Provisions and reserves

provisions and reserves

What Is A Provision?

Provision is an amount that is set aside to cover future uncertain, but probable expenses/losses or obligations that belong to the current accounting period. Provision is a charge against the income of current accounting period and ensures proper matching of income and expenses which helps in ascertaining the true profit or loss of the company for the period. There are specific expenses/losses or obligations that may arise in future but whose amount cannot be determined exactly. So a certain estimated amount is kept aside for them which is called as provision. Some of the examples of provisions are:-
– Provision for doubtful debts
– Provision for discount on debtors
– Provision for depreciation
– Provision for preference dividend
– Provision for taxation

What Is A Reserve?

Reserve is a part of profits of the company which is set aside and retained in the business for purposes such as expansion, working capital, issuing bonus shares,etc or some other specific purpose. Reserve is an appropriation of profits. There are two types of reserves:-
(1) Revenue reserve:-
Revenue reserve is created out of the profit earned by the company from its normal trading/operating activities. Revenue reserve can be used for general purposes such as expansion of business, increasing working capital,etc or for some specific purposes such as redemption of debentures, dividend equalization, etc.
(2) Capital reserve:-
Capital reserve is created out of the profit earned from activities such as sale of assets, revaluation of assets, issue of shares at premium,etc which are not the normal trading/operating activities of the company. Capital reserve can be used for purposes such as issue of bonus shares, writing off preliminary expenses, etc.

Difference Between Provision And Reserve:-

Provision Reserve
It is a probable loss or obligation. It is a portion of profit.
It is a charge against profit as it is deducted from the income. It is an appropriation of profit as it is allocated to various heads.
It must be created irrespective of profit or loss. It can be created only if profits are earned.
True profit or loss cannot be ascertained without creating provision. True profit or loss can be ascertained even without creating reserve.
Profit or loss is affected by provision. Profit decreases after creating provision. Profit or loss is not affected by reserve. It is created after ascertaining profit.
The amount of provision does not belong to the owners i.e. shareholders. The amount of reserve belongs to the owners i.e. shareholders.
Provision is either shown on the assets side of balance sheet by way of deduction from the items for which it is created for e.g. provision for doubtful debts from debtors or on the liabilities side of balance sheet for e.g. provision for taxation. Reserve is shown on the liabilities side of balance sheet as Reserves and Surplus after share capital.

 

Contingent assets and liabilities

contingent assets and liabilities

What Is A Contingent Asset?

Contingent asset is a possible asset which arises from past events the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events which are not wholly within the control of the company. It usually arises from unplanned or unexpected events that give rise to the possibility of an inflow of economic benefits to the company. Contingent asset is not recognized and disclosed in financial statements as it may result in the recognition of gain that may never be realized. It is usually disclosed in the director’s report. When the realization of gain is certain then it does not remain a contingent asset but becomes an actual asset and is recognized and disclosed in the financial statements. An example of contingent asset would be the possibility to receive compensation from a lawsuit where the outcome of case and amount of compensation is not yet known.

What Is A Contingent Liability?

Contingent liability is a possible obligation which arises from past events the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the company. It usually arises from unplanned or unexpected events that give rise to the possibility of an outflow of economic benefits from the company. Contingent liability is not recognized and disclosed in financial statements. It is disclosed by way of a note to the financial statements. When the incurring of loss is probable and the amount of loss can be estimated then it does not remain a contingent liability but becomes an actual liability and is recognized and disclosed in the financial statements as provision. Some of the examples of contingent liabilities are:-
– Lawsuit against the company in which the company may have to pay compensation where the outcome of case and amount of compensation is not yet known.     
– Possible penalty for copyright or patent infringement where the outcome of  case and amount of penalty is uncertain.
– Possible fine for not following a government law.
– Arrears of dividend on cumulative preference shares.
– Bills discounted but not yet matured.

There are some differences in disclosure and recognition of contingent assets and liabilities:-
Contingent assets are not required to be disclosed but contingent liabilities are required to be disclosed.
If contingent liabilities are disclosed, they are generally disclosed in the report of Board of Directors whereas contingent liabilities are disclosed by way of note to balance sheet.
Contingent assets are recognized as actual assets in the financial statements only if the realization of gain is certain whereas contingent liabilities are recognized as actual liabilities in the financial statements even if the incurring of loss is not certain but is probable and the amount of loss can be estimated.

Difference Between Contingent Asset And Other Asset And Contingent Liability And Other
Liability:-

Contingent
Asset
Other Asset Contingent
Liability
Other Liability
It is a possible asset whose occurrence depends on an event which may or may not happen in future. It is a present asset which has already occurred because of the happening of a past event. It is a possible obligation whose occurrence depends on an event which may or may not happen in future. It is a present obligation which has already occurred because of the happening of a past event.
The inflow of economic benefits is not certain. The inflow of economic benefits is certain. The outflow of economic benefits is not certain. The outflow of economic benefits is certain.
It is not recognized and disclosed in financial statements. It is recognized and disclosed in financial statements. It is not recognized and disclosed in financial statements. It is recognized and disclosed in financial statements.
It is usually disclosed in the director’s report. It is disclosed on the assets side of balance sheet. It is disclosed by way of note to the balance sheet. It is disclosed on the liabilities side of balance sheet.

