The Accounting Process Final Class

8/13/2019 The Accounting Process Final Class

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Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies

University of Delhi, Delhi 110007. No part of this document can be produced or published

without her consent.

The Accounting Process: A Case StudySunil Bakshi is a business school graduate. He has always been interested in computers and

wants to start his own hardware business. As he passed out of the business school, hisgrandfather funded him Rs 2,00,000 to start his own business. He decided to start a computer

parts business and named his firm Sunil Computer Mart.

His memory of elementary accounting taken during the first term was somewhat shaky, but he

knew that he would need accounting information to manage his business. He remembered the

accounting equation (Assets = Liabilities + Owners Equity) and that it always should balance.

First Week:During the first week, his diary contained the following items:

Event (1)

1st

January

Opened a bank account in business name and transferred Rs 1,00,000 into

it.

Event (2)

02/ 01

Took a shop on rent in Nehru Place from a person known to his father

Event (3)02/ 01

Gave Rs 10,000 to the shop owner, representing first months rent (Rs5000) and one months security deposit.

Event (4)05/ 01

Spent Rs 500 on cleaning and fixing up the interior of the store.

Event (5)06/ 01

Met a long lost friend, who incidentally was in the same business andoffered to partner in the business. Sunil said he would decide about it later

At the end of the week he recorded the effects of these events on the accounting equation as

follows:

Sunil Computer Mart

Financial Position Statement as on the end of first weekOwners Equity +Liabilities

Rs. Assets Rs.

ShareholdersEquity + 1,00,000 (1)

- 500 (4)

Liabilities Cash + 1,00,000 (1)

- 10,000 (3)

- 500 (4)

Prepaid Rent + 5,000 (3)

Security Deposit + 5,000 (3)

Figures in brackets indicate the event number that the entry refers to.

Note that the events (2) and (5) have had no effect on Sunils statement. They did not change the

financial position of his business. Taking a shop on rent will have no effect till the time the shop

is given to Sunil in usable condition. Sunil was not obliged to take his friend as a partner, his


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friend will become partner only when Sunil decides to share his resources with him and the

partner brings additional resources to work with Sunil.

Also note how Sunil recorded the effect of events (1), (2) and (3) and the reasoning behind such

recordings:

Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has

invested this money into the business. Therefore, it is also reflected inowners equity, which represents Sunils share of the business.

Effect of (3) Gave Rs 10,000 to the shop owner, representing first months rent (Rs5000) and one months rent as security deposit (Rs 5,000). This means

that the cash goes down by Rs 10,000. One asset (cash) has merely been

exchanged for other two (prepaid rent & security deposit). Prepaid rent

means the rent paid in advance whose benefit is yet to be taken. Totalassets did not change and therefore, total liabilities did not change either.

Effect of (4) Spent Rs 500 on cleaning and fixing up the interior of the store. Clearly

cash must have been given to pay for it. Although future benefits orfuture cost savings could result from this, the benefits are too uncertain

from this intangible asset. With no visible asset increasing and cashreduced by Rs 500, the effect has to be either on liabilities or owners

equity. Liabilities are not increasing; therefore the owners equity has to

decrease by this amount to maintain the balance. Remember we talked

about expenses reducing owners equity. This is a perfect example.

Second Week:

Starting with the second week, Sunil started recording only those events that materially affectedhis firms financial position. The events recorded during the second week are:

Event (6)

07/ 01

Various parts of the computers costing Rs 30,000 were purchased from a

wholesale supplier.

Event (7)

08/ 01

Other supplies like stationary, packing material, covers, etc. for use in the

business was also purchased. Rs 2,000 cash was paid for it.

Event (8)

09/ 01

One used display counter and one used computer & printer was purchased

for Rs 25,000. Rs 5,000 cash was paid and the rest was payable after threemonths with 18 per cent annual interest.

Try and record the above events in the financial position format given above on a separate piece

of paper. Then match your statement with the one given below:

Sunil Computer MartFinancial Position changes in the second week

Owners Equity +

Liabilities

Rs. Assets Rs.


