Accountancy and Financial Management - I Notes | B.Com. (Accountancy) Semester 1 | Mumbai University

Chapter One

The Accounting Concepts

Syllabus topic 1, "Accounting Concepts and Conventions."

In one line

An accounting concept is a basic assumption on which the recording of transactions proceeds, and without which the figures would mean different things to different readers.

The nine

1. Business entity concept. The business is treated as separate from its owner. His private house is not the firm's asset and his private expenses are not the firm's expenses.

Consequence: capital is shown as a liability of the business, because the business owes the owner what he put in. A student who cannot explain why capital appears on the liabilities side has not understood this concept.

2. Money measurement concept. Only what can be expressed in money is recorded.

Consequence: the skill of the workforce, the loyalty of customers and the quality of management appear nowhere, however much they decide the future. It is also why the limitations of financial statement analysis begin where they do.

3. Going concern concept. The business is assumed to continue in operation for the foreseeable future, with neither the intention nor the necessity of liquidation or of materially curtailing its scale.

Consequence: assets are carried at cost less depreciation and not at what they would fetch if sold today, because they are not going to be sold. AS 1 names it a fundamental accounting assumption.

4. Cost concept. An asset is recorded at the price paid for it, and that figure, less depreciation, is carried forward.

Consequence: a plot bought in 1998 for Rs 2,00,000 stands at Rs 2,00,000 however much it is now worth. This is the concept behind the historical cost limitation of ratio analysis.

5. Dual aspect concept. Every transaction has two aspects, a debit and a credit, of equal amount.

Consequence: the accounting equation, Assets = Liabilities + Capital, holds always, and the trial balance agrees. It is the foundation of double entry.

6. Accounting period concept. The endless life of a business is cut into periods so that results can be reported.

Consequence: every accrual, every prepayment and every adjustment exists because of this concept. Without a period, nothing would need to be apportioned.

7. Matching concept. The costs of a period are matched against the revenues of that period, and not against the cash paid.

Consequence: outstanding expenses are charged although unpaid, prepaid expenses are carried forward although paid, and depreciation spreads a cost over the years that benefit from it.

8. Realisation concept. Revenue is recognised when it is earned, which for goods is normally when they are delivered and the property in them passes, and not when the order is received or when the cash comes in.

Consequence: a signed order is not a sale. AS 9 is this concept written out as a standard, and the chapter on it does so.

The Accounting Concepts

9. Accrual concept. Revenues and costs are recognised as they are earned or incurred, and recorded in the period to which they relate, not as money is received or paid.

Consequence: the accounts are kept on the accrual basis, which section 128(1) of the Companies Act requires of a company in terms. AS 1 names it a fundamental accounting assumption.

The three AS 1 singles out

AS 1 paragraph 10 names three as fundamental accounting assumptions, and defines each in its own words.

	AS 1's own definition
Going concern	The enterprise is normally viewed as continuing in operation for the foreseeable future, with neither the intention nor the necessity of liquidation or of materially curtailing the scale of the operations
Consistency	Accounting policies are consistent from one period to another
Accrual	Revenues and costs are accrued, that is, recognised as they are earned or incurred and not as money is received or paid, and recorded in the financial statements of the periods to which they relate

And paragraph 27 gives the consequence. If the three are followed, no specific disclosure is required. If any one is not followed, the fact must be disclosed.

AS 1 calls consistency a fundamental assumption; most textbooks call it a convention. Both are used. Say which classification you are following, and if you have room, note that AS 1 treats it as an assumption.

Concept against convention

	Concept	Convention
What it is	A basic assumption on which recording proceeds	A practice or custom followed in preparing the statements
Origin	Logical necessity	Usage, accepted over time
Choice	Not optional	A matter of practice, and can vary
Examples	Business entity, going concern, dual aspect	Consistency, disclosure, conservatism, materiality

The next chapter takes the conventions.

Quick revision


Business entity	The business is separate from its owner; capital is a liability
Money measurement	Only what can be expressed in money
Going concern	Continuing for the foreseeable future; assets at cost, not break-up value
Cost	Recorded at what was paid
Dual aspect	Two equal aspects; Assets = Liabilities + Capital
Accounting period	The life is cut into periods; hence every adjustment
Matching	Costs of a period against revenues of that period
Realisation	Revenue when earned, not when ordered or received
Accrual	As earned or incurred, not as received or paid
AS 1's three	Going concern, consistency, accrual; disclosure only if NOT followed

Test yourself

Why does capital appear on the liabilities side?
Which concept explains why a plot bought in 1998 stands at its 1998 cost?
Name the three fundamental accounting assumptions in AS 1.
What must be disclosed about them, and when?
Which concept makes an outstanding expense a charge although it is unpaid?

The Accounting Concepts

Answer in one sentence

1. Because of the business entity concept, under which the business is separate from its owner and therefore owes him what he has put in.

2. The cost concept, under which an asset is recorded at the price paid and carried at that figure less depreciation.

3. Going concern, consistency and accrual.

4. Nothing, if all three are followed; if any one is not followed, the fact must be disclosed, under AS 1 paragraph 27.

5. The matching concept, read with accrual, under which the costs of a period are charged against that period's revenues whether or not they have been paid.

Contents This chapter on its own page

Chapter Two

The Accounting Conventions

Syllabus topic 1, "Accounting Concepts and Conventions."

In one line

A convention is a practice, accepted by usage, that governs how the accounts are prepared where the concepts leave a choice.

The four

1. Consistency. The same accounting policies are followed from one period to another, so that the figures of successive years can be compared.


