Accounting For A Sole Proprietorship

Sole Proprietorship

A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

A sole proprietorship is a simple type of business structure that is owned and operated by the same person. It does not involve many of the complex filing requirements associated with other types of business structures such as corporations. Sole proprietorships allow persons to report business income and expenses on their individual tax returns.

Sole proprietorships are attractive to small investors because they are relatively easy to start up. Also, the owner is entitled to all the profit that the sole proprietorship collects. On the other hand, sole proprietorships can be risky because there is no separation between the owner and the business. 

In other words, the owner remains personally liable for any losses or debts that the sole proprietorship incurs. They can also be held legally responsible for violations committed by the business or its employees. A sole proprietorship can best be summed up by the phrase, "You are the business.

In addition to the relative simplicity compared to large corporations, opening a sole proprietorship is a low-cost method of entering into the business world. From consultants and free lancers to independent contractors, nearly anyone can create a sole proprietorship.

As the name suggests, "sole proprietorship" refers to a business that is owned by a single owner and should not be confused with a corporation. There are no corporate taxes involved and the sole proprietor pays income tax on the profits generated. The person who organized the business pays personal income taxes on the profits made. This makes the accounting procedure relatively simple for the sole proprietor, who also enjoys complete autonomy in terms of making business decisions.

Setting up a sole proprietorship is easy. One of the main steps is to obtain a local business license (a sales tax permit may also be required). For certain businesses, such as restaurants or legal practices, you may need additional local or state licenses. Legal regulations and licenses aside, there are other major factors to consider when setting up a sole proprietorship. You will have to create a business plan, develop marketing and advertising campaigns, set up a budget, and find ways to fund your business.

Advantages and Disadvantages of a sole proprietorship

Many business owners choose to operate as a sole proprietorship to alleviate the difficult tax procedures that go along with other forms of operation. As a sole proprietor, you would simply have to file an individual income tax return (IRS Form 1040) including your business losses and profits. There are no restrictions on the number of people you can hire, and from the tax and legal perspective there is no distinction between you and your business. You can therefore hire as many people as you want and also recruit independent contractors if need be. Being in complete control of their business, sole proprietors make all the business decisions keeping law in mind.

Some of the Advantages of a Sole Proprietorship

There are many reasons why a person would choose to start their business up using a sole proprietorship structure. Some of the main advantages of sole proprietorships include:

Ease of formation: Starting a sole proprietorship is much less complicated than starting a formal corporation, and also much cheaper. Some states allow sole proprietorship to be formed without the double taxation standards applicable to most corporations. The proprietorship can be named after the owner, or a fictitious name can be used to enhance the business’ marketing.

Tax benefits: The owner of a sole proprietorship is not required to file a separate business tax report. Instead, they will list business information and figures within their individual tax return. This can save additional costs on accounting and tax filing. The business will be taxed at the rates applied to personal income, not corporate tax rates.

Employment: Sole proprietorship can hire employees. This can lead to many of the benefits associated with job creation, such as tax breaks. Also, spouses of the business owner can be employed without having to be formally declared as an employee. Married couples can also start a sole proprietorship, though liability can only assumed by one individual.

Decision making: Control over all business decisions remains in the hands of the owner. The owner can also fully transfer the sole proprietorship at any time as they deem necessary.

 Disadvantages of Sole Proprietorships

Forming a sole proprietorship does involve some risks, mainly to the owner of the business, as legally speaking they are not treated separately from the business. Some disadvantages of sole proprietorships are:

Liability: The business owner will be held directly responsible for any losses, debts, or violations coming from the business. For example if the business must pay any debts, these will be satisfied from the owner’s own personal funds. The owner could be sued for any unlawful acts committed by the employees. This is drastically different from corporations, wherein the members enjoy limited liability (i.e., they cannot be held liable for losses or violations).

Taxes: While there are many tax benefits to sole proprietorship, a main drawback is that the owner must pay self-employment taxes. Also, some tax benefits may not be deductible, such as health insurance premiums for employees.

Lack of “continuity”: The business does not continue if the owner becomes deceased or incapacitated, since they are treated as one and the same. Upon the owner’s death, the business is liquidated and becomes part of the owner’s personal estate, to be distributed to beneficiaries. This can result in heavy tax consequences on beneficiaries due to inheritance taxes and estate taxes.

Difficulty in raising capital: Since the initial funds are usually provided by the owner, it can be difficult to generate capital. Sole proprietorship do not issue stocks or other money-generating investments like corporations do.

So, while sole proprietorship do not necessarily create more liabilities, they do expose the business owner to a risk of being sued. Lawsuits can be filed against the business owner for legal violations, as well as to collect any outstanding debts.

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Accounting for a sole proprietorship

The accounting for a sole proprietorship does not require a separate set of accounting records, since the owner is considered to be inseparable from the business. Nonetheless, one should maintain records for business activities, in order to judge whether these operations are generating a profit.

A sole proprietorship tends to generate smaller amounts of revenue and incur lower levels of expenses than more complex types of organizations. Consequently, it can make sense to start off with the most minimal accounting record keeping that is based on the cash flows into and out of a bank account. This means maintaining separate cash receipts and cash disbursements journals, and little else. This is considered a single entry accounting system, since it cannot be used to produce a balance sheet, only an income statement.

A single entry system is most suited to a cash basis accounting system, where revenues are recorded as cash is received, and expenses are recorded as payments are made. There is no attempt to track assets or liabilities, so there is no formal tracking of fixed assets, inventory, and so forth in separate journals.

