation is the method of charging cost of fixed assets to the profit & loss account as an expense.
Fixed Assets are those assets which are:
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·  Of long life
·  To be used in the business
·  Not bought with the main purpose of resale.
When an expense is incurred, it is charged to profit & loss account of the same accounting period in which it
has incurred. Fixed assets are used for longer period of time. Now, the question is how to charge a fixed
asset to profit & loss account. For this purpose, estimated life of the asset is determined. Estimated life is the
number of years in which a fixed asset is expected to be used. Then, total cost of the asset is divided by total
number of estimated years. The value, so determined, is called `depreciation for that year' and is charged to
profit & loss account. The same amount is deducted from total cost of fixed asset. The net amount (after
deducting depreciation) is called ``Written Down Value''.
For instance, an asset has a cost of Rs. 150,000. It is expected to be used for ten years. Depreciation to be
charged to profit & loss account is Rs. 15,000, i-e. cost of asset/estimated life. In this case, it will be
150,000/10 = 15,000.
That is why depreciation is called an accounting estimate.
To understand its accounting treatment, consider the above mentioned illustration
Let's suppose the useful life of furniture is five years. Then, depreciation for the year will be (2,000/5 = 400).
Now, the profit & loss account will show the following picture:
Saeed & Co.
Profit & Loss Account for the year ended January 31, 2002
Particulars
Amount
Amount
Rs.
Rs.
37,000.
Income / Sales / Revenue (See Note #1)
Less: Cost of Goods Sold
(16,250)
Gross Profit
20,750.
12,500 + 400
(12,900)
Net Profit/ (Loss)
9,850
Balance sheet will look like this:
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Financial Accounting (Mgt-101)
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Saeed & Sons
Balance Sheet As At January 31, 2002
Liabilities
Assets
Particulars
Amount
Particulars
Amount
Rs.
Rs.
Capital
150,000 Fixed Assets
Profit and Loss Account
9,850 Furniture Account
2,000
Less: depreciation
(400)
159,850
1,600
Current Liabilities
Current Assets
Accrued Expenses
5,000 Cash
161,250
Closing Stock
2,000
Total
164,850 Total
164,850
Treatment of depreciation is practically demonstrated at this point. Its journal entry will be discussed in
detail, when we cover the topic `Fixed Assets'.
DRAWING
Capital is the cash or kind invested by the owner of the business. Sometimes, the owner wants to take cash
or kind out of the business for personal use. This is known as drawing. Any money taken out as
drawings will reduce capital.
The capital account is very important account. To stop it getting full of small details, cash items of drawings
are not entered in the capital account. Instead, a drawing account is opened, and all transactions are entered
there.
Sometimes goods are also taken by the owner of the business. These are also known as drawings.
To understand the accounting treatment of drawings, look into the following trial balance:
Saeed & co.
Trial Balance As On ( January 31, 2002)
Title of Account
Code
Dr. Rs.
Cr. Rs.
Cash Account
01
161,250
Capital Account
02
160,000
Furniture Account
03
2,000
Drawings
04
10,000
Profit & loss account
05
8,250
Salim& co. (Creditor)
06
0
Usman & co. (Debtor)
07
0
Accrued expenses
08
5,000
Total
173,250
173,250
BALANCE SHEET
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Financial Accounting (Mgt-101)
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Saeed & Sons
Balance Sheet As At January 31, 2002
Liabilities
Assets
Particulars
Amount
Particulars
Amount
Rs.
Rs.
Capital
160,000 Fixed Assets
Profit and Loss
8,250 Furniture
2,000
Account
(10,000) Account
Less: Drawings
158,250
Current
Current
Liabilities
5,000 Assets
161,250
Accrued Expenses
Cash
Total
163,250 Total
163,250
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