 

Accounting terms

Accounting terms

Following are some of the basic
accounting terms and their
explanation:-

Transaction:-

Transaction is a financial event that takes place in the course of business or for furtherance of business. It involves transfer of money or goods and services and is recorded in the books of accounts. For e.g. purchase of goods, sale of goods, cash deposit in bank, salary payment, etc.

Voucher:-

Voucher is a document which serves as an evidence or support to a transaction. For e.g. in case of credit purchase, purchase invoice or in case of cash purchase, cash memo. The vouchers act as source documents on the basis of which transactions are recorded in the books of accounts.

Entry:-

Entry is a recording made in the books of accounts in respect of a transaction that has taken place. Entries are passed in the books of accounts on the basis of vouchers.

Capital:-

Capital is the amount that is invested in the business by the owners. It also includes the assets that are brought into the business by the owners. In case of sole proprietorship, the owner is the sole proprietor himself. In case of partnership, the owners are the partners. In case of company, the owners are the shareholders. Profits (retained) are added to the capital and losses are deducted from the capital.

Drawings:-

Drawings are the total amount of cash or goods or any other assets that are withdrawn by the owner of business for his personal use. Drawings amount is deducted from the capital. Drawings are possible only in sole proprietorship and partnership form of business. There are restrictions on drawings in the company.

Asset:-

Asset is an item of economic value owned by a company with the expectation that it will provide future benefit to the company. There are two main types of assets:-
(1) Fixed asset:-
Fixed assets are the assets which are held by the company for a long period of time i.e. more than one accounting year. There are two types of fixed assets:-
(a) Tangible fixed assets:- Tangible fixed assets are the assets which can be physically verified i.e. seen and touched for e.g. land, building, machinery, furniture, etc.
(b) Intangible fixed assets:- Intangible fixed assets are the assets which cannot be physically verified i.e. seen and touched for e.g goodwill, patent, copyright, trademark, etc.
(2) Current asset:-
Current assets are the assets which are held by the company for a short period of time i.e. less than one accounting year. Some of the important examples of current assets are stock, trade debtors, sundry debtors, cash in hand, bank balance, prepaid expenses, loans and advances given by the company on short-term basis,etc.

Liability:-

Liability is the amount of money that the company owes to the outside parties. There are two main types of liabilities:-
(1) Long-term liabilities:-
Long-term liabilities are the liabilities that are due for re-payment after one accounting year. Some of the important examples of long-term liabilities are debentures, bonds, term loans from banks and financial institutions, fixed deposits issued by the company, etc.
(2) Current liabilities:-
Current liabilities are the liabilities that are due for re-payment within one accounting year. Some of the important examples of current liabilities are trade creditors, sundry creditors, outstanding expenses, loans and advances received by the company on short-term basis,etc.

Purchases:-

Purchases are the amount of goods bought by the company for resale or for use in the production of goods or rendering of services in the normal course of business. Purchases may be cash purchases or credit
purchases.
Total purchases = cash purchases + credit purchases

Sales:-

Sales are the amount of goods sold that are bought or manufactured by the company or services rendered by the company. Sales may be cash sales or credit sales.
Total sales = cash sales + credit sales

Purchase Return:-

When the goods are returned to the suppliers because of some defect or if the goods are not as per the specifications, it is called as purchase return. Purchase return is also called as return outward. Purchase returns are deducted from the amount of total purchases.

Sales Return:-

When the goods are returned by the customers because of some defect or if the goods are not as per their specifications, it is called as sales return. Sales return is also called as return inward. Sales returns are deducted from the amount of total sales.

Retained Earnings:-

Retained earnings is the portion of net profit of the company which is not paid out as dividend to the shareholders but retained by the company to reinvest in the business or to pay debt or to purchase some asset. Retained earnings is shown under the capital in the balance sheet. It is the sum of all the profits retained by the company since its inception.

 

Subsidiary books

Subsidiary books

What Are Subsidiary Books?

Subsidiary books are the subdivision of journal. The journal is sub-
divided in such a way that a separate book is used for each category of transactions which are similar in nature and are large in number. Subsidiary books are also called as special journals or day books.

Types Of Subsidiary Books:-

Following are the different types of  subsidiary books which are
generally opened by most companies:-
(1) Cash book
(2) Purchases book
(3) Sales book
(4) Purchase returns book
(5) Sales returns book
(6) Bills receivable book
(7) Bills payable book
(8) Journal proper

(1) Cash Book:-

Cash book is a book in which all the cash receipts and payments are recorded. Cash receipts are recorded on the debit side and cash payments are recorded on the credit side. There are four types of cash book:-
(i) Single column cash book:- Single column cash book has only one amount column on each side. All cash receipts are recorded on the debit side and all cash payments are recorded on credit side. So only cash receipts and cash payments are recorded in this book.
(ii) Double column cash book:- Double column cash book has two amount columns on each side i.e one for cash and other for discount. All cash receipts and cash discount allowed are recorded on the debit side and all cash payments and cash discount received are recorded on the credit side. So cash receipts and payments and discount received and allowed are recorded in this book.
(iii) Three column cash book:-Three column cash book has three amount columns on each side i.e one for cash, one for discount and one for bank. All cash receipts, cash discount allowed and bank deposits are recorded on the debit side and all cash payments, cash discount received and bank withdrawals are recorded on the credit side. So cash receipts and payments, discount allowed and received and bank deposits and withdrawals are recorded in this book.
(iv) Petty cash book:- Petty cash book is used to record only small petty cash expenses by the petty cashier. Petty cashier is the person who is authorized to make payments for petty cash expenses and to record them in petty cash book. In petty cash book, only cash receipts from the main cashier are recorded and not other receipts. Some of the examples of petty cash expenses are stationary expenses, conveyance expenses, office tea expenses, cartage, etc. So only cash receipts from main cashier and small payments of cash are recorded in this book.

