Lessn-5 ACCOUNTING CYCLE/PROCESS (Cntinued) Preparing Balance Sheet frm Trial Balance: We have assumed that the first mnth i.e. July was taken up in setting up f the business and n business activity as such tk place in this mnth. It means there were n Revenues & Expenses and hence n Incme Statement. Preparing Balance Sheet frm Trial balance: invlves re-arranging f items r Accunts in the Trial Balance. What is dne is that Assets are taken n the left side and liabilities and wner s equity n the right. This is the Accunt Frm f Balance Sheet. Alternate frm is Reprt Frm in which Assets are written abve and liabilities and wner s equity are written belw. Assets Balance Sheet Khizr Prperty dealer Fr the mnth f July 2006 Liabilities & Owner's Equity Cash 22,500 Accunts Payable 23,400 Accunts Receivable 9,500 Khizr, Capital (wner s equity) 180,000 Land 130,000 Building 36,000 Office Equipment 5,400 Ttal 203,400 Ttal 203,400 It is t be seen that each f the 7 transactins during July, changed the Accunting Equatin, and hence each gave rise t new balance sheet. The questin may arise as t why make jurnal & ledger entries. The answer is that we have t have reasnable time-perid at the end f which balance sheet may be prepared. This time-perid is Accunting Perid which is usually ne year. And during this perid individual transactins ccurring daily are jurnalized and ledgerised i.e. psted in ledgers. Assets are ecnmic resurces that are wned by a business and are expected t benefit future peratins. In mst cases, the benefit t future peratins cmes in the frm f psitive future cash flws. The psitive future cash flws may cme directly as the asset is cnverted int cash (cllectin f a receivables) r indirectly as the asset is used in perating the business t create ther assets that result in psitive future cash flws (building & land used t manufacture a prduct fr sale). Assets may have definite physical frm such as building, machinery r stck. On the ther hand, sme assets exist nt in physical r tangible frm, but in the frm f valuable legal claims r right. Examples are accunts receivables, investment in gvt. bnds and patent rights etc. Liabilities are debts and bligatins f the business. The persn r rganizatin t which the debt is wed is called creditrs. All businesses have liabilities; even the mst successful cmpanies purchase stcks, supplies and receive services n credit. The liabilities arising frm such purchases are called Accunts payable. Cpyright Virtual University f Pakistan 18
Lessn-5 Rule f Debit and Credit fr Assets and Liabilities Assets (increase in assets is debit and decrease in asset is credit) Liabilities (Increase in liability is credit and decrease in liability is debit) Classificatin f Assets: There are tw types f assets: 1. Tangible Assets which have physical existence and can be seen r tuched. It includes Fixed as well as Current assets. 2. Intangible assets which have n physical existence like gdwill, patents and cpyrights etc. Fixed Assets Are the assets f permanent nature that a business acquires, such as plant, machinery, building, furniture, vehicles etc. Fixed assets are subject t depreciatin. Lng Term Assets These are the assets f the business that are receivable after twelve mnths f the balance sheet date. Fr example, if business has invested sme mney fr tw years in any saving scheme r has purchased saving certificates fr mre than ne year, it is a lng term asset. Current Assets Are the receivables that are expected t be received within ne year f the balance sheet date. Debtrs, clsing stck & all accrued incmes are the examples f Current Assets because these are expected t be received within ne accunting perid frm the balance sheet date. The year, in which lng term asset is expected t be received, lng term asset is transferred t current assets in that year. Classificatin f Liabilities Capital is the funds invested by the wners f the business. Business has a liability t return these funds t the wner. We knw that fr the purpse f accunting, business is treated separately frm its wners. This is knwn as Separate Entity Cncept i.e. Business is a separate entity. Therefre, if the wner gives smething (can be in frm f Cash r Sme ther Asset) t the business then the business, nt nly has t return the amunt t the wner but it als has t give sme return n that mney. That is why we treat Capital (Owners Funds) as a Liability. Prfit & Lss Accunt The net balance f the prfit and lss accunt i.e. either prfit r lss als belngs t the wners. While explaining capital we said that the business has t give return t the wners. Nw if the business is managed successfully, then this return wuld be a Favrable figure (Prfit). This return will, therefre, be added t the Owners investment. On the ther hand, if the business is nt managed successfully then this return wuld be an unfavrable figure (Lss). It will, therefre, be deducted frm the Owners Investment. Lng Term Liabilities These are the liabilities that will becme payable after a perid f mre than ne year f the balance sheet date. Fr example, if business has Cpyright Virtual University f Pakistan 19