The tax reporting for a sole proprietorship flows through the owner's personal tax return, with a separate form used to itemize the major classes of revenues and expenses incurred by the business. There is no separate tax return for the business, since there is no separate business entity.

The main limitation of this accounting system is that there are insufficient accounting records to be translated into an auditable set of financial statements. If the owner of a sole proprietorship wants to obtain funding for his or her business, the lender will likely require audited financial statements, which will require the following sequence of actions to upgrade the accounting records:

Form a business entity

• Switch to the accrual basis of accounting, using a double entry bookkeeping system
• Have the resulting financial statements audited by a CPA

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Rectification Of Financial Accounting And Commerce Accounting

RECTIFICATION OF ERROR

In financial accounting, every single event occurring in monetary terms is recorded. Sometimes, it just so happens that some events are either not recorded or it is recorded in the wrong head of account or wrong figure is recorded in the correct head of account.Once an error is located, it should be properly corrected. The correction of accounting errors in a systematic manner is called the rectification of errors. In other words, the process of systematically correcting the accounting errors is known as rectification of errors. The presence of Accounting errors affects accuracy of the profit and loss and the financial position of the business shown by the final accounts, therefore, no error should be left uncorrected.

Whatever the reason may be, there is always a chance of error in the books of accounts. These errors in accounting require rectification. The procedure adopted to rectify errors in financial accounting is called"Rectification of error".

Methods Of Rectification Of Accounting Errors

The following method should be followed to rectify the accounting errors:

1. Rectification of errors located before preparation of trial balance

2. Rectification of errors after preparation of trial balance

  Rectification Of Errors Located Before Preparation Of Trial Balance

Errors may be detected in the process of closing books and accounts for preparation of trial balance. The errors detected in the process may be either one-sided errors or two-sided errors. However, once such errors are located they must be rectified immediately.

Rectification Of One-sided Errors Located Before Preparation Of Trial Balance

One-sided errors are those errors which affect only one side of an account. Wrong totaling of subsidiary books, posting a wrong amount, posting on the wrong side are some of the examples of one-sided errors. Since two accounts are not involved in these errors, journal entry can not be passed for rectifying such errors. The one-sided error is rectified by making an additional posting on the affected side of the ledger account.

Rectification Of Two-sided Errors Located Before Preparation Of Trial Balance

The errors that affect two or more accounts are called two-sided errors. Correction of such two-sided errors needs to make rectification journal entries since such errors involve two or more accounts. Therefore, one account is debited and another account is credited to rectify two-sided errors. The rules of debit and credit are applied to rectify these errors.

The following three steps are taken to rectify the two-sided errors.

•  Identify correct entry
•  Rewrite wrong entry
•  Find rectifying entry by making adjustment of correct entry and wrong entry

 Rectification Of Errors After Preparation Of Trial Balance

Sometimes, errors may be detected after an accounting year is over. Those are the errors detected after preparation of trial balance. The errors detected after the completion of accounting year may be one-sided and two-sided errors. Rectification of the errors seen after preparation of trial balance can be made by preparing rectifying journal entries in the subsequent year only.

Double entry system is followed to rectify the errors detected after preparation of trial balance. Two accounts are affected by the two-sided errors. Therefore, one account is debited and another affecting account is credited for such errors. But one-sided errors are rectified by opening 'Suspense Account'.

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HOW TO RECTIFY THESE ERRORS

One way of rectification is that we can simply erase or overwrite the incorrect entry and replace it with the correct one. But this practice is not allowed in accounting. We have to Rectify /correct the mistake by recording another entry.

Types Of Accounting Errors Based On Their Nature

The accounting errors based on their nature can be of the following types:

1. Clerical Errors

2. Errors Of Principe

1. Clerical Errors

The errors which are committed by accounting clerks are called clerical errors. These errors are committed in the process of recording financial transactions. These take place due to the carelessness of the clerk responsible for recording financial transactions. Clerical errors are also called technical errors. The principal types of clerical errors are as follows:

a) Errors Of Omission

The errors committed by not recording a transaction either in the book of original entry or in the ledger book are errors of omission. Such an omission may be either complete or partial.

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Complete Omission

Complete omission takes place if a transaction is not recorded in the journal at all. for example, goods sold to Ali for Rs. 10,000 were not recorded in the sales book at all. A complete omission of transaction may occur due to many reasons such as sales invoice misplaced or lost.

Partial Omission

Partial omission occurs if a financial transaction is recorded only partially. For example, partial error of omission occurs if goods sold to Ali for Rs. 4000 is recorded in sales book but failed to be posted in Ali's account.

b) Errors Of Commission

The errors which are committed while recording or posting a transaction are called errors of commission. Errors of commission may take place either in the journal or in the subsidiary books, or in the ledger. Such errors include posting wrong amounts, posting on wrong side of accounts, wrong totaling or carrying forward, and wrong balancing. For example, if purchase of goods for Rs. 10,000 is entered as Rs. 1000 in the journal or in the ledger, such error is called errors of commission.

c) Compensating Errors

Compensating errors refer to two or more errors which mutually compensate the effects of one another. If one error balances the effect of another error, then the two error are called compensating errors. For example, goods sold for Rs.  5000, but wrongly posted to the customer's account as Rs. 500. Similarly, goods purchased for  Rs.5000, but by chance, wrongly posted to the supplier's account as Rs. 500 . The errors in the personal account are compensated by each other, as Rs. 4500 short on the debit side of the customer's account and on the credit side of the supplier's account.

d) Errors Of Duplication

Errors of duplication are those errors which arise because of double recording. Double posting of a transaction from journal or subsidiary books to ledger also create such errors. For example, goods sold to Ali, but this transaction is wrongly entered twice or more in the sales book or wrongly posted twice or more in Ali's account then it is called the errors of duplication.