What it requires	Not that the best method be used, but that the same method be used
A change is permitted	Where it is required by law or a standard, or where the new method gives a better presentation
And must be disclosed	AS 1 paragraph 26: any change with a material effect must be disclosed, with the amount by which each item is affected, or the fact that the amount is not ascertainable
AS 1 calls it	A fundamental accounting assumption, not a convention

2. Full disclosure. All information material to a user of the accounts must be disclosed.


Where	On the face of the statements, or in the notes
The Act enforces it	Section 129(1) requires a true and fair view, and Schedule III prescribes the disclosures
AS 1 enforces it	Paragraphs 24 and 25: all significant accounting policies should be disclosed, and in one place
Examples	Contingent liabilities, the method of depreciation, the mode of valuing stock, events after the balance sheet date

3. Conservatism, or prudence. Anticipate no profit and provide for all possible losses.

Applied to	The result
Stock	Valued at the lower of cost and net realisable value, AS 2 paragraph 5
Debtors	A provision for doubtful debts is made although no debtor has yet failed
Investments	A permanent diminution is provided for; an appreciation is not taken
A contingent gain	Not recognised; a contingent loss that is probable is provided for

Its limit. AS 1 paragraph 17 lists prudence as a consideration governing the selection of policies, and the Standard's whole scheme is that the statements must be true and fair. Deliberate understatement of assets or overstatement of liabilities is not prudence; it is a misstatement, and creating a secret reserve that way is wrong.

4. Materiality. Financial statements should disclose all material items, which AS 1 paragraph 17 defines as items the knowledge of which might influence the decisions of the user of the financial statements.


What follows	An immaterial item need not be disclosed separately, and may be treated in the way that is convenient
Example	A stapler is charged to revenue although it will last five years; capitalising and depreciating it would cost more than it is worth
The test is not size alone	Directors' remuneration is material whatever its amount, because the Act requires it and the members judge the board on it

The Accounting Conventions

The two that pull against each other

Conservatism and full disclosure sit easily together. Conservatism and consistency do not always.

A company has valued stock at cost for five years. This year the market has fallen and net realisable value is below cost.

Convention	What it says
Consistency	Use the same policy as before
Conservatism	Write the stock down

Conservatism wins, and there is no conflict, because the policy has not changed: the policy was always "lower of cost and net realisable value", and this year the lower figure is the second one. Saying that resolves the apparent conflict and is worth a mark.

The conventions and the standards

Every one of the four has become a rule in a notified standard, which is worth pointing out.

Convention	Where it is now a rule
Consistency	AS 1 paragraph 10(b), a fundamental accounting assumption; paragraph 26, disclosure of a change
Full disclosure	AS 1 paragraphs 24 and 25
Conservatism	AS 1 paragraph 17(a), and AS 2 paragraph 5, lower of cost and net realisable value
Materiality	AS 1 paragraph 17(c)

So the conventions are not merely customary any more. For a company they are enforceable through section 129(1), which requires compliance with the standards.

Quick revision


Consistency	Same policies year to year; a change must be disclosed with its effect
Full disclosure	Everything material, and the policies in one place
Conservatism	Anticipate no profit, provide for all losses; not a licence to understate
Materiality	Items whose knowledge might influence a user's decision
AS 1 paragraph 17	Names prudence, substance over form and materiality as the considerations governing selection of policies
The apparent conflict	Consistency against conservatism, resolved because the policy was always the lower of the two

Test yourself

Name the four conventions.
What must be disclosed when an accounting policy changes?
State the rule of conservatism and its limit.
Give AS 1's definition of a material item.
How is the conflict between consistency and conservatism resolved on a fall in stock values?

Answer in one sentence

1. Consistency, full disclosure, conservatism or prudence, and materiality.

2. The change itself, and the amount by which any item in the financial statements is affected by it, or the fact that the amount is not ascertainable, under AS 1 paragraph 26.

3. Anticipate no profit and provide for all possible losses, but not to the point of deliberately understating assets or creating secret reserves, which would make the statements untrue.

4. An item the knowledge of which might influence the decisions of the user of the financial statements, AS 1 paragraph 17(c).

5. There is no conflict, because the policy was always to value at the lower of cost and net realisable value, and this year the lower of the two happens to be the second.

Contents This chapter on its own page

Chapter Three

Capital and Revenue Expenditure

Syllabus topic 2, "Meaning and Classification - Capital, Revenue: Expenditure and Receipts, Profit and Loss."

In one line

Capital expenditure buys a benefit that lasts beyond this year and goes to the balance sheet; revenue expenditure buys a benefit consumed this year and goes to the profit and loss account.

The five tests

	Test	Capital if
1	The period of benefit	The benefit extends beyond the current year
2	The nature of the item acquired	A fixed asset is acquired, or an existing one is added to
3	The effect on earning capacity	The earning capacity is increased, not merely maintained
4	Frequency	The expenditure is non-recurring
5	Amount	Not a test on its own; a large sum on repairs is still revenue, and a small sum on a machine is still capital, subject to materiality

Test three is the one that decides the hard cases. Repairing a machine restores it and is revenue; fitting it with a device that raises its output is capital, because the earning capacity has gone up.

Capital expenditure

It is expenditure incurred to acquire, or to add to the value of, a fixed asset, or to obtain an advantage of an enduring nature.

