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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.
Adjustment (18)31/ 01
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.
Adjustment (20)31/ 01
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.
Adjustment (21)31/ 01
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
Accounts Receivables
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
Entries in Ledger Accounts
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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Entries in Ledger Accounts
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
Accounts Receivables
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.
Shareholders Equity 1,00,000
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
Accounts Receivables
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.
Shareholders Equity 1,00,000
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
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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
Accounts Receivables
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.