Lessn-5 taken a lan frm bank r any third persn and it is payable after three years, it will be treated as a lng term liability fr the business. Current Liabilities These are the bligatins f the business that are payable within twelve mnths f the balance sheet date. Creditrs and all accrued expenses are the examples f current liabilities f the business because business is expected t pay these back within ne accunting perid. The year in which lng term liability is t be paid back, lng term liability is transferred t current liability in that year. Balance Sheet It is a psitin statement that shws the standing f the rganizatin in Mnetary Terms at a Specific Time. Unlike Prfit and Lss that shws the perfrmance f the entity ver a perid f time, the Balance Sheet shws the Financial State f Affairs f the entity at a given date. Balance sheet is the summarized analysis in a T frm f all assets and liabilities f the entity, with liabilities listed n left hand side and assets n right hand side. Asset is any wned physical bject (tangible asset) r a right (intangible asset) having ecnmic value t the wner. Liability is an bligatin f the business t deliver gds r t prvide a benefit in future. Frmat f Balance Sheet (Accunt Frm) Name f the Entity Balance Sheet As At------- Liabilities Capital 100000 Add Prfit and lss Accunt 15000 Amunt 115000 50000 Assets Fixes Assets Lng Term Assets Current assets Amunt 75000 20000 80000 Lng Term Liabilities 10000 Current liabilities Ttal 175000 Ttal 175000 Cpyright Virtual University f Pakistan 20
Lessn-5 Frmat f Balance Sheet (Reprt Frm) Name f the Entity Balance Sheet As At------- PARTICULARS ASSETS Fixes Assets Lng Term Assets Current Assets Amunt Amunt 75000 20000 80000 Ttal 175000 LIABILITIES Capital Prfit 100000 15000 115000 Lng Term Liabilities 50000 Current Liabilities 10000 Ttal 175000 Illustratin # 1 The fllwing is the Trial Balance extracted frm the bks f Naeem & Sns as n 30/06/2007. Prepare a prfit & lss accunt & balance sheet fr the year ended June 30, 2007. Particulars Dr. Cr. Sales 100,000 Purchases 45,000 purchase return 3,000 Salaries 12,000 Rent 5,000 Debtrs 25,000 Creditrs 16,000 Capital 368,000 Plant & machinery 400,000 Grand Ttal 487,000 487,000 Financial Statements Different reprts generated frm the bks f accunts t prvide infrmatin t the relevant persns. Every business is carried ut t make prfit. If it is nt run successfully, it will sustain lss. The calculatin f such prfit & lss is prbably the mst imprtant bjective f the accunting functin. Such infrmatin is acquired frm Financial Statements. Cpyright Virtual University f Pakistan 21
Lessn-5 Financial Statements are the end prduct f the whle accunting prcess. These shw us the prfitability f the business cncern and the financial psitin f the entity at a specified date. The mst cmmnly used Financial Statements are prfit & lss accunt balance sheet & cash flw statement. Incme & Expenditure Vs Prfit & Lss Accunt Incme and Expenditure Accunt is used fr Nn-Prfit Organizatins like Trusts, NGOs while Prfit and Lss Accunt is used fr Cmmercial rganizatins like limited cmpanies. Prfit & Lss Accunt Prfit & Lss accunt is an accunt that summarizes the prfitability f the rganizatin fr a specific accunting perid. Prfit & Lss accunt has tw parts: First part is called Trading accunt in which Grss Prfit is calculated. Grss prfit is the excess f sales ver cst f gds sld in an accunting perid. In trading cncern, cst f gds sld is the cst f gds cnsumed plus any ther charge paid in bringing the gds in salable cnditin. Fr example, if business purchased certain items fr resale purpse and any expense is paid in respect f carriage r bringing the gds in stre (transprtatin charges). These will als be gruped under the heading f cst f gds sld and will becme part f its price. In manufacturing cncern, cst f gds sld cmprises f purchase f raw material plus wages paid t staff emplyed fr cnverting this raw material int finished gds plus any ther expense in this cnnectin. 