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Shareholders EquityEquipment + 25,000 (8)

Liabilities

Accounts Payable + 30,000 (6) Cash - 2,000 (7)

- 5,000 (8)

Loan Payable + 20,000 (8)

Inventory

Supplies

+ 30,000 (6)

+ 2,000 (7)

Note that the effect of each event is recorded separately. Also, we have not included the figuresof the first weeks events shown above so as to clearly bring out the effect of the transactions and

we are not accumulating the various effects. Another point that should be noted is that certain

increases and decreases in the owners equity are separately identified and recorded for incomemeasurement purposes but at this moment let us only record the changes in owners equity. We

will see later how to use this information to draw up an income statement.

Effect of (6) Assets (inventory) increase by Rs 30,000. Inventory is the term given to

goods and material in hand, which is either ready for sale or will be

manufactured for sale to customers. The corresponding effect is felt on theliabilities (accounts payable), which also increase by Rs 30,000. Accounts

payable is term given to liabilities that represent obligations to the

creditors for goods and services purchased.

Effect of (7) A simple exchange of assets where supplies increase by Rs 2,000 and cash

decreases by Rs 2,000.

Effect of (8) Assets (equipment) increase by Rs 25,000. There are two corresponding

entries; one that affects cash and other one affects loan payable. Cashdecreases by Rs 5,000 and loan payable increases by Rs 20,000.

Third Week:Sunil was now ready to do business and he opened his shop at the start of the third week. On

advice of other businesspersons, he adopted the following policies:

a) All sales of the computer parts would be on cash and carry basis.b) When he will provide extra services like assembling a computer, etc. he would charge extra

for his time and send a bill (invoice) to the customer.

c) As the sales of the parts would be for cash only, he would not attempt to record the outflowof parts (inventory) sold to the customers. He would only record the cash coming in as sales

and accounts receivables based on the invoices written. Accounts receivables could be

defined as an asset representing claims against customers for goods or services sold onaccount.

The events recorded during the third week are:

Event (9) Total sales for the week was Rs 9,600.


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15/ 01

Event (10)

15/ 0122/

01

Total invoices for assembling and servicing (credit sales) for the week

were Rs 2,200.

Event (11)

18/ 01

Quantities of small screws, wires, switches and connectors costing Rs

5,000 were purchased on account as customers were asking for them alongwith the computer parts.

Try and record the above events in the format given above on a separate piece of paper. Then

match your statement with the statement given below:

Sunil Computer Mart

Financial position changes in the third weekOwners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity+ 9,600 (9)

+ 2,200 (10)

Cash + 9,600 (9)

Liabilities Inventory + 5,000 (11)

Accounts Payable + 5,000 (11) Accounts

Receivables

+ 2,200 (10)

Effect of (9) Cash (Assets) increased by Rs 9,600. There was no other effect on the

assets (as it was decided to record the outflow of parts later). Liabilities

were not affected. Therefore, the owners equity increased by the amount

of revenues generated, i.e. Rs 9,600.Effect of (10) Accounts receivables (Assets) increased by Rs 2,200. Liabilities wereunchanged. Therefore, the same effect as in event (9) would be there.

Effect of (11) Inventory (Assets) increased by Rs 5,000. Accounts payable (liabilities)increased by Rs 5,000.

Fourth Week:The diary showed the following entries:

Event (12)

23/ 0130/01

Cash sales for the week were Rs 10,400.

Event (13)23/ 0130/

01

Credit sales for the week were Rs 2,800.

Event (14) Purchase of parts on account, cost Rs 4,000.


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25/ 01

Event (15)

23/ 0130/

01

Some of the customers previously invoiced paid Rs 1,500 on their

accounts.

Event (16)

28/ 01

Sunil paid the wholesaler Rs 25,000 on his account.

Try and record the above events in the financial position format given above on a separate piece

of paper. You would find that the effect of the events, (12), (13) and (14), is the same (although

with different rupee amounts) as the events (9), (10) and (11) respectively.

Sunil Computer Mart

Financial Position changes in the fourth weekOwners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity+ 10,400 (12)

+ 2,800 (13)

Cash + 10,400 (12)

+ 1,500 (15)- 25,000 (16)

Liabilities Inventory + 4,000 (14)

Accounts Payable + 4,000 (14)

- 25,000 (16)

Accounts Receivables + 2,800 (13)

- 1,500 (15)

Effect of (15) Collection of receivables means that cash has come in and the balance

shown against the accounts receivables reduces. This means that only the

asset side is affected.Effect of (16) The effect is just the opposite of the above transaction. Cash is used to

pay the accounts payable. Both the accounts payable and cash reduces bythe same amount.

