Financial Accounting: Unit - 2

Financial Accounting
Unit - 2
Nature of accounting
• Wherever money is involved, accounting is required to

account for it.
• Accounting is often called the language of business.
CS4252 Finance and Accounting 2

• Business is about money - and managers, owners and

other interested parties need to keep track of
– Where the money came from
– Where it is now
– Where it will be in the future
• But that doesn’t tell us what accounting is
• Required
a) What is accounting?
b) Why do you need to learn about the world of accounting?

• Accounting is ‘the process of identifying, measuring,

recording and communicating economic transactions’
(Collis and Hussey, 2007, p. 5)
– Identifying economic transactions of the business and not the
personal affairs of the owners or managers
– Measuring the economic transactions in monetary terms
– Recording them in the accounting system
– Communicating them to users by producing financial statements
that summarise the information

Definition of Accounting
• American Institute of Certified Public Accountants

(AICPA) which defines accounting as
– “the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and
events, which are, in part at least, of a financial character and
interpreting the results thereof”.

Two main branches of accounting
• Financial accounting is ‘a branch of accounting

concerned with ‘classifying, measuring, and
recording the economic transactions of an entity
in accordance with established principles, legal
requirements and accounting standards.
• It is primarily concerned with communicating a
true and fair view of the financial performance
and financial position of an entity to external
parties’.

Two main branches of accounting
• Management accounting is ‘a branch of

accounting concerned with collecting, analysing
and interpreting quantitative and financial
information.
• It is primarily concerned with communicating
information to management for planning,
controlling and decision making’.

Objective of Accounting
• To keep systematic record

• To establish the results of the operation
• To ascertain the financial position of the business
• To portray the liquidity position
• To protect business properties
• To facilitate rational decision – making
• To satisfy the requirements of law

Importance of Accounting
• Owners
– Owners, being businessmen, always keep an eye on
the returns from the investment.
• Management
– The management is interested in financial accounting
to find whether the business carried on is profitable
or not.
– Eyes and ears

• Creditors
– Creditors are the persons who supply goods on
credit, or bankers or lenders of money.
– Profit and Loss Account and Balance Sheet are nerve
centers to know the soundness of the firm.
• Employees
– The demand for wage rise, bonus, better working
conditions etc. depend upon the profitability of the
firm and in turn depends upon financial position.

• Investors
– This group is eager to go through the accounting
which enables them to know the safety of investment.
• Government
– To know the earnings for the purpose of taxation
• Consumers
• Research Scholars
– Accounting information, being a mirror of the
financial performance of a business organization, is of
immense value to the research scholar who wants to
make a study into the financial operations of a
particular firm.
Functions of Accounting
• Record Keeping Function

– The primary function of accounting relates to
recording, classification and summary of financial
transactions- journalisation, posting, and preparation
of final statements.
– Facilitates decision making programme for future
activities.
• Managerial Function
– The variations of actual operations with pre-
determined standards and their analysis is possible
only with the help of accounting.

Functions of Accounting
• Legal Requirement function

– Auditing is compulsory and it’s not possible without
accounting for registered firms.
– Accounting is a base and with its help various
returns, documents, statements etc., are prepared.
• Language of Business
– Various transactions are communicated only through
accounting.
– It shows real and true position of the firm or the
business.

Advantages of Accounting
• Complete record of business transactions

• It gives information about the profit or loss made by the
business at the close of a year and its financial
conditions.
• It provides useful information for making economic
decisions.
• It facilitates comparative study of current year’s profit,
sales, expenses etc., with those of the previous years.

Advantages of Accounting
• Ability to utilize enterprise resources effectively in

achieving primary enterprise goals.
• It provides users with factual and interpretive
information about transactions and other events which
are useful for predicting, comparing and evaluation the
enterprise’s earning power.
• It helps in complying with certain legal formalities like
filing of income tax and sales-tax returns.

