CBSE xi Accountancy – Profit and Loss Account Preparation

The Trading Account simply tells about the gross profit or loss made by a businessman on purchasing and selling of goods. Jt does not take into account the other operating expenses incurred by him during the course of running the business. For example, he has to maintain   an office for getting orders and executing them, taking policy decision and implementing them. All such expenses are charged to the Profit and Loss Account. Besides this, a businessman may have other sources of income. For example, he may receive rent from some of his business properties. He may have invested surplus funds of the business in some securities. He might be getting interest or dividends from such investments. In order to ascertain the true profit or loss which the business has made during a particular period, it is necessary that all such expenses and incomes should be considered.

Important points regarding Profit and Loss Account 

Gross Profit or Gross Loss. The figure of gross profit or gross loss is brought down from the Tading Account. Of course, there will be only one figure, i.e., either of gross profit or gross loss.

Salaries. Salaries payable to the employees for the services rendered by them in running the business being of indirect nature are charged to the Profit and Loss Account. In case of a partnership firm, salaries may be allowed to the partners. Such salaries will also be charged to the Profit and Loss Account.

Interest: Interest on loans whether short-term or long-term is an expense of an indirect nature and, therefore, is charged to the Profit and Loss Account. However, interest on loans advanced by a firm to third-parties is an item of income and, therefore, will be credited to the Profit and Loss Account.

Commission:  Commission may be both an item of income as well as an item of expense. Commission on business hroughtby agents is an item of expense while commission earned by the business for giving business to others is an item of income, Commission to agents is, therefore, debited to the Profit and Loss Account while commission received is credited to the Profit and Loss Account

Bad debts:  Bad Debts denotes, the amount lost from debtors to whom the goods were sold on credit. It is a loss and therefore, should be debited to the Profit and Loss Account

Inventory Valuation Method – First In First Out Method

First In First Out Method (FIFO)

Under this method, it is assumed that the materials/goods first received are the first to be issued/sold. Thus, according to this method, the inventory on a particular date is presumed to be composed of the items which have been acquired most recently

Advantages. The FIFO method has the following advantages:

1. It values stock nearer to current market prices since stock is presumed to be consisting of the most recent purchases.

2. It is based on cost and, therefore, no unrealised profit enters into the financial accounts of the company.

3. The method is realistic since it takes into account the normal procedure of utilisinglselling those materials/goods which have been longest in stock.

Disadvantages. The method suffers from the following disadvantages:

Importance of the Trading Account

Importance of the Trading Account

Trading Account provides the following information to a businessman regarding his business:

I. Gross Profit disclosed by the Trailing Account tells him the upper limit within which he should keep the operating expenses of the business besides saving something for himself. The cost of purchasing and the price at which he can sell the goods are governed largely by market factors over which he has no control. He can control only his operating expenses. For example, if the cost of purchasing an article is Rs 10 and it can be sold ii’ the market at Rs 10 per unit, the gross margin available on each article is Ps 5. In case a businessman proposes to sell 1,000 units of that article in a year, his gross profit or gross margin will be Rs 5,000. His other expenses should therefore be less than Rs 5,000 so that he can also save something for himself.

2. He can calculate his Gross Profit Ratio1 and compare his performance year after year. A fall in the Gross Profit Ratio means increase in the cost of purchasing the goods or decrease in the selling price of the goods or both. In order to maintain at least same figure of gross profit in absolute terms, he will have to push up the sales or make all out efforts to obtain goods at cheaper prices. Thus, he can prevent at least fall in the figure of his gross profit if can not bring any increase in it;

3. Comparison of stock figures of one period from another will help him in preventing unnecessary lock-up of funds in inventories.

4. In case of new products, the businessman can easily fix up the selling price of the products by adding to the cost of purchases, the percentage gross profit that he would like to maintain. For example, if the trader has been so far maintaining a mte of gross profit of 20% on sales and he introduces a new product in the market having a cost of Rs 100, he should lix the selling price at Its 125 in order to maintain the same nile of gross profit (i.e., 20% on sales).

Inventory cost

Inventory cost The term Inventory includes (I) Stock of raw materials, (ii) Stock of work-in-progress, and (iii) Stock of finished Goods. The computation of the cost of inventory is also a tedious process. The vaftiation of tbe stock of raw materials will depend upon the method of pricing materials issues followed by the business. Materials may be issued to production according to First In First Out ([FIFO) Method, Last In First Out (LIFO) Method, Weighted Average Price Method, etc. In each of these cases, the value of the inventory of raw materials may widuly differ. This will be clear with the help of the following example.