Included	Why
The purchase price of a fixed asset	The asset itself
Freight, insurance and installation on it	Costs of bringing it to its present location and condition
Legal charges on the purchase of property	The same
Wages paid for erecting a machine	The same; and it is the classic examination item
Interest on a loan taken to acquire an asset, up to the date the asset is ready for use	Capitalised under the borrowing costs standard
A major improvement that increases the earning capacity	Test three
The cost of a second-hand asset and the repairs needed to make it usable	Both, because the asset was not usable until the repairs were done

The last row is the one MU's examiners like. Repairs to a newly bought second-hand machine, before it is put to use, are capital; the same repairs a year later are revenue.

Revenue expenditure

It is expenditure whose benefit is exhausted within the year, or which is incurred to maintain the earning capacity as it is.

Included
Purchases of goods for resale, and the direct expenses on them
Wages, salaries, rent, rates, insurance, power
Repairs and maintenance that keep an asset in its existing condition
Depreciation	The consumption of a capital asset, charged over the years of benefit
Interest on a loan after the asset is ready for use
Loss on the sale of a fixed asset

Deferred revenue expenditure

A third category, and MU's syllabus does not name it, so give it in one paragraph where a question opens the door.

It is revenue expenditure whose benefit extends over more than one year, so that writing the whole of it off in the year it is incurred would distort the result. It is carried forward and written off over the years benefited.

Capital and Revenue Expenditure

Classic examples
A heavy advertising campaign launching a product
Preliminary expenses of forming a company
Discount on the issue of shares or debentures
Research expenditure written off over the years benefited

The category has narrowed under the standards. Modern practice, and the notified standards, require most such items to be written off in the year incurred, and Schedule III treats an unwritten balance as a fictitious asset deducted from proprietors' funds rather than shown as an asset. Say both: the traditional treatment and the modern one.

The effect of getting it wrong

The error	Profit	Assets	Capital
Capital treated as revenue	Understated	Understated	Understated
Revenue treated as capital	Overstated	Overstated	Overstated

Worked, in one line each.

A machine costing Rs 2,00,000 is debited to repairs. Repairs are overstated by Rs 2,00,000, so the profit is understated by Rs 2,00,000; machinery is missing, so the fixed assets are understated by Rs 2,00,000. And depreciation on it is not charged, which offsets a little of the profit understatement in the same year and all of it in later years.

Repairs of Rs 40,000 are debited to machinery. Repairs are understated, so the profit is overstated by Rs 40,000; machinery is inflated, so the fixed assets are overstated. And depreciation is charged on the inflated figure in this and every later year.

Both errors are errors of principle, so the trial balance still agrees, which is why they are the errors an auditor looks for.

The twelve items to be able to classify on sight

Item	Capital or revenue
Purchase of a delivery van	Capital
Petrol for the van	Revenue
Repainting the van, its usual livery	Revenue
Fitting the van with a refrigeration unit	Capital; earning capacity increased
Wages of workmen erecting a machine	Capital
Wages of workmen operating it	Revenue
Legal fees on buying land	Capital
Legal fees defending a title to land already owned	Capital, because it preserves an existing asset
Legal fees on an income-tax appeal	Revenue
A second-hand machine, and the repairs to make it usable	Both capital
The same repairs a year later	Revenue
Whitewashing the factory	Revenue

Quick revision


Capital	Benefit beyond the year; a fixed asset acquired or improved; earning capacity increased; non-recurring
Revenue	Benefit consumed this year; maintains the earning capacity; recurring
The deciding test	Earning capacity increased against maintained
Deferred revenue	Revenue whose benefit spans years; narrowed by the standards, and an unwritten balance is a fictitious asset
Capital as revenue	Profit understated, assets understated
Revenue as capital	Profit overstated, assets overstated
Both are	Errors of principle; the trial balance still agrees

Capital and Revenue Expenditure

Test yourself

Give the five tests, and say which is not a test on its own.
Wages are paid to workmen who erected a machine. Capital or revenue, and why?
A second-hand machine is bought and repaired before use. How are the repairs treated, and how would the same repairs be treated a year later?
Repairs of Rs 40,000 are debited to the machinery account. What are the two effects?
Why does the trial balance not reveal either error?

Answer in one sentence

1. The period of benefit, the nature of the item acquired, the effect on earning capacity, the frequency, and the amount, of which the amount is not a test on its own.

2. Capital, because they are a cost of bringing the asset to its present location and condition and the benefit extends over the machine's life.

3. Capital, because the machine was not usable until they were done; a year later the same repairs merely maintain it and are revenue.

4. The profit is overstated by Rs 40,000 and the fixed assets are overstated by Rs 40,000, and depreciation is then charged on the inflated figure in every later year.

5. Because both are errors of principle, in which both entries are of the right amount and on the right sides and only the account chosen is wrong.

Contents This chapter on its own page

Chapter Four

Capital and Revenue Receipts

Syllabus topic 2, "Meaning and Classification - Capital, Revenue: Expenditure and Receipts, Profit and Loss."

In one line

A revenue receipt arises in the ordinary course of the business and is credited to the profit and loss account; a capital receipt does not and is not.

The tests

	Test	Capital if
1	The source	It arises from a fixed asset, from the owner, or from a lender, not from trading
2	Recurrence	It is non-recurring
3	The effect on the balance sheet	It creates a liability or reduces an asset, rather than adding to the year's income
4	Whether it is available for distribution	A capital receipt is not distributable as profit

Test three is the useful one. Capital introduced creates a liability to the owner; a loan creates a liability to the lender; the sale of a machine reduces an asset. A revenue receipt does none of the three.