Limitations of Accounting
• Due to historical nature It does not reflect the current

financial position or worth of a business.
• Accounting is limited to monetary transactions only,
excludes qualitative elements like management,
reputation, employee morale, labour strike etc.
• Facts recorded in financial statements are greatly
influenced by accounting conventions and personal
judgments of the Accountant or Management.
• Cost concept is found in accounting. Money value is
bound to change often from time to time.

Meaning of Debit and Credit
• Recording of transactions require a thorough

understanding of the rules of debit and credit relating to
accounts.
• Both debit and credit may represent either increase or
decrease, depending upon the nature of account.
• ‘Dr’ is used for debit and ‘Cr’ is used for credit.

Types of Accounts
• Business transactions have been classified into three

categories:
– (i) Transactions relating to persons => Personal Accounts
– (ii) Transactions relating to properties and assets => Real
Accounts
– (iii) Transactions relating to incomes and expenses => Nominal
Accounts

Types of Accounts
• Personal Accounts
– Accounts recording transactions with a person or
group of persons
– (a) Natural persons: An account recording
transactions with an individual human being is
termed as a natural persons’ personal account.
– (b) Artificial or legal persons: An account recording
financial transactions with an artificial person created
by law or otherwise is termed as an artificial person,
personal account
– (c) Groups/Representative personal Accounts: An
account indirectly representing a person or persons is
known as representative personal
CS4252 Finance and Accounting account. 20
Types of Accounts
• The rule for personal accounts is:

– Debit the receiver
– Credit the giver

Types of Accounts
• Real Accounts
– Accounts relating to properties or assets are known as
‘Real Accounts’, A separate account is maintained for
each asset
– (a) Tangible Real Accounts: These accounts represent
assets and properties which can be seen, touched, felt,
measured, purchased and sold.
– (b) Intangible Real Accounts: These accounts
represent assets and properties which cannot be seen,
touched or felt but they can be measured in terms of
money.

Types of Accounts
• The rule for Real accounts is:

– Debit what comes in
– Credit what goes out
• Nominal Accounts
– Accounts relating to income, revenue, gain expenses
and losses are termed as nominal accounts. These
accounts are also known as fictitious accounts as they
do not represent any tangible asset.
• The rule for Nominal accounts is:
– Debit all expenses and losses
– Credit all incomes and gains
Distinction Between Book-
keeping and Accounting

Branches of Accounting
• Financial accounting;
• Cost accounting; and
• Management accounting.

• Financial accounting
– The accounting system concerned only with the financial state of
affairs and financial results of operations
– Mainly concerned with the preparation of financial
statements for the use of outsiders
– The profit and loss account and the balance sheet,
show them the manner in which operations of the
business have been conducted during a specified
period.

• Cost accounting
– Cost accounting involves the techniques for:
determining the costs of products, processes, projects,
etc. in order to report the correct amounts on the
financial statements, and
– Assisting management in making decisions and in the
planning and control of an organization.
– Cost accounting seeks to determine the cost of unit
produced and sold or the services rendered by the
business unit with a view to exercising control over
these costs to assess profitability and efficiency of the
enterprise.
• Management accounting
– Accounting which provides necessary information to
the management for discharging its functions
– Management accounting is the presentation of
accounting information in such a way as to assist
management in the creation of policy and the day-to-
day operation of an undertaking
– Management accounting is not only confined to the
area of cost accounting but also covers other areas
(such as capital expenditure decisions, capital
structure decisions, and dividend decisions) as well.

Financial Statements
• Financial Statements include:

– Trading and Profit and Loss Account or Income
Statements
– Balance Sheet
• An Income Statement has two parts,

– Trading Account - It reveals gross profit or gross loss
and
– Profit and Loss Account - It reveals net profit or net
loss.

Trading Account
• Trading Account
– Trading Account is the first stage in the process of
preparing final accounts.
– Trading account shows the gross profit or gross loss

during an accounting year.

Trading Account
• Features of Trading Account

– It is the first stage in the preparation of final accounts
of a trading concern
– It records only net sales and direct cost of goods sold
– The balance of this account discloses the gross profit
or gross loss
– The balance of this account is transferred to the Profit
and Loss Account

Trading Account
• Purpose of the Trading Account

– The Trading Account is prepared to know the gross
profit or gross loss during the accounting period.
– The account is based on matching the selling price of

goods and services with the cost of goods sold and
services render.