We showed the financial position effect of each weeks events separately in order to focus on the

effect of each distinct event. The effect of all these events is cumulative. The financial position

statement below shows the effect of all events recorded in the dairy during the month thatchanged the firms financial position.

Sunil Computer Mart

Effect of First Months Events on the financial Position at the end of the monthOwners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity+ 1,00,000 (1)

- 500 (4)

+ 9,600 (9)

Cash +1,00,000 (1)

- 10,000 (3)

- 500 (4)


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+ 2,200 (10)

+ 10,400 (12)

+ 2,800 (13)

- 2,000 (7)

- 5,000 (8)

+ 9,600 (9)

+ 10,400 (12)

+ 1,500 (15)

- 25,000 (16)

Liabilities Equipment + 25,000 (8)

Loan Payable + 20,000 (8) Prepaid Rent + 5,000 (3)

Accounts Payable + 30,000 (6)

+ 5,000 (11)

+ 4,000 (14)

- 25,000 (16)

Inventory

Accounts Receivables

Supplies

+ 30,000 (6)

+ 5,000 (11)

+ 4,000 (14)

+ 2,200 (10)

+ 2,800 (13)

- 1,500 (15)

+ 2,000 (7)

Security Deposit + 5,000 (3)

Assume that you are in the position of Sunil Bakshi. As owner you would be interested to knowwhere the business stands today and whether you have made any profits from the business

transactions in the first month. From the transactions above compile a month-end financial

position (hint: add all the items under a particular category to get the closing balance). Checkyour results against the financial position given below.

Sunil Computer Mart

Financial position at the end of the month

Owners Equity +Liabilities

Rs. Assets Rs.

Shareholders Equity 1,24,500

Equipment 25,000

Liabilities Cash 79,000

Loan Payable 20,000 Inventory 39,000

Accounts Payable 14,000 Accounts Receivables 3,500

Total Liabilities 34,000Supplies

Prepaid Rent

Security Deposit

2,000

5,000

5,000

Total Liabilities +

Owners Equity

1,58,500 Total Assets 1,58,500


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Do you think that this statement accurately represents the firms financial position? Do you need

any more facts before you could complete the preparation of a proper month-end financial

position? Refer back to the accounting process. We have just taken all the balances in theindividual accounts and have not done any adjustments till now. For example, as we have not

taken any inventory and have recorded sales against it, a physical verification would be required

to know how much value of inventory has been sold out. This will also reduce the owners equityby a proportionate amount. Therefore, this unadjusted financial position statement can at bestserve as a starting point to reach the exact position at the end of the period. There are basically

four improperly recorded asset measurements in the above statement. Can you identify them?

Required Month-end Adjustments to Reach Final Financial Position Statement

The four improperly reported asset measurements concern inventory, supplies, prepaid rent and

equipment. We saw above why decrease in inventory is not properly recorded. To rectify thiserror, Sunil will have to count the items and their cost to find the actual value. In manual

accounting systems the inventory is physically verified at least once a year. For computerised

accounting systems, the inventory is automatically updated as the transactions take place, makingit easier to keep a track of the positions.

For the sake of ease, let us make some assumptions. The first assumption is of inventory. Let us

assume that physical verification resulted in Rs 28,500 worth of inventory and Rs 750 worth ofunused supplies at the end of the first month. Another assumption that we make is that the

equipment has a useful remaining life of four years and it can be sold for Rs 1000 at the end of

fourth year. What about the telephone & power costs incurred during the month? Neither bill hasarrived and therefore nothing was recorded in the dairy. Let us assume that Rs 1400 could be

earmarked for both the bills together. Sunil also owns the interest for the loan taken which would

be paid at the end of three months along with the loan amount. It works out to Rs 300 for one

month.

You now have all the necessary information to adjust the unadjusted financial position figures.

Try and do it before you proceed.

