Depreciation (or sinking) fund method. One of the objectives of providing for depreciation (as explained earlier) is to provide for replacement of the assetat the end of its useful life. In case of the three methods discussed earlier, the amount of depreciation charged from the Profit & Loss Account continues to remain in the business. However, this amount may get invested in the course or running the business is some other assets. It may, therefore, not be possible for the business to have sufficient liquid resources to purchase a new asset at the time when it needs funds for replacement. Depreciation Fund Method takes care of such a contingency. According to this method, the amount charged by way of depreciation is invested in certain securities carrying a particular rate of interest. The amount received on account of interest from these securities is also invested from time to time together with the annual amount charged by way of depreciation. At the end of the useful life of the asset, when replacement is required, the securities are sold away and money realised on account the sale of the securities is used for purchase of a hew asset. The method has the advantage of providing a separate sum for replacement of the asset. However, the methodhas a disadvantage. It puts an increasing burden on the profit and loss of each year on account of a fixed charge for depreciation but increasing charge for repairs.
Sum of years digits | Double declining balance method
Sum of years digits (or SYD) method. This method is on the paltern of Diminishing Balance Method. The amount of depreciation to be charged to the Profit and Loss Account under this method goes on decreasing every year. The depreciation is calculated
Double declining balance method. This method is similar to reducing or declining balance method explained above except that the rate of depreciation is charged at the rate which is twice the straight line rate. While computing this rate two things have bee,n kept in mind;
(a) No allowance is to be made for the scrap value of the asset.
(b) The total cost should not be reduced by charging the depreciation to an amount lower than the estimated scrap value of the asset.
The declining charge methods of depreciation are preferred over unifonn charge methods of depreciation on account of the following reasons:
(1) The total cost for use of the asset is evenly spreaded over the useflul life of the asset. Such cost of the use of the asset includes both depreciation and repairs. With the asset growing order.
Depreciation Accounting – Declining Charge Depreciation Methods
Declining Charge Depreciation Methods
In case of these methods the amount charged for depreciation declines over the asset’s expected life. These methods are suitable in those ease where (a) the receipts are expected to decline as the asset gets older and it is believed that the allocation of depreciation should be related to the pattern of asset’s expected receipts.
Following methods fall in this category.
(a) Diminishing balance method. According to this method, depreciation is charged on the book value of the asset each year. Thus, the amount of depreciation goes on decreasing every year. For example, if the cost of an asset is Rs 20,000, and the rate of depreciation is 10%, the amount of depriciation to be charged in the first year will be a sum of Ps 2,000. In the second year, depreciation will be charged at 10% on the hook value of the asset, i.e., Rs 18,000 (i.e., Rs 20,000— Ps 2,000) and so on.
Merits. (i) The method puts an equal burden for use of the asset on each subsequent year. The amount of depreciation goes on decreasing for each subsequent year while the charge for repairs goes on increasing for each subsequent year. Thus, increase in the cost of repairs for each subsequent year is compensated by decrease in the amount of depreciation for each subsequent year.
(ii) The method is simple to understand and easy to follow.
Demerits. (i) The value of the asset cannot be brought down to zero under this method.
(ii) The detennination of a suitable rate of depreciation is also difficult under this method as compared to the Fixed Instalment Method.
Single Entry Accounting System – Networth Method
NET WORTH METHOD
According to this method, the profit or loss made by the business is computed by comparing the net worth (or capital) of the business on two different dates. For example, ifthe capital of the business on 1.1.1990 was P.s 80,000 and it is Rs 90,000 on 31st December, 1999, it can be said that the business has made profit of P.s 10,000 during the period.
Adjustments. Following adjustments are required for determination ofthe profit in case of this method.
(i) Adj ustment for drawings. The proprietor may withdraw money from the business for his personal use. In the absence of any such withdrawal, the capital at the end of accounting period would have been more by the amount ofmoney withdrawn by him. Thus, the amount of drawings should be added back to the capital at the end of the accounting period to find out his true capital on that date.
(ii) Adjustment for capital introduced. The proprietor may introduce further capital in the business during the course of the accounting year. This will increase the capital of the proprietor at the end of the accounting year. It is, therefore, necessary to reduce the amount of capital by the amount of capital introduced by the proprietor during the year in order to ascertain the real increase in the capital of the proprietor on account of profit earned by him during the course of the accounting year.