2 nd part is called Prfit & Lss accunt in which Net Prfit is calculated. Net Prfit is what is left f the grss prfit after deducting all ther expenses f the rganizatin in a specific time perid. Hw t prepare Prfit & Lss Accunt? One way is t write dwn all the Debit and Credit entries f Incme and Expense accunts in the Prfit and Lss Accunt. But it is nt sensible t d s. The ther way is that we calculate the net balance r we can say Clsing Balance f each incme and expense accunt. Then we nte all the credit balances n the credit side and all the debit balances n the debit f prfit and lss accunt. If the net balance f prfit and lss is Credit (credit side is greater than debit side) it is Prfit and if the net balance is Debit (Debit side is greater than credit side) it is a lss. Incme, Expenditure, And Prfit & Lss Incme is the value f gds and services earned frm the peratin f the business. It includes bth cash & credit. Fr example, if a business entity deals in garments. What it earns frm the sale f garments, is its incme. If smebdy is rendering services, what he earned frm rendering services is his incme. Expenses are the resurces and the effrts made t earn the incme, translated in mnetary terms. It includes bth expenses, i.e., paid and t be paid (payable). Cnsider the abve mentined example, if any sum is spent in running the garments business effectively r in prvisin f services, is termed as expense. Cpyright Virtual University f Pakistan 22
Lessn-5 Prfit is the excess f incme ver expenses in a specified accunting perid. Prfit= Incme-expenses In the abve mentined example, if the business r the services prvider earn 100,000 & their expenses are 75,000. Their prfit will be 25,000 (100,000-75,000). Lss is the excess f expenses ver incme in a specified perid f time. In the abve example, if their expenses are 100,000 & their incme is 75,000. Their lss will be 25,000. Rules f Debit & Credit Increase in expense is Debit (Dr.) Decrease in expense is credit (Cr.) Increase in incme is credit (Cr.) Decrease in incme is Debit (Dr.) Classificatin f Expenses It has already been mentined that a separate accunt is pened fr each type f expense. Therefre, in large business cncerns, there may be a large number f accunts in rganizatin s bks. As prfit & lss accunt is a summarized recrd f the prfitability f the rganizatin. S, similar accunts shuld be gruped fr reprting purpses. The mst cmmnly used grupings f expenses are as fllws: Cst f gds sld Administratin expenses Selling expenses Financial expenses Cst f gds sld (CGS) is the cst incurred in purchasing r manufacturing the prduct, which an rganizatin is selling plus any ther expense incurred in bringing the prduct in saleable cnditin. Cst f gds sld cntains the fllwing heads f accunts: Purchase f raw material/gds Wages paid t emplyees fr manufacturing f gds Any tax/freight is paid n purchases Any expense incurred n carriage/transprtatin f purchased items. Administrative expenses are the expenses incurred in running a business effectively. Main cmpnents f this grup are: Payment f utility bills Payment f rent Salaries f emplyees General ffice expenses Repair & maintenance f ffice equipment & vehicles. Selling expenses are the expenses incurred directly in cnnectin with the sale f gds. This head cntains: Transprtatin/carriage f gds sld Cpyright Virtual University f Pakistan 23
Lessn-5 Tax/freight paid n sale If the expense head salaries includes salaries f sales staff then it will be excluded frm salaries & appear under the heading f selling expenses. Financial expenses are the interest paid n bank lan & charges deducted by bank n entity s bank accunts. It includes: Mark up n lan Bank charges Receipt & Payment Accunt A receipt & payment accunt is the summarized recrd f actual cash receipts and actual cash payment f the rganizatin fr a given perid f time. This is a reprt that prvides cash mvement during the reprted perid. In ther wrds, it can be defined as the summarized recrd f the cash bk fr a specific perid. Receipt & Payment Vs Prfit & Lss Accunt Receipt & payment accunt is the summarized recrd f actual cash receipts and actual cash payment during the perid while prfit & lss accunt als includes Receivable and Payable. Incme & Expenditure Vs Prfit & Lss Accunt These are tw similar terms. Only difference between these tw terms is that incme & expenditure accunt is prepared fr nn prfit riented rganizatins, e.g. Trusts, NGO s, whereas prfit & lss accunt is prepared in prfit riented rganizatins, e.g. Limited cmpanies, Partnership firms etc. In case f Incme and Expenditure accunt, Surplus/Deficit is t be find and in case f Prfit and lss accunt, prfit r lss is t be fund. A sample f Prfit and Lss Accunt Grss prfit c/d 40,000 Name f the Entity (Incme cst f sales) Prfit and Lss Accunt Ttal Fr 100,000 the perid Ending Ttal ---- 100,000 Admin DEBIT expenses 15,000 CREDIT Grss prfit b/d 40,000 Selling PARTICULARS expenses AMOUNT 5,000 PARTICULARS AMOUNT Financial expenses 5,000 Cst f sale 60,000 Incme 100,000 Cpyright Virtual University f Pakistan 24