(2) Purchases Book:-

Purchases book is used for recording the credit purchases of goods. Cash purchases are not recorded in this book. Purchase of any asset on cash or credit is also not recorded in this book. Purchases book is used only to record goods purchased on credit. The entries in purchase book are made on the basis of purchase invoices received from the suppliers.

(3) Sales Book:-

Sales book is used for recording the credit sales of goods. Cash sales are not recorded in this book. Sale of any asset on cash or credit is also not recorded in this book. Sales book is used only to record goods sold on credit. The entries in sales book are made on the basis of sales invoices issued to the customers.

(4) Purchase Returns Book:-

Purchase returns book is also called as return outwards book. It is used for recording the goods returned to the suppliers which were purchased on credit. Return of goods purchased on cash are not recorded in this book. Return of any asset purchased on cash or credit is also not recorded in this book. The entries in purchase returns book are usually made on the basis of debit notes issued to the suppliers or credit notes received from the suppliers.

(5) Sales Returns Book:-

Sales returns book is also called as return inwards book. It is used for recording the goods returned by the customers which were sold on credit. Return of goods sold on cash are not recorded in this book. Return of any asset sold on cash or credit is also not recorded in this book. The entries in sales returns book are usually made on the basis of credit notes issued to the customers or debit notes received from the customers.

(6) Bills Receivable Book:-

When the company sells goods on credit, the customer gives a guarantee to make payment in the future in the form of a bill. When the company receives such a bill, it is recorded in the bills receivable book as it will be the bill receivable for company and the company will receive payment in future against such bill.

(7) Bills Payable Book:-

When the company purchases goods on credit, it gives a guarantee to the supplier to make payment in future in the form of a bill. When the company issues such a bill, it is recorded in the bills payable book as it will be the bill payable for company and the company will make payment in future against such bill.

(8) Journal Proper:-

Journal proper is a book in which those transactions are recorded which cannot be recorded in any other subsidiary book. Following types of entries are usually recorded in journal proper:-
(i) Opening entries:- Opening entries are passed at the beginning of the financial year for bringing the balances of assets, liabilities and capital appearing in the balance sheet of previous year into the current financial year.
(ii) Closing entries:- Closing entries are passed at the end of the financial year for closing the nominal accounts by transferring them to the trading and profit and loss account.
(iii) Adjustment entries:- At the end of the financial year, adjustment entries are passed to bring unrecorded items such as closing stock, depreciation, outstanding and prepaid expenses, accrued income and income received in advance, bad debts, etc into the books of accounts.
(iv) Transfer entries:- Transfer entries are passed to transfer amount from one account to other account for e.g. transfer of net profit/net loss to the capital account or retained earnings account, transfer of drawings from drawings account to the capital account, etc.
(v) Rectifying entries:- Rectifying entries are passed to rectify the various errors committed while recording, posting, totaling, balancing, etc.
Some other types of entries which are recorded in journal proper are :-
– Credit purchases of assets
– Credit sales of assets
– Return of assets bought on credit
– Return of assets sold on credit
– Capital brought in kind by the proprietor
– Dishonor of bills receivable
– Cancellation of bills payable
– Withdrawal of goods by proprietor for personal use
– Goods distributed as free samples
– Goods lost by fire, theft, etc

 

 

Trade and cash discount

Trade and cash discount

What Is Trade Discount?

Trade discount is the reduction granted by the supplier/vendor from the list price of products/services on business considerations such as quantity bought, trade practices, etc. List price is also called as catalog price and it is the price that is printed on the product or in the catalog of products/services.

Example of trade discount:-

10 machines are sold at the list price of Rs 50000 each
Trade discount granted is 5%

calculate the trade discount amount and amount payable to supplier.

Solution:-

10 machines @ Rs 50000 each = Rs 500000
Trade discount @ 5% = Rs 25000
Amount payable to supplier = 500000 – 25000 = Rs 475000

What Is Cash Discount?

Cash discount is the reduction granted by the supplier/vendor from the invoice price of products/services in consideration for quick payment or payment within stipulated period.

Example of cash discount:-

In the trade discount example above,  lets say that the supplier is also willing to grant cash discount in addition to trade discount if the payment is made within specific period. Let us assume that he is willing to give a cash discount of 2% if the payment is made within 15 days and 1% if the payment is made within 30 days. No cash discount would be granted if the payment is made after 30 days.

Calculate the cash discount amount and amount payable to supplier if payment is made within 15 days, 30 days and after 30 days.