Capital receipts

Receipt	Where it goes
Capital introduced by the proprietor	Credited to his capital account
A loan taken	Credited to the loan account, a liability
Sale proceeds of a fixed asset	Credited to the asset account; only the excess over book value is a profit
Insurance claim for a fixed asset destroyed	The same
A premium received on the issue of shares	Reserves; not income
A government grant related to a fixed asset	Deducted from the asset's cost, or as a deferred income, under the grants standard
A security deposit received	A liability; it must be returned

Revenue receipts

Receipt	Where it goes
Sale of goods	Trading account
Commission, fees and services rendered	Profit and loss account
Interest and dividend received	Profit and loss account
Rent received on a property let	Profit and loss account
Discount received	Profit and loss account
Bad debts recovered	Profit and loss account
A government grant related to revenue, such as a subsidy on wages	Profit and loss account

The four that are commonly misclassified

1. Sale proceeds of a fixed asset. A machine with a book value of Rs 20,000 is sold for Rs 30,000.

	Rs
Capital receipt, credited to the machinery account	20,000
Profit on sale, credited to profit and loss	10,000
Total received	30,000

The whole Rs 30,000 is not income and the whole Rs 30,000 is not capital. The receipt is split, and saying so is the answer.

2. Compensation received. For the loss of a fixed asset, capital. For the loss of stock or of profits, revenue, because it replaces what would have been income.

3. An amount received on the sale of a right. Selling the right to use a patent for a year is revenue; selling the patent itself is capital.

4. A security deposit. Received from a tenant or a dealer, it is a liability and never income, however long it is held. Only if it is forfeited does it become income.

Capital and Revenue Receipts

The consequence of getting it wrong

The error	Profit	Balance sheet
Capital receipt treated as revenue	Overstated	A liability or an asset reduction is missing
Revenue receipt treated as capital	Understated	A liability is shown that does not exist, or an asset is understated

Worked. A loan of Rs 5,00,000 is credited to the sales account. Sales are overstated by Rs 5,00,000, so the profit is overstated by Rs 5,00,000, and the loan does not appear as a liability, so the balance sheet understates the liabilities by the same amount. And the trial balance still agrees, because both entries were of the right amount on the right sides.

Quick revision


Revenue receipt	Arises in the ordinary course; recurring; credited to the profit and loss account
Capital receipt	From a fixed asset, the owner, or a lender; non-recurring; creates a liability or reduces an asset
Sale of a fixed asset	The book value is a capital receipt and only the excess is a profit
Compensation	For a fixed asset, capital; for stock or profits, revenue
Security deposit	A liability, until forfeited
Capital receipt as revenue	Profit overstated
Revenue receipt as capital	Profit understated

Test yourself

Give three tests for a capital receipt.
A machine with a book value of Rs 20,000 is sold for Rs 30,000. How is the Rs 30,000 treated?
Compensation is received for stock destroyed by fire. Capital or revenue?
A loan is credited to sales. What are the two effects?
When does a security deposit received become income?

Answer in one sentence

1. It arises from a fixed asset, from the owner or from a lender rather than from trading; it is non-recurring; and it creates a liability or reduces an asset rather than adding to the year's income.

2. Rs 20,000 is credited to the machinery account as a capital receipt and Rs 10,000 is credited to the profit and loss account as the profit on sale.

3. Revenue, because it replaces income that would otherwise have been earned on the stock.

4. The profit is overstated by the amount of the loan and the liabilities are understated by the same amount, and the trial balance still agrees.

5. When it is forfeited, because until then it is a liability that must be returned.

Contents This chapter on its own page

Chapter Five

Capital and Revenue Profit and Loss

Syllabus topic 2, "Meaning and Classification - Capital, Revenue: Expenditure and Receipts, Profit and Loss."

In one line

A revenue profit is earned in the ordinary course of business and is freely distributable; a capital profit arises outside it and is not.

The two

	Revenue profit	Capital profit
Arises from	The ordinary course of business	A transaction outside the ordinary course, or on a fixed asset or a capital item
Shown in	The profit and loss account	The profit and loss account or a capital reserve, depending on its source
Available for dividend	Yes, freely	Not as a matter of course
Recurring	Usually	No
Examples	Gross profit, commission earned, interest received	Profit on the sale of a fixed asset, premium on the issue of shares, profit prior to incorporation

Where each capital profit goes

They do not all go to the same place, and that is what the question tests.

Capital profit	Treatment
Profit on the sale of a fixed asset	Credited to the profit and loss account, and shown as a non-operating item; it IS distributable
Premium on the issue of shares	To the securities premium account; it may be used only for the purposes the Companies Act allows and is not distributable as dividend
Profit prior to incorporation	To capital reserve, or written off against goodwill or preliminary expenses; not distributable
Profit on the reissue of forfeited shares	To capital reserve; not distributable
Profit on the redemption of debentures below par	To capital reserve
Profit on the revaluation of a fixed asset	To revaluation reserve; unrealised, and not distributable

Notice that the first row breaks the pattern. A realised profit on the sale of a fixed asset is a capital profit in origin and is taken to the profit and loss account and is distributable. So "capital profit is never distributable" is too strong, and the accurate statement is that a capital profit is not distributable as a matter of course and its treatment depends on its source.

Capital loss

The mirror, and it is asked less often but the same reasoning applies.

Capital loss	Treatment
Loss on the sale of a fixed asset	Charged to the profit and loss account
Loss prior to incorporation	Debited to goodwill, or to capital reserve
Discount on the issue of shares or debentures	Written off against the securities premium or the profit and loss account
Loss on the revaluation of a fixed asset	Charged to the revaluation reserve to the extent of a previous surplus on the same asset, and otherwise to the profit and loss account

Why the distinction exists

Because a business must not distribute its capital. A dividend paid out of a capital profit that has not been realised, or out of a receipt that was never income, is a return of capital to the shareholders disguised as a return on it.