A business buys raw materials in two different lots. In the first lot 1,000 units are purchased @ Rs 10 per unit. In the second lot, 2,000 units are purchased @ Rs 12 per unit. In case the stock of raw materials at the cod of the accounting period is of 1,000 units, the value of the inventory according to each of the methods stated above will be as follows:

FIFO method:

1,000 Units @ Ps 12 per unit = Rs 12,000

(Since materials first purchased will be taken to have been issued to production first of all, the inventory of raw material will, therefore, consist of latest purchases).

LIFO method:

l,000UuiLs@RslOperunit=Rs 10,000

(Since materials purchased in the last will be taken to have been issued to production first of all, the inventory will, therefore, consist of the earliest purchases).

Weighted Average Price Method:

1,000 Units @ Ps 11.333 = Rs 11,333

(The total units purchased are 3,000 for a total cost of Es 34,000. This gives a

weighted average priceRs 11.333 per unit).

Methods of valuation of Inventories

METHODS OF VALUATION OF INVENTORIES

According to International Accounting Standard: 2 (lAS: 2), the inventories should be valued at the lower of “historical cost” and “net realisable value”.

Historical Cost

Historical cost of inventories is the aggregate of costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Thus Historical cost includes not only the price paid for acquisition of inventories but also all costs incurred for bringing and making them fit for jise in production or for sale e.g. transportation costs, duties paid, insurance-in-transit, manufacturing expenses,wages paid or manufacturing expenses incurred for converting raw materials into finished products etc. Selling expenses such an advertisement expenses r storage costs should not be included.

A major objective of accounting for inventories is the proper determination of income thmugh the process of matching appropriate costs against revenues. It requires assigning of proper costs to inventory as well as goods sold.

However, it should be noted that assigning of such costs need not conform to the physical flow of goods.

The various methods for assigning historical costs to inventory and goods sold are being explained below.

Inventory Systems

INVENTORY SYSTEMS

Records pertaining to quantity and value of inventory-in-hand can be maintained according

to any of the following two systems:

(I) Periodic Inventory system.

(ii) Perpetual Inventory system.

Periodic Inventory System

In case of this system the quantity and value of inventory is found out only at the end of the accounting period after having a physical verification of the units in hand. The system does not provide the infomiation regarding the quantity and value of materials in hand on a continuous basis. The cost of materials used is obtained by adding the total value of inventory purchased during the period to the value of inventory in hand iii the beginning of the period and subtracting the value of inventory at the end of the period. For example, if the inventory in the beginning was 1,000 units of Rs 10,000, purchases during the period were of 5,(XX) units of Ps 50,000 and the closing inventory 1,500 units of Rs 15,000, the cost of materials used will be taken as Its 45,000 (i.e., Rs 10,000 + Rs 50,000— P.s 15,000). It is, thus, assumed that materials not in stock have been used. No accounting is done for shrinkage, losses, theft and wastage.

Perpetual Inventory System

It is also known an Automatic Inventory System.

According to the Chartered Institute of Management Accountants London, it is “a system of records maintained by the controlling department, which reflects the physical movement of stocks and their current balance.” The definition given by Wheldon is more exhaustive and explanatory. According to him, it is “a method of recording inventory balances after every receipt and issue, to facilitate regular checking and to obviate closing down for stocktaking”.’ In case of this system the stores ledger gives balance of raw materials, work-in-progress ledger gives the balance of work-in-progress and finished goods ledger gives the balance of finished goods in hand on a continuing basis. The basic objective of this system is to make available detailsabout the quantity and value of stock of each item at all times. The system, thus, provides a rigid control over stock of materials as physical stock can regularly be verified with the stock records kept in the stores and the cost office.

Fundamentals of Accounting – Cost of goods Sold or Purchased

Cost of goods sold. Income determination requires in case of both manufacturing and trading concerns, the cost of goods sold. In case of trading concerns, the job is comparatively easy since the cost of goods sold can be easily found out be taking into account the cost at which the goods have been purchased. However, in case of manufacturing concerns, the cost of goods sold is to be found out taking into consideration the cost involved in their manufacture. Manufacturing costs can be both direct as well as indirect. Direct costs are those costs which can be directly, conveniently and wholly identified with specific products, jobs or manufacturing processes, e.g., cost of raw materials used for manufacturing the products, cost of factory labour etc. Indirect manufacturing costs are those costs which cannot be directly be identified with specific jobs products or processes, e.g., salary paid to the factory manager, rent, rates, lighting, depreciation of factory machines, etc. These cost are to be apportioned on different products on some reasonable basis e.g., the salary paid to the factory manager may be charged to different products on the basis of direct wages for each product. Similarly, rent paid for the factory may be charged to different products on the basis of departmental area occupied by each of the production departments. Apportionment of the indirect costs so made cannot be fairly accurate and, therefore, the cost of the products so computed cannot also be very accurate. Moreover, some costs such as depreciation of plant and machinery or depreciation of factory buildings cannot themselves be determined accurately. Depreciation depends on the cost of the assets, its scrap value and the estimated life of the assets. It is very difficult to make a fair estimate about the scrap value and life of the asset. The amount of depreciation charged may not, therefore, be very correct. Thus, when estimation of the various elements which constitute cost cannot correctly by made, the measurement of income on the basis of such estimates cannot also be very accurate.