Solution:-

If payment is made within 15 days:-
10 machines @ Rs 475000
Cash discount @ 2% = Rs 9500
Amount payable to supplier = Rs 465500

If payment is made within 30 days:-
10 machines @ Rs 475000
Cash discount @ 1% = Rs 4750
Amount payable to supplier = Rs 470250

If payment is made after 30 days:-
10 machines @ Rs 475000
No cash discount in this case
Amount payable to supplier = Rs 475000

Difference Between Trade Discount And Cash Discount:-

Trade Discount Cash Discount
Trade discount is the reduction granted by vendor from the list price of products/services. Cash discount is the reduction granted by vendor from the invoice price of products/services.
Trade discount is granted to promote the sales. Cash discount is granted to promote the prompt payment
Trade discount is shown by the way of deduction in invoice. Cash discount is not shown on the invoice.
Trade discount account is not opened in the ledger. Cash discount account is opened in the ledger for discount received and discount allowed separately.
Trade discount may vary with the quantity purchased. Cash discount may vary with the period within which payment is made.

Capital and revenue receipts and expenditure

Capital and revenue receipts and expenditure
What Are Capital Receipts?

Capital receipts are the receipts which occur from activities which are not part of the normal trading activities of the company. They do not arise from the operating activities of business. Capital receipts are non-recurring in nature and generally appear as liabilities in the balance sheet.

Examples Of Capital Receipts:-

Following are some of the common examples of capital receipts:-

  • Money received from shareholders
  • Money received from debenture holders
  • Loans raised
  • Sale of plant and machinery
  • Sale of investments
  • Insurance claim for machinery damaged

What Are Revenue Receipts?

Revenue receipts are the receipts which occur from activities which are part of the normal trading activities of the company. They arise from the operating activities of business. Revenue receipts are recurring in nature and generally appear as income on the credit side of trading and profit and loss account.

Examples Of Revenue Receipts:-

Following are some of the common examples of revenue receipts:-

  • Sale of goods and services
  • Interest on investments
  • Rent received
  • Commission received
  • Insurance claim for stock damaged

Difference Between Capital Receipts And Revenue Receipts:-

Capital Receipts Revenue Receipts
Capital receipts arise from the non-operating activities of the company. Revenue receipts occur from the operating activities of the company.
Capital receipts are non-recurring and non-continuing in nature. Revenue receipts are recurring and continuing in nature.
Capital receipts usually appear on the liabilities side of balance sheet. Revenue receipts usually appear on the credit side of trading and profit and loss account.

What Is Capital Expenditure?

Capital expenditure is the expenditure which in incurred to acquire a fixed asset which increases the productivity or earning capacity of the company. Such expenditure normally yields benefit beyond the current accounting period. Capital expenditure is generally of a one-off kind but its benefit is derived over several accounting periods. Capital expenditure appears generally as assets in the balance sheet. Capital expenditure is non-recurring in nature.

Examples Of Capital Expenditure:-

Following are some of the common examples of capital expenditure:-

  • Cost of machinery purchased
  • Installation charges of machinery purchased
  • Customs duty on imported machinery
  • Expenses on a foreign tour to purchase machinery
  • Legal expenses to acquire a building
  • Expenses to obtain a license for starting a factory
  • Cost of improvement in electric wiring system
  • Purchase of a patent right
  • Purchase of technical know-how
  • Repair of a second-hand machine before put to use.

What Is Revenue Expenditure?

Revenue expenditure is the expenditure which is incurred to carry out the normal day-to-day activities of the company. They are incurred to maintain existing productivity or earning capacity of the company. Revenue expenditure does not yield benefit beyond the current accounting period. Revenue expenditure appears generally as expenses on the debit side of trading and profit and loss account. Revenue expenditure is recurring in nature.

Examples Of Revenue Expenditure:-

Following are some of the common examples of revenue expenditure:-

  • Depreciation on assets
  • Repairs of machine after it is put to use
  • Annual maintenance charges of the machine
  • Rent paid
  • Interest paid
  • Commission paid
  • Salary paid
  • Insurance premium

Difference Between Capital Expenditure and Revenue Expenditure:-

Capital Expenditure Revenue Expenditure
Capital expenditure is incurred in acquiring fixed assets. Capital revenue is incurred in carrying out normal day-to-day activities of business.
Capital expenditure is non-recurring and non-continuing in nature. Revenue expenditure is recurring and continuing in nature.
Capital expenditure helps in increasing the productivity or earning capacity of the company. Revenue expenditure helps in maintaining the existing productivity or earning capacity of the company.
Benefit of capital expenditure extends to many accounting periods. Benefit of revenue expenditure does not extend beyond the current accounting period.
Capital expenditure usually appears on the assets side of balance sheet. Revenue expenditure usually appears on the debit side of profit and loss account.

What Is Deferred Revenue Expenditure?

Deferred revenue expenditure is the expenditure for which payment has been made or a liability has been incurred but which is carried forward on the presumption that it will be of benefit over a subsequent period or periods. It is an expenditure which is, for the time being, deferred from being charged to income. Deferred revenue expenditure appears in both the trading and profit and loss account and the balance sheet. The written off portion of deferred revenue expenditure appears on the debit side of trading and profit and loss account while the un-written portion of deferred revenue expenditure appears on the assets side of balance sheet.

Examples Of Deferred Revenue Expenditure:-

Following are some of the common examples of deferred revenue expenditure:-

  • Preliminary expenses which are incurred at the time of starting the company
  • Heavy advertising expenses to launch a new product the benefit of which will come in the future years
  • Discount on issue of shares
  • Research and development expenses

 

Depreciation

Depreciation

What Is Depreciation?