Capital and Revenue Profit and Loss

The consequences:

The creditors' cushion is reduced, because the capital they lent against has gone out.
The future earning capacity falls, because the asset that produced the profit was sold.
The shareholders are misled into thinking the business earns more than it does.

A single sentence answers "why distinguish": so that capital is not distributed as though it were income.

Worked, in one line each

A trader's gross profit for the year is Rs 4,00,000. Revenue profit, freely distributable.

He sells a delivery van whose book value is Rs 60,000 for Rs 75,000. Capital profit of Rs 15,000, credited to the profit and loss account as a non-operating item, and distributable.

A company issues shares of Rs 10 at Rs 14. Capital profit of Rs 4 a share, to the securities premium account, and not distributable as dividend.

A company takes over a business from a date before its incorporation and the earlier period shows a profit of Rs 17,000. Capital profit, to capital reserve or against goodwill, and not distributable.

Quick revision


Revenue profit	Ordinary course; profit and loss account; freely distributable
Capital profit	Outside the ordinary course; not distributable as a matter of course
The exception	A realised profit on the sale of a fixed asset goes to profit and loss and IS distributable
Securities premium	Capital profit, not distributable as dividend
Profit prior to incorporation	Capital reserve, or against goodwill
Why distinguish	So that capital is not distributed as though it were income

Test yourself

Distinguish a revenue profit from a capital profit on four bases.
Where does a premium on the issue of shares go, and may it be distributed?
A van with a book value of Rs 60,000 is sold for Rs 75,000. Classify the profit and say where it goes.
Where does a profit prior to incorporation go?
Why does the distinction matter?

Answer in one sentence

1. A revenue profit arises in the ordinary course of business, is shown in the profit and loss account, is usually recurring and is freely distributable; a capital profit arises outside it, may go to a capital reserve, is non-recurring and is not distributable as a matter of course.

2. To the securities premium account, and it may not be distributed as dividend, being usable only for the purposes the Companies Act allows.

3. A capital profit of Rs 15,000, credited to the profit and loss account as a non-operating item, and it is distributable because it has been realised.

4. To capital reserve, or it is written off against goodwill or preliminary expenses, and it is not distributable.

Capital and Revenue Profit and Loss

5. So that capital is not distributed as though it were income, which would reduce the creditors' cushion, lower the future earning capacity, and mislead the shareholders.

Contents This chapter on its own page

Chapter Six

What an Accounting Standard Is

Syllabus topic 3, "Accounting Standard (AS) and Ind-AS & IFRS – An Introduction, Concepts and Benefits."

In one line

An accounting standard is a written statement, prescribed by the Central Government, of how a particular class of transaction is to be measured, presented and disclosed.

The meaning

An accounting standard reduces the choice. Two accountants presented with the same facts could reach different figures, all of them defensible. A standard says which of them is to be used, or narrows the choice and requires the one chosen to be disclosed.

It deals with	Example
Recognition: whether an item enters the accounts at all, and when	AS 9, when revenue is recognised
Measurement: at what amount	AS 2, at the lower of cost and net realisable value
Presentation: where in the statements	Schedule III, with the standards
Disclosure: what must be said about it	AS 1, the significant accounting policies

The chain of authority

Learn this chain; it is the answer to "are accounting standards binding".

Step	Provision
1	The Institute of Chartered Accountants of India formulates and recommends a standard
2	The National Financial Reporting Authority is consulted and its recommendations examined
3	The Central Government prescribes it, by notification: section 133 of the Companies Act 2013
4	Section 129(1) requires the financial statements to comply with the standards notified under section 133
5	Section 129(5) requires any deviation, its reasons and its financial effects to be disclosed
6	Section 143(3)(e) requires the auditor to report whether the statements comply with them

A standard the Institute has issued and the Government has not notified does not bind a company. Saying that is worth a mark, and it is why the notified text is the authority.

The current notification is the Companies (Accounting Standards) Rules 2021, G.S.R. 432(E) of 23 June 2021, which prescribes AS 1 to AS 29. There is no AS 6 and no AS 8; both were withdrawn and merged into other standards, and knowing that is a small mark.

Why standards are needed

	Need
1	To reduce the choice of accounting treatments, so that the same facts give the same figures
2	To make companies comparable with each other and with themselves over time
3	To make the statements reliable to a reader who cannot verify them
4	To limit management's discretion, which is otherwise exercised in management's own interest
5	To give the auditor a benchmark against which to judge
6	To meet the requirements of law and of regulators

The benefits

	Benefit
1	Uniformity in the preparation of financial statements
2	Comparability, both between companies and between years
3	Reliability, so that outsiders can act on the figures
4	Reduced scope for manipulation and for window dressing
5	A basis for the auditor's opinion
6	Additional disclosure, so that what cannot be standardised is at least stated
7	Confidence in the capital market, and comparability with companies abroad as Ind AS converge with IFRS

What an Accounting Standard Is

The limitations

MU's topic says "Concepts and Benefits" and an examiner usually wants the limitations too.

