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MGT101 - Financial Accounting - I - Lecture Handout 12

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THE ACCOUNTING EQUATION

Resources in the business = Resources supplied by the owner

In accounting, terms are used to describe things. The amount of resources supplied by the owner is called capital. The actual resources which are in the business are called assets. This means that the accounting equation above, when the owner has supplied all the resources, can be shown as:

Assets = Capital

Usually, people, other than the owner has supplied some of the assets. Liabilities are the name given to the amounts owing to these people for these assets. The equation has now changed to:

Assets = Capital + Liabilities

It can be seen that two sides of the equation will have the same totals. This is because we are dealing with the same thing with two different points of view. It is:

Resources in the business = Resources: who supplied them
Assets = Capital + Liabilities

It is a fact that total of each side will always equal one another, and this will always be true no matter how many transactions there may be. The actual assets, capital and liabilities may change, but the total of the assets will always equal to the total of capital and liabilities.
Assets consist of property of all kinds, such as buildings, machinery, stocks of goods and motor vehicles.
Also benefits such as debts owned by customers and the amount of money in the bank accounts are included.
Liabilities consist of money owing for goods supplied to the business and for expenses. Also loans made to the firm are included.
Capital is often called the owner’s net worth.

Working capital

Working capital of the business is the net value of current assets & current liabilities.

Current assets are the resources of the business that are expected to be received within 12 months in an accounting period.

Current liabilities are the amount owing to the business that is expected to be paid within one year in a financial year.
So, working capital is the net of what is receivable in an accounting year & what is payable in that year.

Working Capital = Current Assets – Current Liabilities

Example: current assets of the business worth Rs.100, 000 & current liabilities of the business has the value of Rs. 75,000. Then working capital will be Rs. 25,000 (100,000-75,000).

Stock

Stock is termed as “value of goods available to the business that are ready for sale”. For accounting purposes, stock is of two types:

  • Opening stock
  • Closing stock

Opening stock is the value of goods available for sale in the beginning of an accounting year. For purpose of financial reporting, opening stock is added to the purchases for the year to become a part of cost of goods sold. As this is available in the beginning of the year, it is assumed that it will be consumed in the accounting year. That is why; it becomes a part of cost of goods sold. Closing Stock of previous year is the opening stock in present year (current year).

Closing stock is the value of goods unsold at the end of accounting year. For purposes of making financial statements, it is deducted from cost of goods sold & is shown as an asset in the Balance Sheet.
As this is the value of goods that are yet to be sold, so it cannot be included in cost of goods sold. That is why it is deducted from cost of good sold. On the other hand, its benefit will be received in the next accounting year, so it is shown as an asset in the balance sheet.

The contents of cost of goods sold are:

Opening stock
Plus: purchases
Plus: Freight/ carriage paid on purchases
Less: closing stock

Example: opening stock of a business worth Rs. 15,000, business purchased goods of Rs. 12,000 for the year & also paid Rs. 1,500 as carriage on purchases. The value of closing stock at the end of the year is Rs. 10,000. Then, value of closing stock will be calculated as under:

Opening stock 15,000
Add: purchases 12,000
Add: carriage on purchase 1,500
Less: closing stock (10,000)
Cost of goods sold 18,500

Ali Traders
Trial Balance
As On January 31, 20--
Title of Account Code Dr. Rs. Cr. Rs.
Cash Account 01 35,000  
Bank Account 02 130,000  
Capital Account 03   200,000
Furniture Account 04 15,000  
Vehicle Account 05 50,000  
Purchases Account 06 60,000  
Mr. A (Creditor) 07   15,000
Sales 08   95,000
Mr. B (Debtor) 09 15,000  
Salaries 10 5,000  
Expenses 11 20,000  
Expenses Payable 12   20,000
Total   330,000 330,000

According to the Accounting equation,

Assets = Capital + Liabilities
Assets = 35,000+130,000+15,000+50,000+15,000= 245,000
Capital = 200,000
Liabilities = 15,000 + 20,000 = 35,000
Capital + Liabilities = 235,000

We have ignored the Net Profit Rs.10000 (Net profit is a part of the capital and will be added in capital
account)
When we added Net profit in capital then;
Assets = Capital + Liabilities
245000 = 210000+35000
245000 = 245000

Account form Balance Sheet:

Name of the Entity (Ali Traders)
Balance Sheet
As at January 31, 20--
Liabilities & Equity Assets
Particulars Amount
Rs.
Particulars Amount
Rs.
Capital 200,000 Fixed Assets  
Profit and Loss Account 10,000 Furniture 15,000
  210,000 Vehicle 50,000
Current Liabilities   Current Assets  
Mr. A 15,000   Mr. B  
Exp. payable 20,000 35,000 15,000  
    Bank 180,000
    130,000  
    Cash  
    35,000  
Total 245,000 Total 245,000

Report form Balance Sheet:

Ali Traders
Balance Sheet
As At January 31, 20--
Particulars Amount
Rs.
Amount
Rs.
Assets    
Fixed Assets   65,000
Current Assets   180,000
Total   245,000
Liabilities    
Capital 200,000  
Profit and Loss Account 10,000 210,000
Current Liabilities   35,000
Total   245,000

Treatment of closing stock: If closing stock is Rs.1,000 then:

Name of the Entity (Ali Traders)
Profit and Loss Account
For the Month Ending January 31, 20--
Particulars Amount Rs. Amount Rs.
Income / Sales / Revenue   95,000
Less: Cost of Goods Sold ( 60,000 - 1,000 ) (59,000) (59,000)
Gross Profit   36,000
Less: Administrative Expenses (25,000) (25,000)
Net Profit   11,000

 

Ali Traders
Balance Sheet
As At January 31, 20--
Particulars Amount
Rs.
Amount
Rs.
Assets    
Fixed Assets
Current Assets (180,000 + 1,000)
  65,000
181,000
Total   246,000
Liabilities    
Capital
Profit and Loss Account
200,000
11,000
211,000
Current Liabilities   35,000
Total   246,000

Treatment of
Depreciation:

In Profit and Loss Account, it is considered as expense and in Balance Sheet it is deducted from the concerned fixed asset.

If useful life of an asset is 50 month and considered that there is no residual value then,

  • By dividing total cost by life of the asset.
  • Rs.65,000 / 50 months = Rs.1,300 monthly charge (Depreciation)
Name of the Entity (Ali Traders)
Profit and Loss Account
For the Month Ending January 31, 20--
Particulars Amount Rs. Amount Rs.
Income / Sales / Revenue
Less: Cost of Goods Sold ( 60,000-1,000 )
59,000 95,000
(59,000)
Gross Profit
Less: Administrative Expenses
Depreciation
25,000
1,300

36,000

(26,300)

Net Profit   9,700

 

Ali Traders
Balance Sheet
As At January 31, 20--
Particulars Amount Rs. Amount Rs.
Assets
Fixed Assets (65,000 – 1,300)
Current Assets (180,000 + 1,000)
  63,700
181,000
Total  

244,700

Liabilities
Capital
Profit and Loss Account
200,000
9,700
209,700
Current Liabilities   35,000
Total   244,700

Distribution of Profits / Drawing

Ali Traders
Balance Sheet
As At January 31, 20--
Particulars Amount Rs. Amount Rs.
Assets
Fixed Assets (65,000 – 1300)
Current Assets (181,000 - 5,000)
  63,700
176,000
Total  

239,700

Liabilities
Capital
Profit and Loss Account
Drawing
200,000
9,700
(5,000)
204,700
Current Liabilities   35,000
Total   239,700

Illustration:
Consider the Trial Balance given hereunder:

Saeed & co.
Trial Balance
As on January 31, 2002
Title of Account Code Dr. Rs. Cr. Rs.
ACash Account 01 161,250  
Capital Account 02

 

150,000
Furniture Account 03 2,000  
Purchases Account 04 16,000  
Carriage on purchase account 05 250  
Salim& co. (Creditor) 06   0
Sales 07   37,000
Usman & co. (Debtor) 08 0  
Salaries 09 2,500  
Rent 10 3,000  
Stationery 11 2,000  
Utility bills 12 5,000  
Accrued expenses 13   5,000
Total   192,000 192,000

This Trial Balance is extracted from the solved illustration, in lecture 11.
Let’s say, the value of closing stock at the end of the period is Rs. 2,000. Then Profit & Loss Account will bear the following change.