2. Errors Of Principle

Errors of principle are those errors which occur by violating the principles of accounting. Errors of principle may occur due to wrong allocation between capital and revenue expenditure, or wrong valuation of assets. For example, debiting the wage account instead of machinery account for the wage paid to the mechanics used for the installation of machine and debiting the customer's account instead of cash account for the cash sales made. Errors of principle may also occur due to wrong valuation of assets by higher level staff.

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Accounting For Capital And Revenue

Capital and Revenue Expenditure

Expenditure on fixed assets may be classified into Capital Expenditure and Revenue Expenditure. The distinction between the nature of capital and revenue expenditure is important as only capital expenditure is included in the cost of fixed asset.

Capital Expenditure

Capital expenditure includes costs incurred on the acquisition of a fixed asset and any subsequent expenditure that increases the earning capacity of an existing fixed asset.

The cost of acquisition not only includes the cost of purchases but also any additional costs incurred in bringing the fixed asset into its present location and condition (e.g. delivery costs).

Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its benefit is derived over several accounting periods.

 Capital Expenditure may include the following:

• Purchase costs (less any discount received)
• Delivery costs
• Legal charges
• Installation costs
• Up gradation costs
• Replacement costs

As capital expenditure results in increase in the fixed asset of the entity, the accounting entry is as follows:

• Debit
• Fixed Assets
• Credit 
• Cash/Payable

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What is a capital expenditure versus a revenue expenditure?

A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. Usually the cost is recorded in an account classified as Property, Plant and Equipment. The cost (except for the cost of land) will then be charged to depreciation expense over the useful life of the asset.

A revenue expenditure is an amount that is expended immediately—thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense. Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures.

The difference between these two types of expenditure  is the difference between capital  expenditure and revenue  expenditure. It is of great importance in understanding Final Account it is the key that decides whether an  expenditure is considers as an expense loss or asset.

The chief difference between   the two types of expenditure is the length of time for which they benefit the business and since we have to draw a line somewhere so it is sense able to draw this line at one year. 

Timing: Capital expenditures are charged to expense gradually via depreciation, and over a long period of time. Revenue expenditures are charged to expense in the current period, or shortly thereafter.

Consumption: A capital expenditure is assumed to be consumed over the useful life of the related fixed asset. A revenue expenditure is assumed to be consumed within a very short period of time.

Size: A more questionable difference is that capital expenditures tend to involve larger monetary amounts than revenue expenditures. This is because an expenditure is only classified as a capital expenditure if it exceeds a certain threshold value; if not, it is automatically designated as a revenue expenditure. However, certain quite large expenditures can still be classified as revenue expenditures, as long they are directly associated with sale transactions or are period costs.

Examples of capital expenditures

A capital expenditure refers to the expenditure of funds for an asset that is expected to provide utility to a business for more than one reporting period.

Examples of capital expenditures are as follows:

1. Buildings 
2. Capital leases
3. Computer equipment
4. Office equipment
5. Furniture and fixtures
6. Intangible assets 
7. Land 
8. Software
9. Vehicles

An expenditure is otherwise recorded as an expense if either of the following two rules apply:

The expenditure is for an amount less than the designated capitalization limit of a business. The capitalization limit is established to keep a company from wasting time tracking assets that have little value, such as computer keyboards.

The expenditure relates to an item that is expected to be fully consumed within the current reporting period.

Examples of revenue expenditure

All the expenditures which are incurred in the day to day conduct and administration of a business and the effect-of which is completely exhausted within the current accounting year are known as "revenue expenditures". These expenditures are recurring by nature i.e. which are incurred for meeting day today requirements of a business and the effect of these expenditures is always short-lived i.e. the benefit thereof is enjoyed by the business within the current accounting year. These expenditures are also known as "expenses or expired costs." e.g. Purchase of goods, salaries paid, postage, rent, traveling expenses, stationery purchased, wages paid on goods purchased etc.

Following are the examples of revenue expenditure.

1. Wages paid to factory workers.
2. Oil to lubricate machines.
3. Power required to run machine or motor.
4. Expenditure incurred in the ordinary conduct and administration of business, i.e. rent, , carriage on saleable goods, salaries, wages manufacturing expenses, commission, legal expenses, insurance, advertisement, free samples, postage, printing charges etc.
5. Repair and maintenance expenses incurred on fixed assets.
6. Cost of saleable goods.
7. Depreciation of fixed assets used in the business.
8. Interest on borrowed money.
9. Freight, cartage, octroi duty, transportation, insurance paid on saleable goods.
10. Petrol consumed in motor vehicles.
11. Service charges to motor vehicles.
12. Bad debts.

This expenditure is incurred on items or services which are useful to the business but are used up in less than one year and, therefore, only temporarily increase the profit-making capacity of the business.

Revenue expenditure also includes the expenditure incurred for the purchase of raw material and stores required for manufacturing saleable goods and the expenditure incurred to maintain the- fixed assets in proper working conditions i.e. repair of machinery, building, furniture etc

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Financial Statements

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         Financial Statements 

A financial statement (or financial report) is a formal record of the financial activities and position of a business, person, or other entity.: Financial statements are a collection of reports about an organization's financial results, financial condition, and cash flows.

 They are useful for the following reasons:

• 
  
• To determine the ability of a business to generate cash, and the sources and uses of that cash.
• To determine whether a business has the capability to pay back its debts.
• To track financial results on a trend line to spot any looming profitability issues.
• To derive financial ratios from the statements that can indicate the condition of the business.
• To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.

