LECTURE 19 and 20 ACCOUNTING AND AUDITING

FINANCIAL STATEMENTS OF:

1. Sole Proprietorship
2. Manufacturing Concern
3. Company accounts

SOLE PROPREITORSHIP

Financial Statements are the systematically organized summary of all the ledger
account heads presented in such a manner that it gives detailed information about
the financial position and the performance of the enterprise. As seen above, through
categorization of Financial Statements into Income & Position Statement, the profit
or loss is measured at two levels:
(a) Gross Profit or Gross Loss
(b) Net Profit or Net Loss

The profit or loss of the enterprise is obtained through the preparation of Income
Statement i.e Trading and Profit & Loss A/c

The financial position of the business enterprise is judged by measuring the assets,
liabilities and capital of the enterprise and the same is communicated to the users
of financial statements. Financial position of the enterprise can be known through
the preparation of the Position Statement i.e Balance Sheet.

Comparison between Income Statement and Position Statement

Income Statement Position statement

Profit or loss is disclosed in the Income It exhibits assets and liabilities of the
Statement prepared at the close of the business as at the close of the financial year.
financial year
Income Statement is sub-divided into Apart from balance sheet, to judge financial
following two parts for a non- position of the business, sometimes
manufacturing concern: additional statements are also prepared like
(i) Trading account; and cash flow statement, value added statement
etc. which is not mandatory for non-
(ii) Profit and Loss account corporate entities. These additional
statements are prepared for the better
understanding of the financial position of
the business.
Income Statement discloses net profit or Position statement discloses the assets and
net loss of the business after adjusting liabilities position as on a particular date.
from the income earned during the year,
all the expenditures of the business
incurred in that year.
 PREPARATION OF FINAL ACCOUNTS

The principal function of final accounts (Trading Account, Profit and Loss Account
and the Balance Sheet) is to exhibit truly and fairly the profitability and the financial
position of the business to which they relate. In order that these may be properly
drawn up, it is essential that a proper record of transactions entered into by the
business during a particular accounting period should be maintained. The BASIC
PRINCIPLES in regard to accumulation of accounting period data are:

(i) a distinction should be made between capital and revenue receipts and
payments;
(ii) also income and expenses relating to a period of account should be
separated from those of another period.
(iii) different items of income and expenditure should be accumulated under
significant heads so as to disclose the sources from which capital has been
procured and the nature of liabilities, which are outstanding for payment.
Having regard to these basic principles, the various matters to which attention
should be paid for determining the different aspects of transactions, a record of which
should be kept, and the different heads of account under which various items of
income and expenditure should be accumulated, are stated below:
1. Distinction between personal and business income
2. Distinction between capital and revenue expenditure
3. All material information to be disclosed
4. Record only current period transactions
5. Only transactions completed before close of accounts should be given effect
Inter-relationship of the two statements
One of the points to be remembered is that of total expenditure incurred some
type of expenditure appears in the Profit and Loss Account and some in the
Balance Sheet. Consider few examples,

1. Salaries paid is shown on the Dr. side of Profit and Loss Account but outstanding
salaries is shown on liabilities side of Balance Sheet and is added to Salaries.
Profit & Loss A/c

Particulars Amount Particulars Amoun

` t
`
To Salaries 25,000
Add: Outstanding 26,500
1,50
0 Salaries

Balance Sheet
Liabilities Amount Assets Amoun
` t
`
Outstanding Salaries 1,500

Matching Principle:

This principle demands that expenses incurred to earn the revenue should be
properly matched. This means the following:

(a)If a certain revenue and income is entered in the Trading / Profit and Loss Account
all the expenses relating to it, whether or not payment has been actually made,
should be debited to the Trading /Profit and Loss Account. This is why at the end of
the year an entry is passed to bring into account the outstanding expenses. That is
also the reason why the opening inventory of goods is debited to the Trading Account
since the relevant sale is credited in the same account.

(b)If some expense has been incurred but against it sale will take place in the next
year or income will be received next year, the expense should not be debited to the
current year’s Profit and Loss Account but should be carried forward as an asset and
shown in the Balance Sheet. It will be debited to the Profit and Loss Account only
when the relevant income will also be credited. The same reason applies to
depreciation of assets also. The part of the cost which is used to earn current year
revenue is debited in same year.

(c)if an income or revenue is received in the current year but the work against it has
to be done and the cost in respect of it has to be incurred next year, i.e. income
received in advance the income or the revenue is considered to be of next year. It
should be shown in the Balance Sheet on the liabilities side as “income received in
advance” and should be credited to the Profit and Loss Account of the next year. E.g.
Newspapers or magazines usually receive subscriptions in advance for a year. The
part of subscription that covers copies to be supplied in the next year is treated as
income received in advance.

TRADING ACCOUNT
At the end of the year, as has been seen above, it is necessary to ascertain the net
profit or the net loss. For this purpose, it is first necessary to know the gross profit
or gross loss. Gross Profit is the difference between the selling price and the cost of
the goods sold. For a trading firm, the cost of goods sold can be ascertained by
adjusting the cost of goods still on hand at the end of the year against the purchases.
REFER PPT FOR FORMAT OF TRADING ACCOUNT
Points to Remember:-

1. The opening inventory and purchases are written on the debit side.
2. Sales and the closing inventory are entered on the credit side.
3. If there are any direct expenses then they should also be written on the debit
side of the Trading account.
 4. If the balance of credit side is more, the difference is written on the debit side
as gross profit. This amount will also be carried forward to the Profit and Loss
Account on the credit side.
5. In case of gross loss, i.e., when the debit side of the Trading Account exceeds
the credit side, the amount will be written on the credit side of the Trading
Account and transferred to the debit side of the Profit and Loss Account.