Adjustment (17)31/ 01

We assumed that Sunil found the total inventory to be worth Rs28,500 after verification. As the total amount of parts bought were

worth Rs 39,000 and there was no beginning inventory, a consumption

of inventory worth Rs 10,500 (i.e. Rs 39,000 28,500) has takenplace. Note that the consumption could be in any form: sales, stolen,

broken or perished. Inventory is therefore reduced by Rs 10,500 and as

no other asset or liability is involved, owners equity is also reduced

by the same amount.


Similarly, supplies and owners equity are both reduced by Rs 1,250each to record supplies used.


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Adjustment (19)

31/ 01

As the shop has already been used for one month, Rs 5,000 rent paid

in advance for the month ceases to be an asset and becomes anexpense. Therefore prepaid rent is reduced by this amount (which

now becomes zero) as also the owners equity to keep the balance as

no other asset or liability is affected.


As the usefulness of the asset is spread over four years and somefuture usefulness of the asset is used in the first month; some part of

the assets value should be shown as an expense. As the equipment

was bought for Rs 25,000 and the scrap value is Rs 1,000 at the end offour years; the question arises how to treat the loss in value. Whether

the loss in value should be treated as an expense in the first month

itself, over the life of the asset or at the end of the four years?

Logically the loss in value should be written off over the life of theasset as the asset is used gradually over its useful life. This means that

the cost of Rs 24,000 is best spread over four years. What should be

the per month cost to be written off? (Rs.500 per month which comesfrom Rs 24,000/4 = Rs 6,000 per year). This is known as depreciatingthe asset over its useful life. The accumulated depreciation is written

below the asset value and then the net asset value is shown.

Recording a depreciation of Rs 500 means that the asset value isreduced by that amount and to balance the owners equity is also

reduced by the same amount.

The point to be noted here is that inspite of being mentioned on the

asset side, the accumulated depreciation in effect reduces the asset

value when it increases in value. This type of account is called a

contra account.


The firm has an additional liability of Rs 1,400 for services performedby power & telephone companies and this must be added to accounts

payable as the company is liable to pay whenever the bills come.

There is no new asset as the services have already been consumed andtherefore the owners equity must reduce by this amount.

Adjustment (22)

31/ 01

Interest payable is a short-term liability as it is going to be paid after

three months when the money is returned but the amount has been

used for a month so the monthly cost (interest) has to be accounted for

a business expense. Owners equity decreases to balance, as there isno change in any other asset or a liability.

Note that all the six transactions reduced the amount of owners equity, which should now reflect

the true picture of the increases due to the business operations.


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Sunil Computer MartFinancial Statement changes due to month-end adjustments

Owners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity- 10,500 (17)

- 1,250 (18)

- 5,000 (19)

- 500 (20)

- 1,400 (21)

- 300 (22)

Accumulated

Depreciation on

Equipment

- 500 (20)

Liabilities

Accounts Payable

Interest Payable

+ 1,400 (21)

+ 300 (22)

Prepaid Rent

Supplies

Inventory

- 5,000 (19)

- 1,250 (18)

- 10,500 (17)

The financial position statement below gives the final position of Sunil Computer Mart as at end

of the month.

Sunil Computer Mart

Final financial position at the end of the monthOwners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity 1,05,550 Equipment 25,000Less Accumulated

Depreciation (500)

Net Equipment 24,500

Liabilities

Accounts Payable

Interest Payable

15,400

300

Cash

Inventory

79,000

28,500

Loan Payable

Total Liabilities

20,000

35,700


Supplies

Security Deposit

3,500

750

5,000

Owners Equity +

Liabilities

1,41,250 Total Assets 1,41,250


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So at the end of first month Sunils Rs 1,000,000 became Rs 1,05,550 i.e. an increase of Rs

5,550. Not bad considering that Sunil is new to the market and has only been operating for two

weeks.

How Accountants Do I t

So far we have tracking changes in the accounting equation only and this is great as far as

understanding the basic process goes, but the process that the accountants use (and discussed

before) is slightly different. Let us now glance back and see how the accountant would recordthese transactions.

Let us take three of the above mentioned events [(1), (4) and (6)] for illustration purposes.

Event (1)Event (1) Opened a bank account in business name and transferred Rs 1,00,000

into it.

Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has

invested this money into the business.

The dual-entry effect it is reflected in owners equity, which representsSunils share of the business.

Debit-Credit

Rules

Increases in assets (cash) are recorded by debits (remember!).

Increases in owners equity are recorded by credits. (Refer back to the

debit-credit rules if you have forgotten them)

Journal

EntryDr. Cr.

01/ 01 Cash Rs 1,00,000Owners Equity Rs 1,00,000

Entries in Ledger Accounts

Cash

31/ 12 Bal. Rs 0

01/ 01 Rs 1,00,000

Owners Equity

31/ 12 Bal. Rs 0

01/ 01 Rs 1,00,000

The first figure represents the closing balance of the last period. As there was no closing balance(can you tell why?) the starting balance is zero.


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Event (4)Event (4)

05/ 01

Spent Rs 500 on cleaning and fixing up the interior of the store.

Effect of (4) This is a business expense and therefore, should be recorded as such.Clearly cash must have been given to pay for it.

Debit-Credit

Rules

Decreases in assets (cash) are recorded by credits.

Expenses decrease owners equity and are recorded by debits.

Journal

EntryDr. Cr.

05/ 01 Maintenance Expense Rs 500Cash Rs 500


Cash

31/ 12 Bal. Rs 001/ 01 Rs 1,00,000

02/ 01 Rs 10,00005/ 01 Rs 500

Maintenance Expense

05/ 01 Rs 500

Can you explain the figure of Rs 10,000 in the cash account above? It comes from prepaid rent,event (3). Notice that in maintenance expense account no starting balance mentioned as the

expense accounts are started afresh every time a new accounting period starts.

If you remember when we recorded the effect of event (4) in the accounting equation above, we

simply decreased the owners equity. Accountants do not do that. For different types of revenueand expense activities, they open separate accounts so that it is easier for them to compile these

account figures into the financial statements.

Event (6)Event (6)07/ 01

Various parts of the computers costing Rs 30,000 were purchased from awholesale supplier

Effect of (6) Assets (inventory) increase by Rs 30,000.

The corresponding effect is felt on the liabilities (accounts payable)

which also increase by Rs 30,000.

Debit-Credit

Rules

Increases in assets (inventory) are recorded by debits.

Increases in liabilities (accounts payable) are recorded by credits.

Journal

EntryDr. Cr.

Date Inventory Rs 30,000

Accounts Payable Rs 30,000


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Inventory

31/ 12 Bal. Rs 007/ 01 Rs 30,000

Accounts Payable

07/ 01 Rs 30,000

Other events can also be recorded in the same manner. All this would result in accounts, whichwould show the balances as given in the trial balance given below:

Sunil Computer MartUnadjusted trial balance at the end of the month

Dr. Cr.

Shareholders Equity1,00,000

Loan Payable

Event (8)

20,000

Accounts Payable

Event (6), (11), (14) & (16)

14,000

Equipment

Event (8)

25,000

Cash

Event (1), (3), (4), (7), (8), (9),

(12), (15) & (16)

79,000

Inventory

Event (6), (11) & (14)

39,000


Event (10), (13) & (16)

3,500

Supplies

Event (7)

2,000

Prepaid Rent

Event (3)

5,000

Security Deposit

Event (3)

5,000

Cash Sales

Event (9) & (12)

20,000

Credit Sales

Event (10) & (13)

5,000

Maintenance Expense

Event (4)

500

Total

1,59,000 1,59,000


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Events mentioned below the account name are put in there to help you relate these figures to the

financial position and transactions. Accountants do not write them, they only write the account

name.

There are two points that you must note out here. The shareholders equity here does not show

the effect of revenues and expenses events, which are shown separately. For example, look at thecash sales and credit sales. If you club the both the sales figures into the shareholders equity andsubtract maintenance expenses you would get the same figure (Rs 1,24,500) as was reported in

the unadjusted financial position figure before. Many other items also have the same balance, but

note the different way of presentation. Accountants take the ending balances of accounts andwrite it on the respective sides of debit and credit.

This makes it easier for them to compile the figures later into the financial statements. Before we

go on and compile these figures into financial statements dont you think that we also need to dothe adjustments that we did before? Yes, we have to. Let us see how the above mentioned

adjustments are recorded in the trial balance. The adjustments are reproduced below for easier

reference. Why dont you try to do these adjustments in the trial balance yourself before taking alook at the final trial balance?

