Measurement, Valuation and Accounting Estimates:
At the end of the last section, it was stated that Trial
balance forms the basis for preparing financial statements. However, there are certain other tasks that
have to be completed before these final accounts are prepared. You know that accounting entries are made on
the basis of actual transactions carried out during an accounting period. These are all included in the trial
balance. However, there could be certain
other business realities which are to be recognized as either asset, liability,
income, gain, expense, loss or a combination thereof. As we know the matching concept necessitates
the consideration of all aspects which may affect the financial result of the
business. Technically these are called
as adjustments for which entries need to be passed, without which the financial
statements will not give a true and fair view of business activity. We discuss some of these entries and
adjustments in the following sections.
Before discussing these, let us understand the meaning of
Income Statement and Balance Sheet.
Trial Balance based on ledger balances
1.
Income Statement shows
income & gains and expenses & losses for an accounting period. The net result is profit or loss.
2.
Balance sheet shows assets
and liabilities & owner’s equity.
Profit or loss from income statement is added or deducted from owner’s
capital or equity.
Depending on the nature of
business, the income statement is prepared in different forms like:
a)
In case of manufacturing
concern, a manufacturing, Trading and P & L A/c is prepared.
b)
In case of a trading or
service organization, a Trading and P & L A/c is Prepared
The manufacturing or Trading accounts show
gross margins (or gross losses) and the P& L A/c shows Net Profit or Net
loss.
The balance sheet exhibits the list of
assets (which indicate resources owned) and the liabilities & owners’
capital and equity (which shows how the resources are funded).
For company type of organizations, standard
formats for P & L and Balance sheet are given in the companies Act that is
to be adhered to. The accounting should
be as per the prescribed Accounting Standards.
Closing Stock:-
We know when goods are purchased for resale
we include them in purchases A/c, while goods sold are shown in sales A/c. at the end of the accounting period, some of
these goods may remain unsold. If we show the entire cost of purchases in income
statement, it will not be as per the matching concept. We should only show the cost of those goods
that are sold during the period. The
balance cost should be carried forward to the next accounting period through
balance sheet. How should the closing stock
be valued? According to the
conservative principle, the stock is valued at lower of cost or market
price. If cost of stock is Rs.125000 and
its realizable market price is only Rs.115000, then the value considered is
Rs.115000 only. What it means is the
difference of Rs.10000 is charged off to the current period profts.
Please remember the closing stock figure
does not appear in the trial balance, but is valued and directly taken to the
P& L A/c. The entry passed for this
is
Closing Stock A/c Dr.
To
Trading and P&L A/c
In solving the examination problem, this
entry is not actually passed, but the effect of its outcome is given. One effect is “show closing stock as asset in
balance sheet” and second effect is “Show it on the credit side of Trading A/c”
Note: But, if the closing stock
appears in the debit side of Trial balance, it means it has already been
adjusted against purchases. In that
case, the closing stock will appear only in the asset side of the Balance
sheet.
Depreciation
Where the business uses its assets to earn
income, there is wear and tear of the asset life. Assets will have limited life and as we go on
using it, the value diminishes. Again
the question to be asked is – at what value should the asset be shown in the
balance sheet? Consider a machine was bought on 1St april 2013 for
Rs.200000. it’s used for production
activity throughout the year. When the
final accounts are being prepared, at what value should it be shown in Balance
sheet as on 31st March 2014?
Well, according to cost principle initial
entry for purchase of machine is shown at cost paid for it e.g Rs.200000/- in
this case. But the fact that the machine
is used must be recognized in financials.
Hence the value in the balance sheet must be brought down to the extent
of its use. This is called Depreciation. How it is called? While there are different
methods of calculating depreciation, the simple idea is to spread it over the
useful life of the asset, so that at the end of its life the value is zero. In our example, if useful life of the machine
is taken as ten years, the depreciation will be simple rs.200000 / 10 i.e
Rs.20000 every year. So a depreciation
of rs.20000 will be charged to the profit of every year and value of asset will
be brought down by the same value.