	Limitation
1	A choice often remains. AS 2 permits FIFO or weighted average, so two companies can still differ
2	They cannot cover every situation, and a new kind of transaction has no standard until one is made
3	Rigidity. A rule that suits most enterprises may not suit a particular one
4	They are amended, so a comparison across a change is not a clean comparison
5	Compliance is not the same as a true and fair view. Section 129(1) requires both, and Schedule III's instruction 1 makes the form give way where the Act or a standard requires
6	They can be complied with in form and defeated in substance, which is why AS 1 names substance over form as a consideration

The three this paper covers

Standard	What it does	Where
AS 1	Requires disclosure of significant accounting policies, and names three fundamental assumptions	Chapter 80
AS 2	Valuation of inventories at the lower of cost and net realisable value, with the cost formulas	Chapters 90 and 100
AS 9	Revenue recognition from the sale of goods, the rendering of services, and interest, royalties and dividends	Chapter 110

Quick revision


Meaning	A prescribed statement of how a class of transaction is recognised, measured, presented and disclosed
The chain	ICAI recommends, NFRA is consulted, the Central Government prescribes under section 133, section 129(1) makes compliance a duty
Not notified	Does not bind a company
Current Rules	Companies (Accounting Standards) Rules 2021, AS 1 to AS 29; no AS 6, no AS 8
Benefits	Uniformity, comparability, reliability, less manipulation, an audit benchmark, disclosure
Limitations	Choice remains, gaps, rigidity, amendment, compliance is not the same as true and fair

Test yourself

Give the chain by which an accounting standard binds a company.
Does a standard the Institute has issued but the Government has not notified bind a company?
Name four benefits and three limitations.
Which Rules are currently in force and which standards do they prescribe?
What must a company do if it does not comply with a standard?

Answer in one sentence

1. The Institute recommends it, the National Financial Reporting Authority is consulted, the Central Government prescribes it under section 133 of the Companies Act 2013, and section 129(1) requires the financial statements to comply with what is so notified.

2. No, because section 129(1) requires compliance with the standards notified under section 133, and an unnotified standard is not one of them.

What an Accounting Standard Is

3. Uniformity, comparability, reliability and reduced scope for manipulation; and a choice often remains, they cannot cover every situation, and compliance is not the same thing as a true and fair view.

4. The Companies (Accounting Standards) Rules 2021, prescribing AS 1 to AS 29, there being no AS 6 and no AS 8.

5. Disclose the deviation, the reasons for it and its financial effects, under section 129(5).

Contents This chapter on its own page

Chapter Seven

Ind AS and IFRS

Syllabus topic 3, "Accounting Standard (AS) and Ind-AS & IFRS – An Introduction, Concepts and Benefits."

In one line

IFRS are issued by an international board and are not Indian law; Ind AS are the Indian standards converged with them and notified by the Government; AS are the older Indian standards, which most companies still follow.

The three sets

	Accounting Standards (AS)	Indian Accounting Standards (Ind AS)	IFRS
Issued or notified by	The Central Government, Companies (Accounting Standards) Rules 2021	The Central Government, Companies (Indian Accounting Standards) Rules 2015	The International Accounting Standards Board, under the IFRS Foundation
Legal force in India	Binding through section 133 and section 129(1)	Binding on the companies to which they apply	None of itself; they bind only where a country adopts them
Numbering	AS 1 to AS 29	Ind AS 101 to Ind AS 116	IFRS 1 to IFRS 18, and the older IAS
Basis of measurement	Largely historical cost	Substantial use of fair value	The same
Applies to	Companies not covered by the Ind AS Rules, and non-corporate entities	Prescribed classes of company, by net worth and listing	Companies in the jurisdictions that have adopted them

Which Indian companies follow which

The Companies (Indian Accounting Standards) Rules 2015 phase Ind AS in by class.

Phase	Broadly
Voluntary	Any company could adopt Ind AS from 2015-16
Mandatory, first phase	Listed and unlisted companies with net worth of Rs 500 crore or more, from 2016-17
Mandatory, second phase	All listed companies, and unlisted companies with net worth of Rs 250 crore or more, from 2017-18
Later phases	Banks, insurers and non-banking financial companies, on their own timetables
Everybody else	Continues on the AS, under the 2021 Rules

And once a company is on Ind AS its holding, subsidiary, associate and joint venture companies follow, and it cannot go back. Those two sentences answer "who applies Ind AS".

What IFRS are

International Financial Reporting Standards are issued by the International Accounting Standards Board, a body of the IFRS Foundation, which is a private not-for-profit organisation based in London. It has no legislative power anywhere.


How they take effect	A country adopts them, or converges its own standards with them
Adoption	The country's law says IFRS as issued by the Board are its standards
Convergence	The country writes its own standards to say substantially the same thing, with departures
India's course	Convergence, not adoption

Convergence, and the carve-outs

Ind AS are "converged with" IFRS and are not identical to them. The differences are called carve-outs and carve-ins.

	What it means
Carve-out	A departure from IFRS made because the international treatment does not suit Indian law or Indian conditions
Carve-in	An additional requirement in Ind AS that IFRS does not have

Why India converged rather than adopted. Adoption would have meant accepting future changes made in London automatically, and would have collided with Indian statutes: the Companies Act, the Income-tax law and the Reserve Bank's directions all prescribe treatments that a foreign body cannot override. Convergence keeps the substance and keeps the sovereignty, and that sentence is the answer to "why did India not simply adopt IFRS".