Depreciation is the decrease in book value of a fixed asset. It is a permanent and continuous decrease in the book value of a fixed asset due to various causes like physical wear and tear because of use, passage of time, change in economic environment, expiration of legal rights, etc. Depreciation is the non-cash expense of the company. Depreciation expense is spread or allocated over the useful life of an asset as it is regarded as the cost of the fixed asset which is used for generation of revenue. Depreciation expense is charged or matched against the revenue generated through the use of the asset.

Need Of Allocating Depreciation:-

  • To ascertain the true profit or loss made by the company.
  • To show the true valuation of fixed assets.
  • To ascertain the true cost of production.
  • To make provision for replacement of assets.
  • To comply with the legal requirements.

Factors Considered For Determining The Amount Of Depreciation:-

There are three main factors which are considered for determining the amount of depreciation:-

(1) The original cost of the asset and the costs that are incurred on its installation, addition and improvements which are of capital nature.

(2) The expected useful life of the asset i.e. the number of years the asset is expected to last or the number of production or similar units expected to be obtained from the use of the asset. The useful life of the asset is usually shorter than its physical life.

(3) The estimated scrap value or residual value or salvage value of the asset at the end of its life. It is the value which the asset would fetch when discarded as useless and sold.

Methods Of Allocating/Calculating
Depreciation:-

There are many methods of allocating depreciation over the useful life of the asset. But the two most commonly used methods are:-
(1) Straight line method or Fixed installment method
(2) Written down value method or Declining balance method

(1) Straight Line Method:-

Straight line method is the most popular and simple method of calculating depreciation. Under this method, depreciation is charged equally every accounting period over the expected useful life of the asset. So the amount of depreciation is the same each accounting period. The amount of depreciation may reduce the book value to its residual value or even zero, as the case maybe, at the end of asset’s life. Straight line method is appropriate in cases where the benefit to be gained from the asset is likely to have an even spread over its useful life.
The amount of depreciation for each accounting period under the Straight line method is calculated as under:-
Cost of asset – estimated scrap value
        Expected useful life of asset

The rate of depreciation under the straight line method is calculated as under:-
Amount of depreciation ÷ cost of asset × 100

Example of Straight line method:-

Purchase price of machine = Rs 475000
Installation charges of machine = Rs 25000
Expected useful life of machine = 5 years
Estimated scrap value of machine = Rs 50000

Calculate the amount of depreciation per year and rate of depreciation.

Solution:-

Amount of depreciation = 500000 – 50000
                                                             5

                                                    = 450000
                                                             5

                                                    =  90000

Rate of depreciation = 90000 ÷ 500000 × 100

                                                    = 18%

So the amount of depreciation to be allocated each accounting period is Rs 90000 and the rate of depreciation is 18%.

(2) Written Down Value Method:-

Under the Written down value method, depreciation is charged unequally every accounting period over the expected useful life of the asset. So the amount of depreciation is not the same each accounting period though the rate of depreciation is the same. Under Written down value method, a fixed percentage of depreciation is calculated on the original cost of the asset in the first accounting period and on the written down value (original cost – depreciation) in the subsequent accounting periods over the expected useful life of the asset. So the amount of depreciation goes on decreasing each accounting period. Written down value method is appropriate in cases where the benefit to be gained from the asset is likely to be more in its earlier years of use.

Example of Written down value method:-

Purchase price of machine = Rs 475000
Installation charges of machine = Rs 25000
Expected useful life of machine = 5 years
Estimated scrap value of machine = Rs 50000
Rate of depreciation = 18%

Calculate the amount of depreciation for each accounting year.

Solution:-

Amount of depreciation:-

For first year = 18% of 500000 = 90000

For second year = 18% of 410000 (500000 – 90000) = 73800

For third year = 18% of 336200 (410000 – 73800) = 60516

For fourth year = 18% of 275684 (336200 – 60516) = 49623

For fifth year = 18% of 226061 (275684 – 49623) = 40691

So the amount of depreciation to be allocated for the first, second, third , fourth and fifth year is Rs 90000, Rs 73800, Rs 60516, Rs 49623 and Rs 40691 respectively.

Methods Of Recording Depreciation:-

There are two methods of recording depreciation in the books of accounts:-
(1) Creating provision for depreciation or accumulated depreciation account
(2) Without creating provision for depreciation

(1) Creating Provision For Depreciation:-

Under this method, depreciation is not directly charged to the respective asset account. It is credited to the provision for depreciation account and depreciation account is closed by transferring it to the profit and loss account. In the balance sheet, asset appears at its original cost and the accumulated depreciation is shown as a deduction from the asset account. So from the balance sheet, the original cost of the asset and the total depreciation charged to-date on that asset can be known. As the years pass, the balance of accumulated depreciation goes on increasing as depreciation from the earlier years get added to the accumulated depreciation account.

Journal entries under this method:-

For providing depreciation:-

Depreciation a/c…..Dr
 To provision for depreciation a/c

For closing depreciation account and transferring to profit and loss account:-

Profit and loss a/c…..Dr
 To depreciation a/c

(2) Without Creating Provision For
Depreciation:-

Under this method, depreciation is directly charged to the respective asset account. It is credited to the respective asset account and depreciation account is closed by transferring it to the profit and loss account. In the balance sheet, asset appears at its written down value i.e. original cost minus depreciation charged to-date. So from the balance sheet, the original cost of the asset and the total depreciation charged to-date on that asset cannot be known.