Manufacturing Account
MANUFACTURING ACCOUNT
In the preceding pages, we have explained the preparation of the Trading and Profit and Loss Account from the point of view of a trader, i.e., a person who purchases and sells goods. However, a person may manufacture goods by himself for selling them at a profit. In case of such a person, i.e., a manufacturer, it will be necessary to ascertain the cost of manufacturing the goods. In his case, therefore, the profit or loss made by him will be ascertained by preparing the following three accounts:
(i) Manufacturing account This account gives the cost of the goods manufactured by a manufacturer during a particular period.
(ii) Trading account This account gives information about the gross profit or loss made by a manufacturer in selling the manufactured goods. In case a manufacturer also functions as a trader, i.e., besides manufacturing and selling goods of his own, he also purchases arid sells goods of others, he will be a manufacturer-curn-tracler. In such a case, his Trading Account will disclose not only the profit made by him on selling his manufactured goods, but also the profit made by him in selling the goods purchased by him from others.
(iii) Profit and loss account This account gives the overall profit or loss made or suffered by the manufacturer of manufacturer—cum—trader during a particular period.
Capital Expenditure and Revenue Expenditure
Capital transactions
Capital expenditure is expenditure on non-current assets, and capital receipts would result from the disposal of those assets. Other transactions that are regarded as capital transactions are the obtaining of and repayment of non-current finance. Capital transactions initially affect the figures in the balance sheet. Capital transactions are those that affect the organisation in the long term, as well as in the current period
Capital expenditure is the expenditure incurred for acquisition of assets the benefits of which are enjoyed over the years. The benefits of revenue expenditures are exhausted in the year of incurrence. Thus it is seen that utilisation of business capital is made for two distinct purposes:
1) Expenses yielding benefits over the years termed – capital expenditure.
2) Expenditures yielding benefits during the current accounting year – termed as revenue expenditure
Suppose a company incurred an expenditure of Rs. 100000 for advertisement before marketing of a new product
Revenue transactions
Revenue transactions are those that affect the organisation in the current period. Revenue receipts come from sales, and sometimes in the form of income from investments. Revenue expenditure is expenditure on items that are consumed in the period, for example the running expenses of the organisation, cost of sales, etc. Revenue transactions affect the figures in the income statement.
Examples for Capital Expenditure and Revenue Expenditure
Example 1:
An agricultural land was purchased for a mill was Rs. 1,00,000. Rs. 1 0 000 was paid for land revenue.
Solution :
Cost of land amounting to Rs. 1 00 000 will be treated as Capital Expenditure and Land revenue of Rs. 10 000 will be treated as Revenue Expenditure.
Example 2:
Rs. 50,000 was spent on advertising for the introduction of a new product in the market,the benefit of the market which will be divided for four years.
Solution :
Rs. 50,000 spent on advertising is to be treated as deferred revenue expenditure considering the benefit attributable for four years to come Rs. 12,500 is to be written off every year.
Example 3:
Rs. 10,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the plaintiff. The suit was not successful.
Solution :
Rs. 10,000 incurred for defending the title to the firm’s assets is a revenue expenditure. If, however any expenditure incurred for rectifying the title is a capital expenditure.
Joint venture Accounting – Accounting Records
ACCOUNTING RECORDS
There are three vays in which Joint Venture Accounts can be kept. The)’ are as follows:
I. When Separate Set ofBooks for the venture are maintained. This will be necessary when venture is of a large magnitude.
2. When One Venturer keeps the accounts, In this case entire work is entrusted to one of the venturers and the rest simply contribute their share of investment and place it at the disposal of the working venturer.
3. When All Venturers keep accounts, Where venture is not of such magnitude as to warrant a distinct set of books being kept, each venturer will record only such transactions as directly concern him.
In the following pages each of these methods, has been discussed in detail.
WHEN SEPARATE SET OF BOOKS ARE MAINTAINED
Where a complete set of books are maintained for the Joint Venture, following accounts are opened: (i) Joint Bank Account (II) Joint Venture Account (iii) Personal accounts of each Venturer.
In this method parties first pay their contribution tojoint funds in the Joint Bank Account and their payments on joint account are made out of Joint Bank Account.
Joint Venture Account is of the nature of an ordinary Trading and Profit & Loss Account.
It is debited with goods purchased, and expenses incurred) while credited with the sales made. It’s balance shows the profit or loss incurred on the joint venture.
Personal account of each venturer is also opened. It is credited with the amount of contribution made by him tothejoint funds and his share ofprofit(and debited in case of loss).