Ind AS and IFRS

The benefits claimed for a single global standard

	Benefit
1	Comparability across countries, so that an investor can compare an Indian company with a German one
2	Easier access to foreign capital, because a foreign investor need not have the accounts restated
3	Lower cost for groups operating in several countries, which otherwise keep two sets of accounts
4	Better quality of reporting, because fair value often reflects economic reality more closely than historical cost
5	Easier cross-border acquisition, because the target's accounts are readable

The difficulties

	Difficulty
1	Fair value is hard to measure where no active market exists, and estimating it introduces judgment and volatility
2	Profit becomes volatile, because unrealised gains and losses pass through the accounts
3	Training and system cost is heavy, and falls at once
4	Conflict with tax and other laws, which are written round the older treatments
5	Smaller companies gain little from international comparability and bear the whole cost, which is why the phasing is by size

Quick revision


IFRS	Issued by the IASB, a private international body; no legal force in India of itself
Ind AS	Notified by the Government, Rules 2015, numbered 101 to 116, converged with IFRS
AS	Notified by the Government, Rules 2021, numbered 1 to 29, largely historical cost
India's course	Convergence, not adoption, with carve-outs
Applies by	Net worth and listing; once in, the group follows and there is no going back
The main gain	Comparability across countries and access to foreign capital
The main difficulty	Measuring fair value, and the volatility it brings into profit

Test yourself

Who issues IFRS, and do they bind an Indian company of themselves?
What is the difference between adoption and convergence, and which did India choose?
What is a carve-out?
Which Rules notify Ind AS, and how are the companies that must follow them identified?
Give two benefits and two difficulties of a single global standard.

Answer in one sentence

1. The International Accounting Standards Board, a body of the IFRS Foundation, and they do not bind an Indian company of themselves because they are not Indian law.

2. Adoption means the country's law makes IFRS as issued its own standards, while convergence means the country writes its own standards to say substantially the same thing with departures; India chose convergence.

Ind AS and IFRS

3. A departure in Ind AS from the corresponding IFRS, made because the international treatment does not suit Indian law or conditions.

4. The Companies (Indian Accounting Standards) Rules 2015, and the companies are identified by net worth and by whether they are listed, with the group following once the parent is in.

5. Comparability across countries and easier access to foreign capital; against the difficulty of measuring fair value where no active market exists and the volatility that unrealised gains and losses bring into the profit.

Contents This chapter on its own page

Chapter Eight

AS 1: Disclosure of Accounting Policies

Syllabus topic 4, "AS – 1 Disclosure of Accounting Policies."

In one line

AS 1 requires all significant accounting policies to be disclosed, in one place, as part of the financial statements, and requires any change with a material effect to be disclosed with its amount.

What the standard is about

Paragraph 1: the Standard deals with the disclosure of significant accounting policies followed in preparing and presenting financial statements.

Paragraph 2 gives the reason. The view presented can be significantly affected by the accounting policies followed, the policies vary from enterprise to enterprise, and disclosure is therefore necessary if the view presented is to be properly appreciated.

Paragraph 8 states the purpose: to promote better understanding by establishing the disclosure of significant accounting policies and the manner of their disclosure, and to facilitate a more meaningful comparison between the financial statements of different enterprises.

The three fundamental accounting assumptions: paragraph 10

	AS 1's own words
Going concern	The enterprise is normally viewed as continuing in operation for the foreseeable future; it is assumed that it has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations
Consistency	It is assumed that accounting policies are consistent from one period to another
Accrual	Revenues and costs are accrued, that is, recognised as they are earned or incurred and not as money is received or paid, and recorded in the financial statements of the periods to which they relate

Paragraph 9 explains why they are not stated: their acceptance and use are assumed, and disclosure is necessary if they are not followed.

Paragraph 27 is the operative rule and is the most examined sentence in AS 1.

If the fundamental accounting assumptions, viz. Going Concern, Consistency and Accrual are followed in financial statements, specific disclosure is not required. If a fundamental accounting assumption is not followed, the fact should be disclosed.

What an accounting policy is: paragraph 11

The accounting policies refer to the specific accounting principles and the methods of applying those principles adopted by the enterprise in the preparation and presentation of financial statements.

Paragraph 12 adds the reason there is no single list: the differing circumstances in which enterprises operate make alternative principles and methods acceptable, and the choice calls for considerable judgement by the management.

The areas in which policies differ: paragraph 14

AS 1 gives a list of examples and says it is not exhaustive. These are the areas in which a policy must be stated.

	Area
1	Methods of depreciation, depletion and amortisation
2	Treatment of expenditure during construction
3	Conversion or translation of foreign currency items
4	Valuation of inventories
5	Treatment of goodwill
6	Valuation of investments
7	Treatment of retirement benefits
8	Recognition of profit on long-term contracts
9	Valuation of fixed assets
10	Treatment of contingent liabilities

AS 1: Disclosure of Accounting Policies

Ten areas, and a question asking where policies differ wants six or more of them.

The considerations governing selection: paragraph 17

Three, and each is a convention from an earlier chapter given statutory force.

	AS 1's words
(a) Prudence	In view of the uncertainty attaching to future events, profits are not anticipated but recognised only when realised, though not necessarily in cash; and provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate
(b) Substance over form	The accounting treatment and presentation should be governed by the substance and not merely by the legal form of transactions and events
(c) Materiality	Financial statements should disclose all material items, that is, items the knowledge of which might influence the decisions of the user

Paragraph 16 gives the overriding consideration: the primary consideration in selecting policies is that they should represent a true and fair view.