Journal entries under this method:-

For providing depreciation:-

Depreciation a/c…..Dr
 To respective asset a/c

For closing depreciation account and transferring to profit and loss account:-

Profit and loss a/c…..Dr
 To depreciation a/c

What Is Amortization?

Amortization is the decrease in the value of intangible assets such as patents, copyright, trademarks, etc. Amortization is the non-cash expense of the company. Amortization expense is spread or allocated over the useful life of the asset.

What Is Depletion?

Depletion is the physical reduction due to the exhaustion of natural resources like oil, coal, timber, minerals, etc. Depletion is the non-cash expense of the company.

 

                 
                                                  

 

 

 

 

 

 

 

 

 

Bank reconciliation statement

Bank reconciliation statement 

What Is Bank Reconciliation?

Bank reconciliation is the process of comparing and finding out the difference between the bank balance shown in the company’s pass book (bank statement) supplied by the bank and the bank balance shown in company’s own cash book at a particular point of time. It involves preparing a bank reconciliation statement explaining all the causes of difference in balance between them and then reconciling or adjusting the bank balance shown by the cash book with the bank balance shown by the pass book (bank statement) so that they are in agreement with each other.

Need Of Bank Reconciliation:-

When the company receives the bank pass book (bank statement), it compares the entries in the pass book with the entries in the cash book. Generally, entries in the cash book should tally with the entries in the pass book and the balance shown by both the cash book and pass book must also be the same. But many times, the balance shown by both the books differ because of some reasons. In such a case, it is necessary to do bank reconciliation to find out the reasons for the difference in bank balance of cash book and that of the pass book and to take necessary steps to ensure that the balance shown by both the books is the same.

Causes/Reasons For Difference In Bank Balance Of Pass Book And Cash Book:-

Following are the main reasons because of which there is difference in the bank balance shown by the pass book (bank statement) and the cash book:-

Cheques deposited but not yet cleared:- The Cheques deposited by the company are not yet cleared by the bank. Due to the time lag between the deposit of Cheques and their clearance, the bank balance as per pass book will be lower than the bank balance as per cash book as the company debits the bank account as soon as the Cheques are deposited. So it is reflected immediately in the cash book. But the bank credits the company’s account only when the Cheque is actually cleared. So it is reflected later in the pass book.

Cheques issued but not yet presented for payment:- The Cheques issued by the company are not yet presented to the bank for payment. Due to the time lag between the issue of Cheques and their presentation for payment at the bank, the bank balance as per pass book will be higher than the bank balance as per cash book as the company credits the bank account as soon as the Cheques are issued. So it is reflected immediately in the cash book. But the bank debits the company’s account only when the Cheque is actually presented for payment. So it is reflected later in the pass book.

Bank charges not yet recorded in the company’s books:- Charges levied by the bank such as service charges and other charges not yet recorded in the company’s books. Because of the charges levied by the bank, the bank balance as per pass book will be lower than the bank balance as per cash book as the bank debits the company’s account as soon as the charges are levied. So it is reflected immediately in the pass book. But the company credits the bank account only when it comes to know of such charges when it receives the bank statement. So it is reflected later in the cash book.

Interest allowed not yet recorded in the company’s books:- Interest allowed by the bank not yet recorded in the company’s books. Because of the interest allowed by the bank, the bank balance as per pass book will be higher than the bank balance as per cash book as the bank credits the company’s account as soon as the interest is allowed. So it is reflected immediately in the pass book. But the company debits the bank account only when it comes to know of such interest when it receives the bank statement. So it is reflected later in the cash book.

Direct payments by the bank on behalf of the company:- Direct payments by the bank on behalf of the company under the standing instructions of the company. For e.g. bills payable, insurance premium, etc. Because of such direct payments by the bank, the bank balance as per pass book will be lower than the bank balance as per cash book as the bank debits the company’s account as soon as it makes the payments. So it is reflected immediately in the pass book. But the company credits the bank account only when it comes to know of such payments when it receives the bank statement. So it is reflected later in the cash book.

Direct collections by the bank on behalf of the company:- Direct collections by the bank on behalf of the company under the standing instructions of the company. For e.g. bills receivable, dividend, etc. Because of such direct collections by the bank, the bank balance as per pass book will be higher than the bank balance as per cash book as the bank credits the company’s account as soon as it receives the payments. So it is reflected immediately in the pass book. But the company debits the bank account only when it comes to know of such collections when it receives the bank statement. So it is reflected later in the cash book.

Cheque deposited but returned dishonoured:- A Cheque deposited by the company (already credited in the company’s account) gets returned as dishonoured. Because of such dishonour of Cheque, the bank balance as per pass book will be lower than the bank balance as per cash book as the bank debits the company’s account as soon as the Cheque is dishonoured. So it is reflected immediately in the pass book. But the company credits the bank account only when it comes to know of such dishonour when it receives the bank statement. So it is reflected later in the cash book.

Cheque issued but returned on technical grounds:- A Cheque issued by the company (already debited in the company’s account) gets returned due to technical reasons. Because of which the bank balance as per pass book will be higher than the bank balance as per cash book as the bank credits the company’s account as soon as the Cheque is returned due to some technical reasons. So it is reflected immediately in the pass book. But the company debits the bank account only when it comes to know about it on the receipt of the bank statement. So it is reflected later in the cash book.