Trading Account
• Contents of a Trading Account

• Items shown on the debit side of the Trading Account
– Opening Stock - refers to the closing stock of the
previous year.
– This item is usually put as the first item on the debit
side of the Trading Account.
– In case of a trader, the opening stock consists of
different types of finished goods.
– For the manufacturing concern, the opening stock
consists of raw materials; work - in - process and
finished goods.

Trading Account
– Purchases and Purchases returns - The purchases
account will show a debit balance, showing the gross
amount of purchases made of the materials. This
refers to the goods purchased, both cash and credit
purchases, for resale.
– Remember, the purchases of assets which are meant
for permanent use in business such as machinery,
furniture etc., are not included in the purchases.
– The purchases returns account will show a credit
balance showing the returns of materials to the
suppliers.
To Purchase Rs. 3,00,000
Less: Purchases Returns Rs. 10,000
Rs. 2,90,000
Trading Account
• Items shown on the debit side of the Trading Account
• Besides the Purchases returns, the following entries
should also be deducted:
– Goods taken by the proprietor for his personal use
– Goods given as charity
– Goods given by way of samples
– Direct Expenses - Direct expenses are those expenses which
are incurred on the goods purchased till they are brought to
the place of business for sale.
• Examples of such expenses are freight inward, insurance,
customs (import) duty, clearing charges, octroi duty, cartage
etc. In a manufacturing business, besides the above, expenses
incurred for purposes of production such as wages, power
and fuel, factory rent, etc. are also direct expenses.
Trading Account
• Items shown on the Credit Side of the Trading Account

– Sales and Sales Returns - The Sales account always
has a credit balance indicating the total sales made
during the year.
– The sales returns account has always a debit balance
showing the total of the amount of goods returned by
customers. The net of the two amounts is called ' net
sales' and is entered on the credit side of the Trading
Account.
– The Sales Tax or Value Added Tax (VAT) charged is
not a part of the sales revenue.
– Sales Tax or VAT charged is to be deposited with
Government. CS4252 Finance and Accounting 37
Trading Account
• If sales are inclusive of tax, the tax amount must be deducted from the
sales amount.
– Closing Stock - Closing Stock refers to the stock of

unsold goods at the end of the current accounting
period. Usually there is no account to show the value
of goods lying in the godown at the end of the year.
However, to correctly ascertain the grow profit, the
closing stock must be taken and valued.

Balancing of Trading Account:
Gross Profit or Gross Loss
• After recording the items in the respective sides of the
Trading Account, the balance is calculated to determine
Gross Profit or Gross Loss.
• If the total of the credit side is more than that of the debit
side, the excess is Gross Profit.
• If the total of the debit side is more than that of the
credit side, the excess is Gross Loss.
• Gross Profit is transferred to the credit side of the Profit
and Loss Account and Gross Loss is transferred to the
debit side of the Profit and Loss Account.

• After recording the above items in the respective sides of
the Trading Account, the balance is calculated to
ascertain Gross Profit or Gross Loss.
• If the total of the credit side is more than that of the debit
side, the excess is Gross Profit.
• If the total of the debit side is more than that of the
credit side, the excess is Gross Loss.
• Gross Profit is transferred to the credit side of the Profit
and Loss Account and Gross Loss is transferred to the
debit side of the Profit and Loss Account.

Closing Entries for Trading Account
• Preparation of a Trading Account requires recording
entries to transfer the balance of accounts of all the
concerned items to the Trading Account.
• These entries are called Closing Entries as after
recording the entries these accounts are closed.