Adjustment (17)

31/ 01

We assumed that Sunil found the total inventory to be worth Rs

28,500 after verification. As the total amount of parts bought were

worth Rs 39,000 and there was no beginning inventory, a consumptionof inventory worth Rs 10,500 (i.e. Rs 39,000 28,500) has taken

place.

Inventory is therefore reduced by Rs 10,500, and Rs 10,500 is also

shown as inventory consumption.

Adjustment (18)31/ 01 Similarly, supplies are reduced by Rs 1,250 and Rs 1,250 is alsoshown as supplies consumption.

Adjustment (19)

31/ 01

As the shop has already been used for one month, Rs 5,000 rent paid

in advance for the month ceases to be an asset and becomes an

expense.Therefore prepaid rent is reduced by Rs 5,000 (which makes it zero),

which is also shown as the rent expense for the month.

Adjustment (20)

31/ 01

As the usefulness of the asset is spread over four years and some

future usefulness of the asset is used in the first month; some part of

the assets value should be shown as an expense.

This depreciation expense for the first month works out to Rs 500.

This would affect two accounts: accumulated depreciation account,which would increase by Rs 500 and depreciation expense account,

which would show an expense of Rs 500.


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Adjustment (21)

31/ 01

The firm has an additional liability of Rs 1,400 for services performed

by power & telephone companies and this must be added to accounts

payable as the company is liable to pay whenever the bills come.There is no new asset as the services have already been consumed and

therefore the owners equity must reduce by this amount.

Adjustment (22)

31/ 01

Interest payable is a short-term liability as it is going to be paid after

three months when the money is returned but the amount has beenused for a month so the monthly cost (interest) has to be accounted for

a business expense. Interest payable account is created to represent

unpaid interest.

Note that when we were making the adjustments in the financial position, all the six transactions

reduced the amount of owners equity. Here the effect is not on the owners equity as none of the

adjustments has resulted in the increase or decrease in it. All the changes due to theseadjustments have been italicised for easy understanding.

Sunil Computer Mart

Adjusted trial balance at the end of the monthDr. Cr.


Loan Payable

Event (8)

20,000

Accounts PayableEvent (6), (11), (14), (16) &

Adjustment (21)

15,400

Interest Payable

Adjustment (22)

300

Equipment

Event (8)

25,000

Accumulated Depreciation:

Equipment

Adjustment (20)

500

Cash

Event (1), (3), (4), (7), (8), (9),

(12), (15) & (16)

79,000

InventoryEvent (6), (11) & (14) &

Adjustment (17)

28,500


Event (10), (13) & (16)

3,500

Supplies

Event (7) &

750


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Adjustment (18)

Prepaid Rent

Event (3) &

Adjustment (19)

0

Security Deposit

Event (3)

5,000

Cash SalesEvent (9) & (12) 20,000

Credit Sales

Event (10) & (13)

5,000

Maintenance Expense

Event (4)

500

Inventory Consumed Expense

Adjustment (17)

10,500

Supplies Consumed Expense

Adjustment (18)

1,250

Rent Expense

Adjustment (19)

5,000

Depreciation Expense

Adjustment (20)

500

Power & Telephone Expense

Adjustment (21)

1,400

Interest Expense

Adjustment (22)

300

Total

1,61,200 1,61,200

Transforming Tr ial Balance I nformation into Financial Statements

Now we are ready to utilise the trial balance information for developing the financial statements.

Can you guess which of the accounts below will go into balance sheet and which ones will gointo the income statement? (Hint: The trial balance below shows some figures in bold and some

in Italics for ease of identification).

Sunil Computer Mart

Adjusted trial balance at the end of the month

Dr. Cr.