Errors in the cash book:- Errors in the cash book committed by the company such as Cheques deposited but not recorded in cash book, Cheques issued but not recorded in cash book, recording wrong amount, etc.

Errors in the pass book:- Errors in the pass book committed by the bank such as wrongly crediting amount in the pass book, wrongly debiting amount in the pass book, etc.

Procedure Of Bank Reconciliation:-

Following steps are generally involved in bank reconciliation process:-

(1) Comparing the items appearing on the debit side of the company’s cash book with the items appearing on the credit side of the company’s bank pass book i.e deposits column and placing a check mark against items appearing in both the books and noting down the unchecked items. These unchecked items are considered as the causes of difference in balance.

(2) Comparing the items appearing on the credit side of the company’s cash book with the items appearing on the debit side of the company’s bank pass book i.e withdrawals column and placing a check mark against items appearing in both the books and noting down the unchecked items. These unchecked items are considered as the causes of difference in balance.

(3) Preparing a bank reconciliation statement by taking the balance as per company’s cash book as the starting point and adding those unchecked items which have the effect of higher balance in the company’s bank pass book and deducting those unchecked items which have the effect of lower balance in the company’s bank pass book.

                                                             or

Preparing a bank reconciliation statement by taking the balance as per company’s bank pass book as the starting point and adding those unchecked items which have the effect of higher balance in the company’s cash book and deducting those unchecked items which have the effect of lower balance in the company’s cash book.

(4) Passing the necessary journal entries to adjust the cash book balance and preparing bank reconciliation statement as per adjusted cash book balance.

Format Of Bank Reconciliation Statement:-

There are two methods by which bank reconciliation statement can be prepared.
(1) Taking bank balance as per cash book as the starting point
(2) Taking bank balance as per pass book as the starting point

(1) Taking Bank Balance As Per Cash Book As The Starting Point:-

Format of bank reconciliation statement 1

(2) Taking Bank Balance As per Pass Book As The starting point:-

Format of bank reconciliation statement 2

Example Of Bank Reconciliation:-

Following is the cash book and pass book of a company for June 2015.

bank reconciliation example 1
bank reconciliation example 2
 
 Find out the reasons for the difference in the bank balance of cash book and pass book and prepare a bank reconciliation statement of the company for June, 2015 by taking (a) bank balance as per cash book as the starting point and (b)  bank balance as per pass book as the starting point.
Then pass the necessary journal entries and prepare adjusted cash book.
After that prepare bank reconciliation statement as per adjusted cash book balance by taking (a) adjusted bank balance as per cash book as the starting point and (b) bank balance as per pass book as the starting point.

Solution:-

First we need to see which items appear on the debit side of the cash book and also on the credit side of the pass book and place a check mark against those items. The unchecked items appear only in one book and are the causes of difference in balance. In this example unchecked item on debit side of cash book is To CK a/c 30000 which appears only in cash book and not in pass book and the unchecked items on credit side of pass book are Dividend ECS 2000 and Interest credited 1000 which appear only in pass book and not in cash book. (Do not consider To balance b/d 50000 and Balance brought forward 50000).

Then we need to see which items appear on the credit side of the cash book and also on the debit side of the pass book and place a check mark against those items. The unchecked items appear only in one book and are the causes of difference. In this example unchecked item on credit side of cash book is By CP a/c 33000 which appears only in cash book and not in pass book and the unchecked items on debit side of pass book are Insurance premium 4000 and Service charges 500 which appear only in pass book and not in cash book.

 The total number of unchecked items are six. So we have identified these six items as the reasons for the difference of Rs 1500 in bank balance of cash book and pass book. 
– 29.6.2015 To CK a/c 30000 (Reason- cheque deposited but not yet cleared by bank)
– 17.6.2015 Dividend ECS 2000 (Reason- dividend credited in pass book but not recorded in cash book)
– 31.6.2015 Interest credited 1000 (Reason- interest credited in pass book but not recorded in cash book)
– 30.6.2015 By CP a/c 33000 (Reason- cheque issued but not yet presented for payment)
– 30.6.2015 Insurance premium 4000 (Reason- insurance premium not recorded in cash book)
– 30.6.2015 Service charges 500 (Reason- bank charges not recorded in cash book)

We can now proceed to prepare the bank reconciliation statement by first taking (a) bank balance as per cash book as the starting point and then (b) bank balance as per pass book as the starting point.

(a) Bank balance as per cash book as the starting point:-Bank reconciliation example 3

(b) Bank balance as per pass book as the starting point:-

Bank reconciliation example 3

We need to pass the following journal entries to adjust the cash book balance:-

Cash a/c…..Dr  1000
  To interest a/c        1000

Cash a/c…..Dr  2000
  To dividend a/c      2000

Insurance premium a/c…..Dr  4000
  To cash a/c                                          4000

Bank charges a/c…..Dr  500
  To cash a/c                            500

After passing the journal entries we can prepare the adjusted cash book as under:-

bank reconciliation example 5

We can now prepare bank reconciliation statement as per the adjusted cash book balance by first taking (a) adjusted bank balance as per cash book as the starting point and then (b) bank balance as per pass book as the starting point.