• Closing Entries for Trading Account

General Format of Trading
Account

Points to remember
• Trading Account shows Gross Profit or Gross Loss
• Gross Profit can be presented in the form of an equation
as -
• Gross Profit = Net Sales - Cost of Goods Sold
Where
• Net Sales = Total Sales - Sales Returns
• Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses - Closing Stock
• Net Purchases = Total Purchases - Purchases Returns
• C
arriage Inward is debited to the Trading Account and
Carriage Outward to the Profit and Loss Account
• Return Inwards are deducted from Sales whereas Return
outwards are deducted from the Purchases in the
Trading Account. CS4252 Finance and Accounting 45
Illustration: Trading A/C
• Prepare a Trading Account for the year ending March

31, 2015 from the following balances as at March 31,
2015
Details Rs. Details Rs.
Opening Stock 10,000 Wages 5000
Sales (inclusive of sales Tax) 1,70,000 Returns Outwards 8,000
Freight 500 Purchases 1,00,000
Carriage Inwards 1,000 Returns Inwards 5,000
Sales Tax paid 15,000 Octroi Duty 2,500
• Closing Stock is valued at Rs. 20,000 as at March 31,

2015 CS4252 Finance and Accounting 46
Trading Account
For the year ending March 31, 2015
Dr. Cr.
Details Rs. Details Rs.
To Opening Stock 10,000 By Sales A/C 1,70,000
Less: sales Tax 15,000
-------------
1,55,000
Less: Returns Inwards 5,000 1,50,000
To Purchases A/C 92,000
1,00,000 By closing stock 20,000
Less: Returns Outwards
8,000
To Wages 5000
To Carriage Inwards 1,000
To Freight 500
To Octroi Duty 2,500
To Profit & Loss A/C 59,000
(Gross Profit)
1,70,000 1,70,000
Example
Prepare trading account of Sivika for the year ending 31-3-
2014.
• Opening stock = Rs. 4,00,000
• Purchases = Rs. 43,00,000
• Carriage inward = Rs. 2,60,000
• Wages = Rs. 1,20,000
• Credit sales = Rs. 72,00,000
• Cash sales = Rs. 18,00,000
• Sales returns = Rs. 15,80,000
• Purchase returns = Rs. 50,000
• Closing stock = Rs. 5,00,000

Solution
Trading Account
Dr. Cr.

Example
Prepare Trading Account of Lakshmi Corp. for the year
ending 31 March, 2016 from the following information:
• Opening Stock = Rs. 80,000
• Purchases = Rs. 8,60,000
• Freight Inward = Rs. 52,000
• Wages = Rs. 24,000
• Sales = Rs. 14,40,000
• Purchase Returns = Rs. 10,000
• Sales Returns = Rs. 3,16,000
• Closing Stock = Rs. 1,00,000
• Import duty = Rs. 30,000

Solution
Trading Account
Dr. Cr.

From the under mentioned balances obtained at
the end of 31-March 1999, prepare Trading
account.
• Stock of goods on 1-4-98 = Rs. 12,50,000
• Stock of goods on 31-3-99 = Rs. 23,75,000
• Purchases –
– Cash = Rs. 18,50,000
– Credit = Rs. 41,25,000
• Sales –
– Cash = Rs. 25,50,000
– Credit = Rs. 57,50,000
• Returns to suppliers = Rs. 25,000
• Returns by customers = Rs. 30,000
• Duty and clearing charges = Rs. 50,000

Profit and Loss Account
• After preparing the Trading Account, the Profit and Loss

Account is prepared.
• It is prepared to calculate the net profit or net loss of the
business for a given accounting period.
• “A Profit and Loss Account is an account into which all
gains and losses are collected in order to ascertain the
excess of gains over the losses or vice versa” - Prof.
Carter
Need:
• To determine Net Profit/Loss
• Comparison with the Previous Year's Profit/Loss
• Control over Expenses
Features of Profit and Loss Account

• It is the second stage in the preparation of the final
accounts
• It relates to a particular accounting period and is
prepared at the end of that period.
• This account is credited with the gross profit and income
from other sources and debited with indirect expenses
and losses
• The balance of this account is the net profit or net loss
• The capital of the owner is increased or decreased by the
balance of this account (Net Profit or Net Loss).