PROFIT AND LOSS ACCOUNT

The Profit and Loss Account starts with gross profit on the credit side. If there is
gross loss, it will be written on the debit side. After that all those expenses and losses,
which have not been entered in the Trading Account, will be written on the debit side
of Profit and Loss Account. Incomes and gains, other than sales, will be written on
the credit side.

If we understand word ‘expenses’ properly, there should be no difficulty in

distinguishing between items that will be debited to the Profit and Loss Account and
those that will be shown as Assets in the balance sheet. Further, it may be noted
that the expenses which are personal in nature will not be charged to Profit and Loss
A/c. Only those revenue expenses and losses which are related to the current year,
are debited to Profit and Loss Account.

CERTAIN ADJUSTMENTS AND THEIR TREATMENTS

1. Abnormal loss of Inventory by accident or fire : Sometimes loss of goods occurs due
to fire, theft, etc. If due to accident or fire, a portion of Inventory is damaged, the
value of loss is first to be ascertained. Thereafter, Abnormal Loss Account is to be
debited and Purchase Account or Trading Account is to be credited.

Loss by Fire Account Debit

To Purchases/Trading Account

Insurance Company’s A/c (Insurance Claim) Debit.

Profit & Loss A/c Debit
To Loss by Fire A/c

2. GOODS SENT ON APPOVAL

Sometimes goods are sold to customers on sale or return basis or on approval basis.
It should not be treated as actual sale till the time it is not approved by the
customer. When goods were sold we have passed the entry for actual sales.
Therefore, at the year end, if the goods are still lying with the customers for
approval, following entries are to be passed:
 Goods costing 10,000 sent to a customer on sale or return basis for 12,000.
The entry for such unapproved sale shall be-

(i) Sales A/c Debit. 12,000

To Trade receivables A/c 12,000

(ii) Stock on approval A/c Debit. 10,000

To Trading A/c 10,000

3. GOODS USED OTHER THAN SALE : Sometimes goods are used for some other
purposes, such as distributed as free samples, used in construction of any assets
or used by proprietor for personal use. In such cases the amount used for other
purposes is subtracted from Purchases A/c and depending upon the specific use
done, the suitable account head is debited.

For example:-

When goods are given away as donation-

Donation A/c Dr.

To Purchase

When goods are used by the proprietor for his personal use-

Drawings A/c Dr.

To Purchases A/c

When goods are distributed as free samples: -

Free Samples / Advertisement A/c Debit.

To Purchases A/c

4. COMMISION : Sometimes commission is payable to manager based on net

profit; in such a case calculation is done as follows:

Commission on net profit before charging such commission =

Profit before commission x Rate of commission/100

Commission on net profit after charging such commission =

Profit before commission x Rate of commission/100 + Rate of commission

FINAL ACCOUNTS OF MANUFACTURING ENTITIES

DIFFERENCE BETWEEN TRADING AND MANUFACTURING ACCOUNT

(a) Trading account shows Gross Profit while Manufacturing Account shows cost of
goods sold which includes direct expenses.

(b) Manufacturing account deals with the raw material, and work in progress
while the trading account would deal with finished goods only.

PUROSE OF MANUFACTURING ACCOUNT

1. It shows the total cost of Manufacturing

2. It provides details of factory cost
3. It provides the basis to set the Marker Price/ Cost of production

MANUFACTURING COST

+ Raw Material Consumed .…..….

+ Direct Manufacturing Wages ………
+ Direct Manufacturing Expenses ………
+ Direct Manufacturing Cost ………
+ Indirect Manufacturing expenses or
+ Manufacturing Overhead ………
Total Manufacturing Cost
Manufacturing costs are classified into :
Raw Material consumed is arrived at after adjustment of opening and
closing Inventory of raw materials:
Raw Material Consumed = Opening inventory of Raw Materials + Purchases – Closing inventory of Raw
Materials

INDIRECT MANUFACTURING EXPENSES OR OVERHEAD EXPENSES

These are also called Manufacturing overhead, Production overhead, Works

overhead, etc.
 Overhead defined as total cost of indirect material, indirect wages and indirect
expenses.
Overhead = Indirect Material + Indirect Wages + Indirect Expenses

(a) Indirect material means materials which cannot be linked directly with the units
produced, for example, stores consumed for repair and maintenance work, small
tools, fuel and lubricating oil, etc.
(b) Indirect wages are those which cannot be directly linked to the units produced, for
example, wages for maintenance works, holding pay, etc.
(c) Indirect expenses are those which cannot be directly linked to the units produced,
for example, training expenses, depreciation of plant and machinery, depreciation of
factory shed, insurance premium for plant and machinery, factory shed, etc.

MANUFACTURING ACCOUNT

Manufacturing Account
Particulars Units Amount Particulars Units Amount
` `
To Raw Material Consumed: By By-products at net realizable value
Opening inventory …. By Closing Work-in- Process
Add: Purchases ….. By Trading A/c
Less: Closing inventory ….. …… Cost of production
To Direct Wages ……
To Direct expenses: ……
Prime cost ……
To Factory overheads:
Royalty .….
Hire charges …..
To Indirect expenses: …..
Repairs & Maintenance .….
Depreciation .…. …….
Factory cost …….
To Opening Work-in-process .……