(a) Adjusted bank balance as per cash book as the starting point:-

Bank reconciliation example 6

(b) Bank balance as per pass book as the starting point:-

Bank reconciliation example 7

Earlier the bank balance as per cash book was Rs 28000 and the bank balance as per pass book was Rs 29500. So there was a difference of Rs 1500 in balance of both the books. We identified six causes of difference in balance between the two and then prepared the bank reconciliation statement showing those six causes.

Then we passed four journal entries to adjust the cash book balance and prepared an adjusted cash book.

After preparing the adjusted cash book, the new bank balance as per cash book became Rs 26500 while the bank balance as per pass book remained the same Rs 29500. So the difference between the two became Rs 3000. This difference of Rs 3000 is because of two causes – (i) Cheque deposited but not yet cleared by bank (To CK a/c 30000) and (ii) Cheque issued but not yet presented for payment (By CP a/c 33000). We already have entries for these two causes in the cash book. So we passed journal entries for other four causes so as to reflect those four transactions in the cash book as those transactions were not recorded in the cash book but were present only in the pass book. We then prepared the bank reconciliation statement as per the adjusted cash book balance showing these two causes of difference.

Currently bank balance as per pass book is still showing Rs 29500 because entries for those two causes of difference are not yet reflected in the pass book and are present only in the cash book. But when the Cheque deposited by the company of Rs 30000 is cleared by the bank and the Cheque issued by the company of Rs 33000 is presented for payment by the other party, the bank balance as per pass book would become Rs 26500 (29500+30000-33000) which is the same as cash book balance. Then the bank balance of both cash book and pass book will be exactly the same and match with each other.

 

 

Cash flow statement

Cash flow statement

What Is A Cash Flow Statement?

Cash flow statement, also called as statement of cash flows, is part of the financial statements of a company and shows the inflows i.e receipts and outflows i.e payments of cash and cash equivalents of the company during a particular period. It shows the movement of cash into the company and movement of cash out of the company. It reports from where cash has come i.e sources of cash and how it is spent i.e uses of cash during a particular period.
Cash flow statement reports the cash inflows and cash outflows of a company by classifying them according to the company’s three major activities- operating, investing and financing.

(1) Cash flows from operating activities:-

Inflows and outflows of cash arising from the operating activities are called as cash flows from operating activities.Operating activities are the main business activities of the company and are the principal revenue- producing activities for the company. Operating activities result in cash inflows and cash outflows. Cash inflows result from selling goods and providing services while cash outflows result from the cost of goods sold and other operating expenses. Following are some of the examples of cash flows from operating activities:-
– Cash receipts from sale of goods and rendering of services (cash inflow)
– Cash receipts from commission, royalties, fees and other revenues (cash inflow)
– Cash refunds of income taxes if they cannot be specifically identified with financing or investing activities (cash inflow)
– Cash payments to suppliers for goods and services (cash outflow)
– Cash payments to and on behalf of employees (cash outflow)
– Cash payments of income taxes if they cannot be specifically identified with financing or investing activities (cash outflow)

 (2) Cash flows from investing activities:-

Inflows and outflows of cash arising from the investing activities are called as cash flows from investing activities. Investing activities of the company involve acquisition and disposal of tangible and intangible fixed assets and also other long-term investments. Following are some of the examples of cash flows from investing activities:-
– Cash receipts from disposal of fixed assets (cash inflow)
– Cash receipts from the sale of shares and debt instruments of other companies (cash inflow)
– cash receipts of dividend and interest (cash inflow)
– Cash receipts from the repayment of loans and advances made to other parties (cash inflow)
– Cash payments to acquire or construct fixed assets (cash outflow)
– Cash payments to purchase shares and debt instruments of other companies (cash outflow)
– Cash payments in the form of loans and advances made to other parties (cash outflow)

 (3) Cash flows from financing activities:-

Inflows and outflows of cash arising from the financing activities are called as cash flows from financing activities. Financing activities of the company involve raising capital through the issue of shares, debt instruments, borrowings and redemption of debt instruments, repayment of borrowings and payment of dividend and interest. Following are some of the examples of cash flows from financing activities:-
– Cash proceeds from issuing shares and other equity instruments (cash inflow)
– Cash proceeds from issuing debt instruments such as debentures and bonds
(cash inflow)
– Cash proceeds from issuing preference shares (cash inflow)
– Cash receipts from borrowings (cash inflow)
– Cash payments to redeem debt instruments such as debentures and bonds (cash outflow)
– Cash payments to redeem preference shares (cash outflow)
– Cash payments to repay borrowings (cash outflow)
– Cash payments of dividend and interest (cash outflow)

 To prepare the cash flow statement profit and loss account of the current accounting period and balance sheets of current accounting period and previous accounting period are used. Additional information is also taken into consideration to prepare the cash flow statement.

Format Of Cash Flow Statement:-

Cash flow statement is divided into three sections:-
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
There are two methods by which cash flow statement can be prepared.
(1) Direct method
(2) Indirect method
The main difference between the two methods is the way in which the cash flows from operating activities are shown in the cash flow statement.

 (1) Direct Method Of Cash Flow Statement:

Direct method of cash flow statement

(2) Indirect Method Of Cash Flow Statement:-

ndirect method of cash flow statement