Items of Profit and Loss Account:
• Expenses and losses shown on the debit side of the

Profit and Loss Account can be classified as follows:
• Administration and Office Management Expenses -
Administration expenses include the following-
– 1. Establishment Expenses
– 2. Office salaries
– 3. Office rent and rates
– 4. Lighting
– 5. Printing and Stationery
– 6. Postage and Telephone Charges
– 7. Legal Expenses
– 8. Audit Fee
– 9. General or Trade Expenses

• Selling and Distribution Expenses - These will
comprise the following:
– 1. Salesmen's salaries and commission
– 2. Commission of Agents, 3. Advertising
– 4. Warehousing Expenses, 5. Packing Expenses
– 6. Freight and Carriage on Sales
– 7. Export Duties
– 8. Maintenance of Vehicles for distribution of goods and their
running expenses
– 9. Insurance of Finished Goods, Stock and Goods in Transit


• Financial Expenses - These are those expenses which are
incurred in respect of arranging Finance for business.
– a. Interest on Loan b. Interest on Capital and c. Discount
Allowed.
• Abnormal Losses - Abnormal loss such as stock loss by
fire not covered by insurance, loss on sale of fixed assets,
loss by theft, cash defalcation, etc., may occur during the
accounting period.
• Abnormal losses are treated as extraordinary expenses
and debited and shown separately in the Profit and Loss
Account. CS4252 Finance and Accounting 57
• Incomes and items of profit which are shown on the

credit side of Profit and Loss Account can be divided
into the following groups:
• Income from Main Business - These refer to those
profits and incomes which are received from the
operations of the main business.
– Gross Profit
– Profit on consignment
– Profit on Joint Venture and
– Commission Receivable

• Financial and other Incidental Income –

• Income received from other sources except the main
function of the business comes under this category.
These include –
– Interest on Fixed Deposits

– Income from Investment
– Rent Received
– Interest on Drawings and
– Discount Received.

• Balances of the Profit and Loss Account

Net Profit or Net Loss:
• The balance in the Profit and Loss Account represents
the net profit or net loss.
• If the credit side is more than the debit side, it shows net
profit.
• If the debit side is more than the credit side, it shows net
loss.
• Both (Net Profit or Net Loss) are transferred to the
Capital Account.

Difference between Trading Account and Profit and Loss Account

• Some Terms

Prepare Profit and Loss Account, from the
following balances of Mr. Murugan for the year
ending 31.3.2007.
• Office rent Rs. 3000
• Printing expenses Rs. 2,200
• Tax, Insurance Rs. 1,400
• Discount received Rs. 400
• Advertisement Rs. 3,600
• Salaries Rs. 8,000
• Stationeries Rs. 2,400
• Discount allowed Rs. 600
• Travelling expenses Rs. 2,600
• Gross Profit transferred from the Trading A/c Rs.
25,000
Profit and Loss Account of Mr. Murugan For the year
ending 31.3. 2007
Dr. Cr.
Particulars Amt. (Rs.) Particulars Amt. (Rs.)
To Salaries 8,000 By Gross 25,000
Profit
To Office rent 3,000 By Discount 400
received
To Stationeries 2,400
To Printing expenses 2,200
To Tax, Insurance 1,400
To Discount allowed 600
To Travelling expenses 2,600
To Advertisement 3,600
To Net Profit (Capital A/c) 1,600
25,400
CS4252 Finance and Accounting 25,400 64
From the following prepare profit and loss
account
for the year ended 31-3-2013
Particulars Dr. Amount (Rs.) Cr. Amount (Rs.)
Gross Profit 9,50,000
Commission received 5,000
Interest received 4,000
Sundry income 7,000
Depreciation 10,000
Salaries 15,000
Discount (Dr) 8,000
Discount (Cr) 12,000
Bank charges 4,000
Audit fees 2,000
Stationery 400

Profit and Loss account for the year ended
31-3-2013
Particulars Dr. Particulars Cr.
Amount (Rs.) Amount (Rs.)
To Depreciation 10,000 By Gross Profit 9,50,000

(b/d)
To Salaries 15,000 By Commission 5,000
received
To Discount (Dr) 8,000 By Interest received 4,000
To Bank charges 4,000 By Sundry income 7,000
To Audit fees 2,000 By Discount (Cr) 12,000
To Stationery 400
To Net profit c/d 9,38,600
9,78,000CS4252 Finance and Accounting 9,78,000 66
Manufacturing Account
• The main purpose of manufacturing account is

to show:
– (i) Cost of goods manufactured; and
– (ii) Major items of costs such as raw material
consumed, productive wages, direct and indirect
expenses of production.