The standard contents of a set of financial statements are:

Balance sheet: Shows the entity's assets, liabilities, and stockholders' equity as of the report date. It does not show information that covers a span of time.

Income statement: Shows the results of the entity's operations and financial activities for the reporting period. It includes revenues, expenses, gains, and losses.

Statement of cash flows: Shows changes in the entity's cash flows during the reporting period.

If a business plans to issue financial statements to outside users (such as investors or lenders), the financial statements should be formatted in accordance with one of the major accounting frameworks. These frameworks allow for some leeway in how financial statements can be structured, so statements issued by different firms even in the same industry are likely to have somewhat different appearances.

If financial statements are issued strictly for internal use, there are no guidelines, other than common usage, for how the statements are to be presented.

At the most minimal level, a business is expected to issue an income statement and balance sheet to document its monthly results and ending financial condition. The full set of financial statements is expected when a business is reporting the results for a full fiscal year, or when a publicly-held business is reporting the results of its fiscal quarters.

What are the qualitative characteristics of financial statements?

The following are all qualitative characteristics of financial statements:

Understand ability: The information must be readily understandable to users of the financial statements. This means that information must be clearly presented, with additional information supplied in the supporting footnotes as needed to assist in clarification.

Relevance: The information must be relevant to the needs of the users, which is the case when the information influences the economic decisions of users. This may involve reporting particularly relevant information, or information whose omission or misstatement could influence the economic decisions of users.

Reliability: The information must be free of material error and bias, and not misleading. Thus, the information should faithfully represent transactions and other events, reflect the underlying substance of events, and prudently represent estimates and uncertainties through proper disclosure.

Comparability: The information must be comparable to the financial information presented for other accounting periods, so that users can identify trends in the performance and financial position of the reporting entity.

Purpose of financial statements by business entities

"The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions." Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities, equity, income and expenses are directly related to an organization's financial position.

Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business and economic activities and accounting and who are willing to study the information diligently." Financial statements may be used by users for different purposes:

Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis is then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's annual report to the stockholders.

Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analyses are often used by investors and are prepared by professionals (financial analysts), thus providing them with the basis for making investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.

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Adjustments And Their Effect On Final Account

Adjustments And Their Effect On Final Account

Final Accounts are prepared, normally, for a complete period. It must be kept in mind that expense sand incomes for the relevant accounting period are to be taken, while preparing final accounts.If an expense has been incurred but not paid during the period, a liability for the unpaid amount should be created, before finding out the operating result and financial position of a concern. In order to prepare the final accounts on mercantile system of accounting, all expenses and incomes relating to the period, whether incurred or not, received or not, should be brought into the books.For doing this, a concern is required to pass certain entries at the end of the year to adjust the various items of incomes and expenses. Such entries are called adjusting entries.

 Adjustment item 1st Effect 2nd Effect Closing Stock Credit side of Trading Assets side of a/c Balance Sheet Outstanding Expenses Debit side of Trading and Profit & Loss a/c Liabilities side of by way of addition to Balance Sheet expenses Prepaid Expenses Debit side of Trading and Profit & Loss a/c Assets side of by way of deduction Balance Sheet from Expenses Contd…

 Adjustment item Accrued Income (income earned but not received) 1st Effect 2nd Effect Credit side of profit & loss a/c by way of addition to Assets side of Balance Sheet income Income Received in Advance (income Credit side of Profit & loss Liabilities side of the received but not a/c by way of deduction Balance Sheet earned in the from the income financial year) Depreciation Assets side of Balance Sheet Debit side of Profit & Loss by way of deduction from a/c the value of concerned asset. Bad Debts Assets of Balance Sheet by Debit side of Profit & Loss way of deduction from a/c sundry debtors. Contd…

  Adjustment item 1st Effect 2nd Effect Interest on Capital Liabilities side of the Debit side of Profit & Balance Sheet by way of Loss a/c addition to the capital. Interest on Drawings Liabilities side of Balance Credit side of Profit & Sheet by way of addition Loss a/c to the drawings which are deducted from the capital. Debit side of Profit & Loss a/c or by way of addition to Bad Debts. Provision for Doubtful (Old provision for Debts doubtful debts at the beginning of the year will be deducted) Assets side of Balance Sheet by way of deduction from sundry Debtors (After deduction of further bad debts, if any). Contd…

  Adjustment item Provision for Discount on Debtors Reserve for Discount on Creditors 1st Effect Debit side of Profit & Loss a/c Credit side of Profit & Loss a/c Deferred Revenue Debit side of Profit & Expenditure Loss a/c 2nd Effect Deduction from Debtors (after deduction of further bad debts and provision for doubtful debts) on the assets side of the Balance Sheet. Liabilities side of the Balance Sheet by way of deduction from creditors. Assets side of Balance Sheet by way of deduction from capitalized expenditure. Contd…

  Adjustment item 1st Effect 2nd Effect Loss of Stock by Fire If the stock is fully Credit side insured Account of Trading Assets side of Balance Sheet It will be shown on the credit side of Trading Account with If the stock is partly the value of stock and shown insured on the debit side of Profit & Loss a/c for the part of the stock which is not insured Loss of stock by fire is shown on assets side of Balance Sheet with the amount which is to be realized from the insurance co. i.e., that part of the loss which is insured. If the stock is not Credit side of Trading a/c insured Debit side of Profit & Loss a/c Contd…

  1st Effect 2nd Effect Reserve Fund Debit side of Profit & loss a/c along with net profit in the inner column Liabilities side of the Balance Sheet. If reserve fund is already there, it will be shown by addition to the existing reserve fund on the liabilities side of the Balance Sheet. Goods distributed as Free Samples Debit side of Trading a/c by way of deducted from the purchases Debit side of Profit and Loss a/c as Advertisement expenses. Adjustment item Contd…  Adjustment item 1st Effect 2nd Effect Managers Commission Debit side of Profit & Loss a/c Liabilities side of Balance Sheet Goods on sale or Approval Basis Credit side of Trading a/c by way of deduction from the sales at sale price and added to the closing stock at cost price Assets side as a deduction from sundry debtors sale price) and stock at cost on the Assets side of the Balance Sheet.