Saeed & Co.
Profit & Loss Account
For the period ended January 31, 2002
Particulars Amount Rs. Amount Rs.
Income / Sales / Revenue
(See Note #1)
Less: (Cost of Goods Sold - Closing
stock)
=16,250 –
2,000
37,000
(14,250)
Gross Profit
Less: Admin. Expenses
(See Note # 2)
 

22,750
(12,500)

Net Profit/ (Loss)   10,250

Its effect in the Balance Sheet is as follows:

Saeed & Co.
Profit & Loss Account
For the period ended January 31, 2002
Liabilities   Assets  
Particulars Amount
Rs.
Particulars Amount
Rs.
Capital
Add: Net Profit
150,000
10,250

Fixed Assets
Furniture Account

2,000
  160,250    
Current Liabilities
Accrued Expenses
5,000 Current Assets
Cash
Closing Stock
161,250
2,000
Total 165,250 Total 165,250

This is a practical demonstration of the treatment of closing stock. But, we are not mentioning the journal entry of closing stock at this stage. It will be discussed in detail, when we will study the topic of fixed assets.

Depreciation

Depreciation is the method of charging cost of fixed assets to the profit & loss account as an expense. Fixed Assets are those assets which are:

  • Of long life
  • To be used in the business
  • Not bought with the main purpose of resale.

When an expense is incurred, it is charged to profit & loss account of the same accounting period in which it has incurred. Fixed assets are used for longer period of time. Now, the question is how to charge a fixed asset to profit & loss account. For this purpose, estimated life of the asset is determined. Estimated life is the number of years in which a fixed asset is expected to be used. Then, total cost of the asset is divided by total number of estimated years. The value, so determined, is called ‘depreciation for that year’ and is charged to profit & loss account. The same amount is deducted from total cost of fixed asset. The net amount (after deducting depreciation) is called ‘‘Written down Value’’.
Example: An asset has a cost of Rs. 150,000. It is expected to be used for ten years. Depreciation to be charged to profit & loss account is Rs. 15,000 (Cost of asset/estimated life). In this case, it will be 150,000/10 = 15,000.
That is why depreciation is called an accounting estimate.

To understand its accounting treatment, consider the above mentioned illustration:

Let’s suppose the useful life of furniture is five years. Then, depreciation for the year will be (2,000/5 = 400). Now, the profit & loss account will show the following picture:

Saeed & Co.
Profit & Loss Account
For the period ended January 31, 2002
Particulars Amount Rs. Amount Rs.
Income / Sales / Revenue (See Note #1)
Less: Cost of Goods Sold (16,250 – 2,000)
  37,000.
(14,250)
Gross Profit
Less: Admin. Expenses + Depreciation
12,500 +
400

22,750
(12,900)

Net Profit/ (Loss)   9,850

Balance sheet will look like this:

Saeed & Sons Balance Sheet
As At January 31, 2002
Liabilities   Assets  
Particulars Amount
Rs.
Particulars Amount
Rs.
Capital
Add: Net Profit
150,000
9,850

Fixed Assets
Furniture Account

2,000
(400)
  159,850   1,600
Current Liabilities
Accrued Expenses
5,000 Current Assets
Cash
Closing Stock
161,250
2,000
Total 164,850 Total 164,850

Treatment of depreciation is practically demonstrated at this point. Its journal entry will be discussed in detail, when we cover the topic ‘Fixed Assets’.

Drawing

Capital is the cash or kind invested by the owner of the business. Sometimes, the owner wants to take cash or goods out of the business for personal use. This is known as drawing.
Any money taken out as drawings will reduce capital.
The capital account is very important account. To stop it getting full of small details, cash items of drawings are not entered in the capital account. Instead, a drawing account is opened, and all transactions are entered there.

Sometimes goods are also taken by the owner of the business. These are also known as drawings. To understand the accounting treatment of drawings, look into the following trial balance:

Saeed & co.
Trial Balance
As on January 31, 2002
  Assets  
Title of Account Code Dr. Rs. Cr. Rs.
Cash Account 01

161,250

 
Capital Account 02   160,000
Furniture Account 03 2,000  
Drawings 04 10,000  
Profit & loss account 05   8,250
Salim& co. (Creditor) 06   0
Usman & co. (Debtor) 07 0  
Accrued expenses 08   5,000
Total   173,250 173,250

Balance Sheet

Saeed & Sons Balance Sheet
As At January 31, 2002
Liabilities   Assets  
Particulars Amount
Rs.
Particulars Amount
Rs.
Capital
Add: Net Profit
Less: Drawings
160,000
8,250
(10,000)

Fixed Assets
Furniture Account

2,000
  158,250   1,600
CCurrent Liabilities
Accrued Expenses
5,000 Current Assets
Cash
161,250
Total 163,250 Total 163,250

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