 

Objectives of Inventory Valuation

OBJECTIVES OF INVENTORY VALUATION 

Inventory has to be properly valued because of the following reasons:

(i) Determination of income. The valuation of inventory is necessary for determining the ne income earned by a business during a particular period. Gross profit is the excess of sales over cost of goods sold. Cost of goods sold is ascertained by adding opening inventory to and deducting closing inventory from purchases.

(ii) Determination of financial position. The inventory at the end of a period is to be shown as a current asset in the balance sheet of the business. In ease the inventory is not properly valued, the balance sheet will not disclose the correct financial position of the business.

Meaning of Inventory

MEANING OF INVENTORY

Inventories are unconsumed or unsold goods purchasecior manufactured. According to the International Accounting Standard: 2 (lAS: 2), inventories are tangible froperty.

(a) held for sale in the ordinary course of business,

(b) in the process of production for such sale, or

(c) to be consumed in the production of goods or services for sale.

Thus, the term inventory includes stock of (i) finished goods, (ii) work in-progress and (iii) raw matcrials and components. In case of a trading concern inventory primarily consists of finished goods while in case of a manufacturing concern, inventory consists of raw materials, components, stores, work-in-process and finished goods.

Accoutancy Class xi – Classification Of Receipts

CLASSIFICATION OF RECEIPTS

Receipts can be classified into two categories: Capital Receipts, and Revenue Receipts

(I) Capital receipts. Capital Receipts consist ofadditioiial payments made to the business either by shareholders of the company or by the proprietors ofthe business or receipts from sale of fixed assets ofa business. For example, the amount raised by the company by way of share capital isa capital receipt. Similarly, ifa flirn sells its machinery for a sum ofRs 10,000, the receipt is a capital receipt.

It should be noted that a capital receipt is different from a capital profit. Receipt denotes receiving payment in cash. Moreover, the whole of it may or may not be a capital profit. There maybe a capital loss too. For example, ifa plant costing Rs 10,000 is sold for Rs 12,000, there is a capital receipt ofRs 12,000, but there will be a capital profit of only Rs 2,000. Similarly, if the same plant had been sold only for Rs 8,000, there is a capital receipt ofRs 8,000 but there is a capital loss ofRs 2,000.

(ii) Revenue receipts. Any receipt which is not a capital receipt is a revenue receipt. In business most ofthe receipts are revenue receipts. However, a revenue receipt is also different from-n revenue profit or revenue income. Receipt denotes receiving of payment in cash. Moreover, the entire amount ofreceiptmay or may not be a revenue income. For example, if the goods costing Rs 20,000 are sold for Rs 25,000, there is a revenue receipt ofRs 25,000, hut revenue profit or income is only ofRs 5,000.

The distinction between capital and revenue is important both for income determination and taxation purposes. Various tçsts have been laid down from time to time for distinguishing between these two. Some ofthese are based on, economic considerations, some on accounting principles and some have been pronounced by the courts. However, difficulties still arise in making a clear cut distinction between these two. There have been cases which fall on the border line. In many cases, the policies ofthose incharge ofthe business will decide whether certain expenditure or income should be classified revenue or capital. However, the rules given in the preceding pages and the illustrations given in the following pages will to a great extent help a student in making a fairly reasonable distinction between capital and revenue.

Fundamentals of Accounting – Accounting period concept

As a matter of fact, the income from a business enterprise can be precisely determined only at the end of its life, i.e., when the business is finally closed down. However, in order to have an idea about the progress made by the business and to take remedial measures in time, business income is determined after the expiry of a reasonable period. Such a period is termed as ‘accounting period’, The income disclosed by the Tncome Statement is the income made during the accounting period. However, this is only an interim report. The actual income earned by the business will be known only when the business is finally closed down. Thus, the measurement of accounting income is also subject to the Accounting Period Concept.