 Main Types Of Adjustments

• Accrued Expenses
• Prepaid Expenses
• Accrued Revenue
• Unearned Revenue
• Depreciation of Asset
• Interest on Capital
• Interest on Drawings

Accrued Expenses

There are certain expenses, which have been incurred but not paid. These expenses are called outstanding expenses. For example, salary to the clerk Rs. 10,000 is due for the month of December. Books are closed at the end of December. In order to bring this transaction into accounts, the following adjustment entry will be passed:Salary Account …..Dr Rs.10,000 To Outstanding Salary A/c.Rs. 10,000 The two fold Profit & Loss Account.(ii)Outstanding Salary Account, being personal and having credit balance, will be shown on the liabilities side of the Balance Sheet.

Following adjusting entry will be passed:

Salaries A/c.................................................. Dr. 10,000

             Outstanding A/c....................................... 10,000

Prepaid  Expenses

Those expenses which have been paid, in full, but their utility or benefit has not expired during the accounting period are called prepaid or unexpired expenses. In other words, amount has been paid even for the period subsequent to the balance sheet date. For example, annual premium Rs. 12,000 is paid on 1st July, where accounting year closes on 31st December. Rs. 6000 will reinsurance paid in advance.

The following adjusting entry will be passed:

Prepaid Insurance Premium Account….............Dr.Rs. 6,000
              Insurance Premium ............................................Rs. 6,000

Accrued Income

Income earned but not received during the accounting period is called accrued Income.

Suppose, the interest on investments shown in the trial balance is Rs. 19,500.The adjustment may run like this. Interest @10% is due on investments of Rs. 10,000 for 6 months, though accrued, has not been yet been received.This interest Rs. 500 will be accrued income. In order to bring this into account.

The following adjusting entry will be passed:

Accrued Interest on Investments Account …..Dr Rs........ 500

                      Interest on Investment Account Rs....................500

Unearned Revenue

Sometimes, the amount received in respect of an income during the year pertains, partially, to the next year. Suppose a landlord corrects rent for one quarter, in advance, and closes his account on 30th June each year. Suppose, a tenant has occupied a house on 1st June and pays Rs. 1,800 as rent for 3 months. The landlord must not treat the whole of the rent received as income for the current year. Two months’ rent pertains to the next year and should be credited to the Profit and Loss Account of next year. This will ensure that the income for the current year is not overstated.

The required entry is:

Rent Account….Dr Rs.....................................................1,200

     Rent Received in Advance Account Rs............................1,20

Depreciation Of Asset

The value of fixed assets goes on reducing year by year because of wear, tear and flux of time. This fall in the value should be treated as a loss or expense, to be considered before profit or loss is ascertained. The value to be shown in the Balance Sheet must also be, suitably, reduced.To continue to show it at the old figure will be overstating the assets. Depreciation is usually computed on the basis of the life of the assets. Suppose, a machine costs Rs. 1,00,000 and has a life of 5 years. Then, each year 1/5th of the cost, i.e., Rs. 20,000 should be treated as an expense; only the remaining amount is to be shown in the balance sheet.

 The entry is:

Depreciation Account…Dr Rs................................... 20,000

       Machinery Account........................................................20,000

 Interest on Capital

The proprietor may wish to ascertain his profit, after considering the interest for the amount invested in the firm. Suppose, the capital is Rs. 2,00,000 and the rate of interest is 5%. Then,the interest will be Rs. 10,000. It will be treated like other expenses and debited to the Profit and Loss Account; the amount will also be credited to the Capital Account.

The entry is:

Interest on Capital Account ….........................Dr Rs.10,000

            Capital Account......................................................10,000

Interest on Drawings

The proprietor may also realize that when he draws money for private use, the firm loses interest as funds for business are reduced. Therefore, the proprietor’s capital may be debited with the interest on the money drawn by him. Interest will depend on the amount and the date of withdrawal concerned. In absence of information about the date of drawings, it should be assumed that the drawings were made, evenly, throughout the year; therefore, interest should be charged for six months on the full amount. Suppose, capital is Rs. 2,00,000 and the total drawings are Rs. 10,000. The rate of interest is 6% on the drawings.The average amount of drawings on which interest is to be charged is Rs. 5,000. So, interest@ 6% on drawings Rs. 5,000 will be Rs. 300.

 The entry to be passed is:

Interest on Drawings .............................................Dr  Rs. 300

           Profit & Loss Account Rs............................................. 300
  

Provision for Bad Debts

Prudent accounting principle is to make provision for expected losses and not to take credit for expected profits.
All credit sales would not be realized in the year in which the sales are made. Sales may be made in one year and actual realizations may happen in the succeeding year. A firm, therefore,makes provision at the end of the accounting year, for likely bad debts, which may happen during the course of the next year. The simple reason is all collections do not occur in the same year in which sales are made. Some sales are likely to become bad in the course of the next year.So, the proper course would be to charge such likely bad debts in that accounting year in which sales have been made, since, the profit on such sales has been considered in the year in which the sales have been made.