Loan Payable 20,000

Accounts Payable 15,400

Interest Payable 300

Equipment 25,000


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Accumulated Depreciation:

Equipment

500

Cash 79,000

Inventory 28,500

Accounts Receivables 3,500

Supplies 750

Security Deposit 5,000

Cash Sales 20,000

Credit Sales 5,000

Maintenance Expense 500

Inventory Consumed Expense 10,500

Supplies Consumed Expense 1,250

Rent Expense 5,000

Depreciation Expense 500

Power & Telephone Expense 1,400

Interest Expense 300

Total

1,61,200 1,61,200

As you would have guessed by now (I sincerely hope that you have) the accounts in bold would

go into the balance sheet and the accounts in italics would go into the income statement. Let us

first look at the income statement.

The Income StatementWe already know that Profit = Sales Expenses, now let us see which are the expense items for

Sunil Computer Mart.

Rs. 500 Spent on cleaning and fixing up the interior of the shop

10,500 Worth of inventory sold to the customers

1,250 Worth of supplies used

5,000 Worth of prepaid rent expired due to the end of the month

500 Depreciation charged on equipment


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1,400 Commitment to pay for power and telephone already used

300 Interest liability for the amount used for the month

Rs. 19,450 Total Expenses

Since total revenues (or sales) during the month was to the tune of Rs 25,000, the profit for the

month can be calculated by subtracting the above-mentioned amount of the expenses. It comesto Rs 5,550. The income statement that an accountant would draw up is shown below:

Sunil Computer Mart

Income Statement for the month of January

Revenue Rs.

Cash Sales 20,000

Credit Sales 5,000

Total Revenue 25,000

Less: Expenses

Raw Material & Supplies 11,750Maintenance Expense 500

Rent 5,000

Power & Telephone 1,400

Total Expenses 18,650

Gross Profit 6,350

Depreciation 500

Interest 300

Net Profit 5,550

Note that by taking the expenses, which are due but not yet paid, we are following theconservatism principle. Also by taking sales on credit for which the payment has not come in this

month, we are following the accrual system of accounting.

The Profit & Loss a/c shown above has certain limitations. Remember that the depreciation

expenses are based on estimates of the useful lives of the firms equipment. Also, the income

statement includes only those events thatare evidenced by business transactions. Perhaps, during the month Sunils shop has caught the

attention of many potential customers. A good customer base is certainly beneficial to Sunil in

the long run; however, it cannot be recorded, as it cannot be measured objectively until the actualtransactions take place.

Despite these limitations, income statement is of vital importance and indicates that the firm has

been profitable in the first month of operations. Alter-native titles for the income statementinclude earnings statement, profit & loss statement, etc. In India the term profit & loss account is

used. As internationally income statement is the most popular term we will continue to use this

term throughout the text.

The Balance Sheet


18/18




As you already know the balance sheet lists the amounts of owners equity, liabilities and assets

at the end of the accounting period. The balances of the owners equity, asset and liabilityaccounts are taken directly from the adjusted trial balance figures given above.

Sunil Computer MartBalance Sheet as on 31stJanuary

Owners Equity +

Liabilities

Rs. Assets Rs.

Shareholders Equity 1,00,000 Fixed Assets

Reserves & Surplus 5,550 Gross Block

Less Accumulated

Depreciation

Net Block

25,000

(500)

24,500

Liabilities

Accounts Payable

Interest Payable

15,400

300

Current Assets

Cash

Inventory

79,000

28,500

Loan Payable

Total Liabilities

20,000

35,700


Supplies

Security Deposit

3,500

750

5,000

Total Owners Equity+

Liabilities

1,41,250 Total Assets 1,41,250

The balance sheet has a striking resemblance to the final financial position that we made using

the accounting equation. This had to be as the accounting equation represents the balance sheet.There are two things that need explanation here: 1) Reserves & Surplus and 2) Bifurcation of

Assets into fixed and current. Reserves & Surplus represent the earnings that accumulate in the

owners account. One of the several entries in it comes from the income statement . Can you tellme which figure from the income statement comes here? Simply looking at the figures you can

guess that it is the net profit figure that gets added up in the Reserves & Surplus Account. As the

opening balance was zero and there were no other entries, it is the only figure that is shown here.

Assets are bifurcated into fixed and current. Current assets represent those assets that will be

quickly converted to cash or used up in operations. Current assets include cash, marketable

securities, accounts receivables, inventory, etc. Fixed assets are those assets, which are not meantto be sold or converted into finished products themselves, but are used for business operations.

The Accounting Process Final Class

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