Various Items Shown In Manufacturing Account
• Debit side items
• Raw material consumed
– opening stock of raw materials plus Purchases and
incidental expenses of purchase less closing stock of
raw materials.
• Direct wages and expenses
• Indirect factory expenses factory rent, salaries,
lighting, power, heat and fuel, machinery repairs,
depreciation and other factory expenses
• Opening work in progress
• Sale of Scrap CS4252 Finance and Accounting 68
Various Items Shown In Manufacturing Account

• Credit side items
• Closing work-in-progress
• Sale of scrap
• Cost of Finished goods manufactured

From the following balances in the ledger of Mr.
Kannusamy for the year ended 31-3-2002, prepare
manufacturing account.
• Opening work-in-progress Rs. 1,00,000
• Opening stock of raw materials Rs. 55,000
• Purchases of raw materials Rs. 10,00,000
• Closing stock of raw materials Rs. 40,000
• Carriage on purchases Rs. 10,000
• Factory wages Rs. 50,000; Fuel and coal Rs. 45,000
• Factory power Rs. 20,000
• Depreciation on plant and machinery Rs. 15,000
• Factory supervisor’s salary Rs. 75,000; Closing work-in-
progress 20,000 CS4252 Finance and Accounting 70
Dr. Cr.

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Financial Accounting

• Wherever money is involved, accounting is required to

CS4252 Finance and Accounting 2

• Business is about money - and managers, owners and

CS4252 Finance and Accounting 3

• Accounting is ‘the process of identifying, measuring,

CS4252 Finance and Accounting 4

• American Institute of Certified Public Accountants

CS4252 Finance and Accounting 5

• Financial accounting is ‘a branch of accounting

CS4252 Finance and Accounting 6

• Management accounting is ‘a branch of

CS4252 Finance and Accounting 7

• To keep systematic record

CS4252 Finance and Accounting 8

CS4252 Finance and Accounting 9

CS4252 Finance and Accounting 10

• Record Keeping Function

CS4252 Finance and Accounting 12

• Legal Requirement function

CS4252 Finance and Accounting 13

• Complete record of business transactions

CS4252 Finance and Accounting 14

• Ability to utilize enterprise resources effectively in

CS4252 Finance and Accounting 15

• Due to historical nature It does not reflect the current

CS4252 Finance and Accounting 16

• Recording of transactions require a thorough

CS4252 Finance and Accounting 17

• Business transactions have been classified into three

CS4252 Finance and Accounting 18

• The rule for personal accounts is:

CS4252 Finance and Accounting 21

CS4252 Finance and Accounting 22

• The rule for Real accounts is:

CS4252 Finance and Accounting 24

CS4252 Finance and Accounting 26

CS4252 Finance and Accounting 27

CS4252 Finance and Accounting 29

• Financial Statements include:

• An Income Statement has two parts,

CS4252 Finance and Accounting 30

– Trading account shows the gross profit or gross loss

CS4252 Finance and Accounting 31

• Features of Trading Account

CS4252 Finance and Accounting 32

• Purpose of the Trading Account

– The account is based on matching the selling price of

CS4252 Finance and Accounting 33

• Contents of a Trading Account

CS4252 Finance and Accounting 34

• Items shown on the Credit Side of the Trading Account

– Closing Stock - Closing Stock refers to the stock of

CS4252 Finance and Accounting 38

CS4252 Finance and Accounting 39

CS4252 Finance and Accounting 40

CS4252 Finance and Accounting 42

CS4252 Finance and Accounting 43

CS4252 Finance and Accounting 44