The following journal entry is passed for creating a provision for bad debts:

Profit & Loss A/c Dr Rs..............................................1,000

             Provision for Bad Debts.....................................1,000

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Method Of Preparation Of Trading Account

Method Of Preparation Of Trading Account

We know, Trial Balance is a list of all Ledger accounts balances, so all necessary information for preparation of a Trading A/c is available from the Trial Balance. As gross profit or gross loss of a particular period is determined through Trading Account. So it's heading will be as follows:

                           XYZ & Co.

Trading Account for the year ended 31.12.2005 

      (if accounting period ends on 31.12.2005)

From the Trial Balance the balance of opening stock A/c, Purchase A/c, Returns Inwards A/c end of all direct expenses are transfer on the debit side if the Trading A/c, and the balances of sales A/c, Returns outward A/c and closing stock A/c are transfer on the credit side of the Trading A/c.

If the credit side of a Trading A/c exceeds the debit side, the result is "Gross Profit", and id debit side exceeds the credit side, the result is "Gross Loss". 

The performa of a Trading Account is shown below:

If credit side exceeds the debit side = Gross Profit

If  debit side exceeds the credit side = Gross Loss

Different items of Trading Account are discussed below; (Debit side):

(1) Stock (Opening)

It is unsold part of the last year's purchases. It is available from stock A/c in the Ledger and has debit balance in Trial Balance. It indicates the value of goods lying unsold at the end of the last year. Now it will become the part of current year's purchases. Last year's closing stock is current year's opening stock. Again, current year's closing stock will be next year's opening stock. In the case of a newly set up business, there cannot, however, be any opening stock.

(2) Purchases

It is the value of all goods purchased in the current accounting year and it is available from Purchase A/c in the Ledger. 'Purchase returns' are deducted from Purchases and net purchases are shown on the side of the trading A/c.

(3) Carriage Inward

It means the expenses incurred or bringing purchased goods from the place where they have been purchased, to the shop or go down of the business. It should be remembered that expenses for sending sold goods to customer's shop or house are not recorded in this account. They are debited to carriage outward A/c, an indirect expense, which is transferred to profit and loss A/c. Carriage Inward is transferred to the debit side of the Trading A/c. 

(4) Wages

This refers to the remuneration paid to the workers for the loading and unloading of Purchased goods or it is the remuneration paid the workers who are directly engaged in productive activities. Any how, this is an expense which is directly related with saleable goods and is always debited to the Trading Account.  

(5) Insurance In Transit

While bringing the goods from outside, they may be destroyed or stolen in transit. Such loss may be insured against. The amount of premium paid to the "Insurance Company" is debited to the insurance in transit A/c and is transferred to the debit side of the Trading A/c being an expense connected with the purchase of goods.

(6) Custom Duty

The duty imposed by Government on import and export of goods is known as custom duty. Custom duty is of two types-import duty & export duty. Duty paid on goods imported from abroad is known as import duty and is debited to the Trading A/c. But duty paid on goods exported (i.e. export duty) being expenses connected with sales, is debited to P&L A/c. So, import duty on the goods purchased from abroad is a direct expenses and export duty on the goods sold is an indirect expense.

(7) Clearing Charges

In case of imports from abroad goods are cleared from ports. For this, port authorities charge something which is called clearing charges. This is a direct expense and is debited to Trading Account.

(8) Freight Inward

Charges paid or bringing purchased goods from abroad through steamer, rail or air are known as freight inward. Being an expense connected with the purchase of goods, it is debited to the Trading A/c.

(9) Transport Inward

As discussed above.

(10) Excise Duty On Goods Manufacture

Duty imposed by the government on goods manufactured or produced within the country, is called excise duty. This being an expense connected with the saleable goods or production, is  debited to the manufacturing A/c or Trading A/c, as the case maybe.

(11) Royalty

In a word, royalty means rent.A Manufacturer has to pay such rent, when he acquires the right to produce an article. 

(12) Dock Charges

These are duties imposed on ships and their cargoes when they are unloaded on the port. this is a direct expense and is debited to the Trading A/c.

(13) Coal, Coke, Fuel, Gas, Oil Etc

These items of expenditure being connected with the production of goods should be debited to the Manufacturing A/c or the Trading A/c as the case may be.

(14) Octori Duty

This is a duty which is imposed by the Municipal Corporation or the Municipal Committee when goods purchased enters its territory. So, when the goods are purchased from  the another city, this duty has to be paid. It is an expense connected with purchase of goods and is debited to the Trading A/c.

 (15) Consumable Stores

These are the expenses incurred to keep the machine in right condition and include engine oil, soft soap, cotton waste, oil grease and wase consumed in factory. The amount of such stores consumed  during the year will be debited to the Trading A/c.

(16) MANUFACTURING EXPENSES

All expenses incurred in manufacturing or producing the goods in factory as factory insurance, factory rent, depreciation on factory building, lighting are direct expenses and are debited to Manufacturing A/c as the case may be.

CREDIT SIDE(1) SALES

It is the values of all the goods solid during the current accounting year and it is available from the sale A/c in the Ledger. It  is the major source of revenue in a business which deals in goods. 'Sales returns' are deducted from sales and the net sales are show on the credit side of the Trading A/c.