Accounting Concepts – Business Entity Concept
Business Entity Concept: According to this concept, business is treated as an entity separate from its owners, creditors, managers and others. All transactions of the business are recorded in the books of the business from the point of view of the business. Transactions are also recorded between the owner and the firm, for instance, when capital is provided by the owner, the accounting record will show the firm as having received so much money and as owing to the proprietor, means the enterprise is liable to the owner for capital investment made by the owner. Since the owner invested capital, which is also called risk capital he has claim on the profit of the enterprise.
The failure to recognize the business as a separate accounting entity would make it extremely difficult to evaluate the performance of the business since the private transactions would get mixed. The overall effect of adopting this concept is:
— Only the business transactions are recorded and reported and not the personal transactions of the owners.
— Income or profit is the property of the business unless distributed among the owners.
— The personal assets of the owners or shareholders are not considered while recording and reporting the assets of the business entity.
Preparing the Balance Sheet
Preparing the balance sheet
The Balance Sheet is a statement which sets out the Assets and Liabilities as on a certain date. It is prepared with a view to measure the true financial position at a particular point of time. The Balance Sheet has the following form.
The balance sheet shows the assets, liabilities and capital that exist at the date at which it is drawn up. It will includeallthe ledger accounts that have balances on them.
It should be noted that the balance sheet is not an ‘account’. Its name is not the balance sheet ‘account’ and it is not part of the double-entry bookkeeping system. The balance sheet, as its name implies, is a list of all the balances in the ledger accounts.
A Balance Sheet has the following characteristics:
a) It is prepared at a particular date and not for a period.
b) it is prepared only after preparation of the Trading and Profit & Loss A/c. Without
the Profit & Loss A/c it will not give the financial position of the firm adequately.
c ) Capital is equal to the difference of assets and liabilities. Therefore the two sides of the balance sheet must have the same totals otherwise it is an indication of the presence of errors.
d) It is not an account but only a statement of assets and liabilities..
e) The balance sheet shows the financial position of a business at going concern concept.
Rectification of Errors – Suspense Account
When a trial balance does not agree efforts are made to locate errors and rectify them. However, if reason for disagreement of trail balance cannot be found, a new account called suspense account is opened in order to give trial balance an appearance of agreement. Then final accounts are prepared. Debit balance in suspense account is shown on assets side while credit balance is recorded on liabilities side.
A suspense account is opened in two instances i.e.
(i) To balance a disagreed trial balance — In the trial balance, if the debits are short the difference has to be debited to Suspense Account and if the credits are short, Suspense Account has to be credited to make trial balance agree apparently. Thus trial balance is tallied and final accounts are prepared. Later when errors are detected, the rectifying entries are passed. The suspense account will show balance until all entries are corrected. When all errors affecting the trial balance have been rectified by means of journal entries, the Suspense Account will show no balance.
(ii) To post uncertain items: Sometimes, an item cannot be posted to the correct account because of lack of information. In this case, all the errors are rectified by means of journal entries opening suspense account. Thus, suspense account is opened and is given the debit or credit as the case may be. When debit is short of credit, the difference is debited to Suspense Account making the debits equal to the credits. Similarly, if in a rectifying journal entry, credit is otherwise short of debit, the difference is credited to suspense Account. ‘Ltrer when error’s are detected, the rectifying entries are passed.
Accounting Equation
ACCOUNTING EQUATION
All business transactions are recorded as having a dual aspect. The proprietor of the business brings capital into the business out of which the business (a separate entity) purchases assets for its use. Thus, the amount of the assets of a business is equal to the amount of capital contributed by the proprietor of the business.
Thus, Capital = Assets.
In case the capital contributed by the proprietor is insufficient, the business takes borrowing from other parties or outsiders. These parties may give loan or allow credit facilities at the time of purchase of goods. The money which is owed to outsiders and which has to be paid, sooner or latter are called liabilities. For example: Loans, Bank Overdraft, Creditors, Bills Payable, and Outstanding Expenses etc. On the one hand, the loan given by the outside parties increases the assets of the business, on the other hand, claims of creditors and lender of money on the assets of the business increase.
Hence, the sum of resources (assets) = obligations (capital + liabilities)
Therefore, Capital + Liabilities = Assets; or
Capital = Assets — Liabilities.
This equation is known as accounting equation. This equation is based on the concept that for every debit, there is an equivalent credit. The entire system of double entry book-keeping is based on this concept.
This statement is always true no matter what transactions the business undertakes. Any transaction that increases or decreases the assets of the business must increase or decrease its liabilities by an identical amount.