Lessn-5 Net prfit (Grss prfit expenses) Calculatins f Grss prfit and Net prfit Grss prfit = Incme cst f sales = 100000-60000 = 40000 Net prfit = Grss prfit Expenses = 40000 (15000+ 5000+5000) = 15000 A sample f Incme Statement PARTICULARS Incme/Sales/Revenue Less: Cst f sales Grss prfit Less: Administratin expenses Selling expenses Financial expenses Name f the Entity Incme statement Fr the perid Ending ---- AMOUNT AMOUNT Rs 100000 (60000) 40000 15000 5000 5000 (25000) Net prfit 15000 Recgnitin f Incme and Expenditure Accunt: Incme shuld be recgnized / recrded at the time when gds are sld r services are rendered. Expenses shuld be recgnized / recrded when benefit relating t that expense has been drawn. Incme Statement and Net Incme Incme Statement summarizes perating results f a business by matching revenues with expenses ver the same accunting perid. Net incme is the increase in wner s equity resulting frm prfitable peratins f a business. This is accmpanied by increase in ttal assets, (but nt necessarily cash) r decrease in ttal liabilities. It may happen that a prfitable business may als run shrt f cash, because the prfit that it earns is tied up in ther assets i.e. Accunts Receivables, fixed assets etc r else, it was used in paying ut its bligatins like Accunts Payable etc. Net lss is the crrespnding decrease in wner s equity. Elements f Incme Statement 15,000 Ttal 40,000 Ttal 40,000 Revenues: This is defined as sale price f gds sld and services rendered during an accunting perid. Cpyright Virtual University f Pakistan 25
Lessn-5 Expenses: These cnstitute Cst t the business f the gds and services used in business peratins during the same accunting perid. In ther wrds, these are cst f ding business. Just as in Balance Sheet we have sub-elements r sub-accunts, in Incme Statement als there are sub-elements/sub-accunts i.e. difference surces f Revenues, different expenses like cst f gd sld, depreciatin expenses, interest expense etc. Accrual Basis f Revenue & Expense Accunting Revenue Recrding is dne n Realizatin Principle. In this case, the date f rendering services r date f delivery f gd sld is cnsidered as the date f earning revenue. Fr example, if services are rendered in January and actual receipt f revenue/fee takes place in February i.e. after ne mnth as per agreement, still the revenue wuld be recrded in the mnth f January since it was earned in January. Expense Recrding is dne n matching principle. This means that revenues are ffset by all expenses incurred in prducing thse revenues, pertaining t a particular accunting perid. It wuld thus be seen that there is cause-and-effect relatinship between revenues and expenses. Fr example, June salaries are paid in July but these have t be recrded as salaries expense fr June. It must als be nted that Revenue & cash Receipts and Expense & cash payments are different. The tw can happen befre, after r during the accunting perid. Dr. & Cr. Rules fr Recrding Revenues and Expenses are the same as thse fr Owner s equity r Capital Accunt. Expenses are the csts f the gds and services used up in the prcess f earning revenue. Examples include the cst f emplyee s salaries, advertising, rent, utilities, and the gradual wearing-ut (depreciatin) f such assets as buildings, autmbiles, and ffice equipment. All these csts are necessary t attract and serve custmers and here by earn revenue. Expenses are ften called the csts f ding business that is, the cst f the varius activities necessary t carry n a business. An expense always causes a decrease in wner s equity. The related changes in the accunting equatin can be either (1) a decrease in assets, r (2) an increase in liabilities. An expense reduces assets if payment ccurs at the time that the expense is incurred. If the expense will nt be paid until later, as fr example, the purchase f advertising services n accunt, the recrding f the expense will be accmpanied by an increase in liabilities. Cpyright Virtual University f Pakistan 26