(2) STOCK (CLOSING)

It indicates the value of goods lying unsold at the end of the current accounting year. At the end of the year a list of unsold goods in prepared showing the quantity and value of each item. The total of the list represent the value of closing stock. The list should be prepared with utmost care and attention. Although closing stock in an assent, yet it is shown on the credit of the Trading A/c.

WHY CLOSING STOCK IS SHOWN IN THE TRADING ACCOUNT ?

Closing stock is shown on the credit side of the Trading A/c in order to make the comparison correct and logical between expenses and revenue. If it is not shown, the matching of expenses and revenue may be wrong. For example, suppose we purchased 100 units of a product @ of Rs. 10 per unit and sold all these unit @ of Rs. 15 each. Our purchases are Rs. 1000 (100*10) and our sales are Rs. 1500 (100*15). Purchases are shown on the credit side of the Trading A/c and sales on the credit side resulting a gross profit of Rs. 500. This is a correct comparison .But, suppose, we  sold only 80 units @ of Rs. 15 each.In that case our purchases are, again Rs. 1000 but our sales are Rs. 1200 and the gross profit is Rs. 200. But this is not the true gross profit because we matched the purchases price of 100 units with the sales price of 80 units only, which is not justified.

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Matching Revenue And Expenses

Matching Revenue And Expenses

To determine net profit for any particular accounting period we use the "Matching principle". The word matching refer to the close relationship that exists between certain expense and revenue realised a result of incurring these expenses. In other words, revenue of the relevant accounting period should be  matched against the expenses of the same period to ascertain profits or losses made by business. 

In the form of equation it may be stated  that;

                    Profit = Revenue - Expenses 

Again, it should be noted that this year's expenses are associated with this year's revenue. We do not compare this  year's expenses with last year's revenue because there is no close relationship between the two.

Trading Account

It has already been discussed that every business concern ascertain profit or loss of the business at the end of the year through the Final Account Business Concerns may be of the following two types:

1. Trading Concerns

Trading concerns are those which do not manufacture goods, rather, they but they finished goods from the manufacturer or wholesaler and sell them to retailer or direct to customers. 

There are four stages in the Final Accounts of a trading Concern:

(a) Trading Account

This shows gross result (Gross profit or Gross loss) of the business.

(b) Profit And Loss Account

This shows net result (net profit or net loss) of the business.

(c) Profit And Loss Account Appropriation Account

This shows how the net profit or net loss of the business has been distributed or disposed off. This is not prepared in the case of sole proprietorship business.

(d) Balance Sheet

This discloses the financial position of the business.

2. Manufacturing Concerns

Manufacturing concerns are those which produced or manufacture goods i.e. convert raw material into finish goods. They sell the goods to the wholesaler or dealers.

There are five stages in the Final Accounts of a manufacturing Concern:

(a) Manufacturing Accounting - this shows the cost of goods manufactured.

(b) Trading Account.

(c) Profit And Loss Account.

(d) Profit And Loss Account Appropriation Account.

(e) Balance Sheet.

All above mentioned stages are collectively known as Final Account or Final Statement. Profit or Loss of every business is generally determined in two stages. In the first stage Gross result, Gross profit or Gross Loss) is ascertained and in the second stage net profit or net loss is ascertained.

Gross Profit Or Gross Loss

Gross profit is ascertained by deducting cost of goods sold (all direct expenses like purchases, carriage, custom duty, stock charges, octori duty ) from sales.

          Gross profit = Total sales - All direct expenses 

For example,Suppose Salman purchased some goods for Rs. 10,000 and paid Rs.200 on account of carriage and Rs. 100 as octori duty. He sold the goods for Rs. 14,000. Now, the cost of goods sold will be Rs. 10,300 (10,000 + 200 + 100) and Gross profit will be Rs. 3700.

           Gross profit = Total sales - All Direct Expenses

              3700         = 14000 - 10300 (10,000 + 200 + 100)

2. Net Profit Or Loss

It is ascertained by deducting all indirect expenses (the expenses incurred for running the business and selling the goods) from the Gross profit.

 For example,Suppose in the above example Salman paid Rs. 1000 as salaries and Rs. 500 as rent. His net profit will be Rs.2200.

         Net  profit = Gross profit - All Indirect Expenses

         Net  profit = 3700 - (1000 + 500) = Rs.2200

Thus the account which is prepared for determining gross profit or gross loss of a business concern, is called "Trading Account" and the account which is prepared for determining net profit or loss net of a business concern is called "Profit and Loss Account".

Features

The Trading Account has the following features;

• It is the first stage of the Final Accounts of a trading concern.

• It is prepared on the last day of an accounting period.

• Only direct revenue and direct expenses are recorded on its debit side and direct revenue on its credit side.

• All items of direct expenses and direct revenue concerning current year are taken into account but no item relating to past or next year is considered in it.

• If its credit side exceeds - it represents Gross profit and if debit side exceeds - it shows Gross Loss.

Why is Trading Account Prepared?

We have already discussed that, the profit or loss determined by a Trading A/c is the gross result of the business but not the true result. Then a question arises - what is the use of preparing Trading Account ?

The Trading Account is necessary because it has the following advantages:

• Gross profit of a business is very important data, since all business expenses are met out of it. So the amount of gross profit should be adequate to meet all the indirect expenses of a business.

• The amount of net sales can be determined through this account. Gross sales can be ascertained from sales A/c in the ledger, but net sales are determined by deducting sales returns from gross sales in Trading A/c.

• The success or failure of a business can be ascertained by comparing net sales of the current year with that of the last year. It should be noted that an increase in the amount of net sales of the current year over the last year may not be regarded as a sign of success, since sales may increase because of rise in price level.