The entry passed for this is:
Depreciation A/c Dr.
To
Fixed Asset A/c
The effect given is one – include in the P
& L a/c as expenses for the period and two –reduce from asset value in the
Balance Sheet.
Accrued Expenses or Outstanding Expenses
There may be expenses incurred for the
current accounting period, but not actually paid for. The matching concept, however, necessitates
that this expense must be recognized as expense for the current year and should
not be deferred till its actual payment. Typically, we know salary for the
month is normally paid in the 1st week of the next month. Imagine the accounting period close on 31st
March. The salary for the month of March
is not paid till 31st March.
But is it is related to this month,
it must be booked as expenses for the current month and also as a
liability payable in the next month (which is in next accounting period). The entry for this is
Expense A/c Dr.
To
Outstanding Expense A/c or Expense payable a/c
The two effects when preparing the final
accounts are:
One- Add in respective expense in P & L
A/c and two – Show as a liability in the Balance sheet.
Prepaid expenses
At times we may pay for certain expenses
which are period related. For example,
the business has taken an insurance policy against fire on which the annual
premium payable is Rs.75000. the policy
is taken on 1st January 2013 valid till 31st December
2014. But the company’s accounting period ends on 31st March
2013. When considering the insurance
expenses for the accounting year, what amount should be considered? See the
following.
As can be seen, out of the total premium
period of 12 months, only 3 months are related to the current accounting period
and the remaining 9 months premium is related to the next accounting
period. Hence only 3 months premium is
to be considered as expenses for the current year is 75000/4= Rs.18750.
The entry for this is
Prepaid insurance A/c Dr.
To
Insurance A/c
The two effects while preparing final
accounts are
One- Reduce from respective expense in
P&L A/c and Two- show as an asset in the balance sheet.
Accrued Incomes
Just as expenses accrue, there are
instances of income getting accrued at the end of accounting period. The extent to which it accrues, it must be
booked as income for the current accounting period. Consider, the business has put a One year
fixed deposit of Rs.1,00,000 with Citi Bank at a fixed interest of 9% p.a. on 1st
February 2013 and the interest is credited by the bank on a semi-annual basis. Also
consider that the accounting period ends on 31st March 2013. The city bank will credit the 1st
semi-annual interest on 31st july 2013 and the next on 31st
January.
It can be noticed that interest for the 2
months will be considered as accrued as on 31st of March 2013 and
must be taken as income for the current accounting year.
The entry for this is
Accrued interest A/c Dr.
To
Interest A/c
The two effects while preparing final
accounts are:
One- Show as income in the P& L A/c and
Two - Show as an asset in the Balance
sheet.
Income Received in Advance
If an income is received which is not
related to the current accounting period, it cannot be included in the current
year’s P&L A/c. So, if it’s already
included as income it must be reduced. The
entry for this is
Respective income a/c Dr.
To
Income received in advance
The effects while preparing final accounts are
One- reduce from respective income and
Two- show it as liability in Balance sheet.
Accounting in Practice
These are days of computerized accounting. Even smaller firms like sole proprietors use
accounting packages like tally 9.0 which are very strong. At this stage it is necessary to understand
the practical aspects of how accounting is actually done by these
packages. Based on years of experience,
they come with a standard chart of account. The chart of account is nothing but
master ledger accounts and they are numerically coded for quick and easy
identification and reporting. These are
customized screens made to enter different transactions. Hence, the user can not by mistake put a
purchase transaction into sales book. The
customers and vendors are also alpha-numerically coded for ease of
identification. Once the basic documents are entered, the job of posting,
balancing and trial balance is all automated.
So actually, most of the potential errors can be avoided.
There is an increased feeling among
students that when there are automated systems available, why should one go
through the study of manual processes. This
is absolutely essential for grasping basic concepts. Once, you thoroughly understand them, it will
be easy to operate any computerized accounting package in practice.