• Percentage of gross profit on net sales can be easily determined from Trading A/c. This percentage is a very important yardstick for measuring the success or failure of a business. Compared to last year, if the rate increase, it indicates success; on the other hand if the rate decreases , it is an indication of failure.

• Percentage of different items of buying expenses (direct expenses) on the gross profit can be easily determined by comparing the percentage of the current year with that of the previous year the variations can be ascertained. An analysis of variances will disclose their causes which will help in controlling the amount of expenses.

• Inventory or stock turnover can be determined from Trading A/c. The success or failure of a business can be measured by this rate. High rate indicates a favorable sign i.e. goods are sold soon after their purchase. On the other hand, low rate signifies deterioration , i.e. goods are sold long after their purchase   

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Final Accounts: The Completion Of Accointing Cycle

Final Accounts: The Completion Of Accounting Cycle

Every businessman goes into a business with the idea of making profit, which is the reward of his efforts. He tries his best to get more and more profit at the smallest economic cost.

    The role of accounting is to accumulate accounting data in such a manner that the amount of profit made or loss sustained during a particular period could be ascertained. The "Final Accounts" enable us to check on the conduct of the business, and to discover whether it is being run profitably. They are the means of conveying to the owner, management, creditors, and interested outsiders a concise picture of profitability and financial position of the business. The preparation of  Final Account is not the first stage of an accounting cycle but they are the final products of the accounting cycle ,  that is why, they are called 'Final Accounts'.

These accounts summaries all the accounting information recorded in the original books of entry and the ledger considered of hundreds or thousands of pages . The Final Accounts and Financial statements' consist of,

• Trading and Profit and Loss Account or Income Statement, which is prepared to know the profit earned or loss suffered by the business during a specific period.

• Balance sheet, which is prepared to know the financial position of the business during  specific period.    

These two accounts or statement are collectively known as "Final Account or Financial Statement".

                         Trial Balance

        A Starting Point For Final Accounts 

We know the Trial Balance is simply a list of ledger accounts balances at the end of an accounting period. This summary of the ledger at the end of an accounting period, is a convenient starting point in the preparation of the Final Accounts . i.e. Trading and Profit and Loss Account, and balance sheet.

A  Trial Balance usually contains the following types of balances,

• Balances from Expenses Accounts

• Balances from Revenue Accounts

• Balances from Assets  Accounts

• Balances from Liabilities Accounts

• Balances from Capital Accounts

The first two types of  balances are transferred to  Trading and Profit and Loss.

The other three types of balances are transferred to the Balance Sheet to know the financial position of the business.

Thus we prepare from the trial balance a Trading and Profit and Loss Account by matching Revenue balances with Expenses balances and by the time we have finished, we have a very much smaller Trial Balance, which is then arranged into a "Balance Sheet". So,

                         Profit = Revenue - All expenses

What Do We Mean By Revenue:

In common language "Revenue" means Tax or  income. But in a business concern revenue means "Sale proceeds of goods or services or it is the price of goods sold or services rendered to the customers. Again  according to the American Accounting Association, "Revenue - is the monetary expression of the aggregate of products or services transferred by an enterprise to its customers during a period of time". When a business delivers goods to its customers or renders services to them, it either receives immediate payment in cash  or acquires an account receivable (Debtor) which will be the inflow of Cash and receivable (Debtors) from sales made in that period. Thus,

       Revenue = Amount Received in Cash + Receivable 

Sources Of Revenue:

The sources of revenue are:

1. Sale proceeds of goods or services. (Sales A/c).
2. Interest received on investment.(Interest A/c Cr. balance).
3. Dividend received on share (Dividend A/c).
4. Discount received from creditors (Discount received A/c Cr balance).
5. Commission received from customers (Commission A/c Cr. balance).
6. Profit on sale of assets (Expect Goods).

If may be mentioned here that various terms are used to described different types of revenue. For example business which sells goods rather than services will use the term "Sales" to describe the revenue; revenue earned by a property dealer may be called "Commission earned; in the professional practice of payers, charted accountants, the revenue is called "fee earned".

Every business has one or two major sources of revenue and may also, have some minor sources of revenue also. So the sources of revenue may be divided into two categories.

Operational Source Or Major Sources Or Direct Source Of Revenue

The revenue earned out of normal business activities belongs to this source. For example, for a trader, sale proceeds of goods is a major source of revenue; for a property Dealer, commission earned is a major source of revenue. for a lawyer, fees earned is a major source of revenue.

Financial Sources Or Minor Sources Or Indirect Source Of Revenue

Any revenue arising from sources other than normal business activities belongs to this category. e.g. Interest, dividend, profit on sale of fixed assets etc.

Expenses

Expenses mean the expired cost incurred for earning revenue of a certain accounting period.They are the cost of the goods and services used up in the process of obtaining revenue. In other words, it becomes possible to earn revenue with the help of expenses. For example, purchase of goods, wages, salaries, rent, carriage, customs duty etc. We have to incur all these expenses in order to earn revenue.

Expenses are mainly divided into two categories;

1. Direct Expenses 
2. Indirect Expenses

Direct Expenses:

Expenses connected with purchases of goods are known as "Direct Expenses" . For example, Freight, insurance of goods in transit, carriage, wages, customs duty import duty, Octori duty etc. Without incurring these expenses, it is not possible to bring the goods from the purchase point to the go-down of the business. Such expenses are collectively known as direct expenses.

Indirect Expenses:

All the expenses other than direct expenses are assumed as indirect expenses. Such Expenses have  no relationship with purchase of building, depreciation, printing charges etc.

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