The disclosure requirements: paragraphs 18 to 26

Paragraph	Requirement
18	All significant accounting policies adopted should be disclosed
19	Such disclosure should form part of the financial statements
20	It would be helpful if they were all disclosed in one place rather than scattered
paragraph 22 and 26	Any change with a material effect must be disclosed, with the amount by which any item is affected, or, where that is not ascertainable, the fact must be indicated
26, second limb	A change with no material effect this period but reasonably expected to have one in later periods must also be disclosed in the period the change is adopted
23	Disclosure cannot remedy a wrong or inappropriate treatment

Paragraph 23 is the sentence that stops disclosure being used as a defence. Stating that a wrong policy was followed does not make the statements true and fair.

What a policies note looks like

A short one, in the form a company uses.

Policy	The disclosure
Basis of preparation	The financial statements are prepared under the historical cost convention on the accrual basis, in accordance with the accounting standards notified under section 133 of the Companies Act 2013
Inventories	Valued at the lower of cost and net realisable value, cost being determined on the weighted average basis
Depreciation	Provided on the written down value method over the useful lives specified in Schedule II
Revenue recognition	Revenue from the sale of goods is recognised when the property in the goods passes to the buyer
Retirement benefits	Contributions to defined contribution schemes are charged as incurred; gratuity is provided on an actuarial valuation

AS 1: Disclosure of Accounting Policies

Five lines, and a question asking you to draft a policies note wants about this much.

Quick revision


What AS 1 does	Requires disclosure of policies; it does not choose them
Paragraph 10	Three fundamental assumptions: going concern, consistency, accrual
Paragraph 27	Disclosure only if an assumption is not followed
Paragraph 14	Ten areas in which policies differ, and the list is not exhaustive
Paragraph 17	Prudence, substance over form, materiality
Paragraph 16	The primary consideration is a true and fair view
Paragraphs 24 to 26	All significant policies, in one place, and any material change with its amount
Paragraph 23	Disclosure cannot remedy a wrong treatment

Test yourself

What does AS 1 require, and what does it not do?
Name the three fundamental accounting assumptions and state paragraph 27's rule.
Give six areas in which accounting policies differ.
Name the three considerations governing the selection of policies.
Can a wrong accounting treatment be cured by disclosing it?

Answer in one sentence

1. It requires all significant accounting policies to be disclosed as part of the financial statements and in one place; it does not prescribe which policy is to be used.

2. Going concern, consistency and accrual; if all three are followed no specific disclosure is required, and if any one is not followed the fact must be disclosed.

3. Depreciation methods, valuation of inventories, treatment of goodwill, valuation of investments, treatment of retirement benefits, and valuation of fixed assets.

4. Prudence, substance over form and materiality, with the primary consideration being that the policies represent a true and fair view.

5. No; paragraph 23 says in terms that disclosure of accounting policies or of changes in them cannot remedy a wrong or inappropriate treatment of the item.

Contents This chapter on its own page

Chapter Nine

AS 2: Scope, and the Cost of Inventories

Syllabus topic 5, "AS – 2 Valuation of Inventories."

The objective

AS 2's own objective paragraph. A primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognised. The Standard deals with that value, including the ascertainment of cost and any write-down to net realisable value.

"Until the related revenues are recognised" is the connection to AS 9. Stock sits on the balance sheet until it is sold, and the moment it is sold its cost becomes an expense matched against the revenue.

What an inventory is: paragraph 3.1

Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

Clause	What it covers
(a)	Finished goods, and goods bought for resale
(b)	Work in progress
(c)	Raw materials, stores, spares, consumables and loose tools awaiting use

Paragraph 4 adds two things. Inventories include merchandise, software held for resale, and land or other property held for resale. They do NOT include spare parts, servicing equipment and standby equipment that meet the definition of property, plant and equipment, which go under AS 10.

That exclusion is the trap. A machine spare held for a particular machine, of material value and used over more than one period, is a fixed asset and not stock.

What is outside the scope: paragraph 1

	Excluded
(a)	Work in progress arising under construction contracts, including directly related service contracts, which AS 7 deals with
(b)	Work in progress arising in the ordinary course of business of service providers
(c)	Shares, debentures and other financial instruments held as stock-in-trade
(d)	Producers' inventories of livestock, agricultural and forest products, and mineral oils, ores and gases, to the extent measured at net realisable value in accordance with well established practices in those industries

Paragraph 2 explains (d). Those inventories are measured at net realisable value at certain stages of production, for example when crops have been harvested or ores extracted and sale is assured under a forward contract or a government guarantee, or where a homogenous market exists and there is a negligible risk of failure to sell.

Clause (d) is why the sibling paper on farm accounting is governed by Ind AS 41 and not by AS 2. A living animal or a growing crop is outside this Standard.

The measurement rule: paragraph 5

Inventories should be valued at the lower of cost and net realisable value.

One sentence, set in the Standard's bold italic type, which means it is a main principle. The rest of AS 2 is the two halves of that comparison.

AS 2: Scope, and the Cost of Inventories

The cost of inventories: paragraph 6

The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Three components, and the last phrase is the test for anything not obviously in the first two.

Costs of purchase: paragraph 7

Included	Deducted
The purchase price	Trade discounts
Duties and taxes, other than those subsequently recoverable from the taxing authorities	Rebates
Freight inwards	Duty drawbacks
Other expenditure directly attributable to the acquisition	Other similar items

"Other than those subsequently recoverable" is the input tax credit rule. GST that the enterprise will recover as input tax credit is not part of the cost of the stock; a duty it cannot recover is.

Trade discount is deducted; cash discount is not. A cash discount is a reward for early payment and is a financing item, credited to the profit and loss account. That pair is examined.

Costs of conversion: paragraphs 8 and 9

Costs directly related to the units of production, such as direct labour, plus a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods.

	Definition, in AS 2's words
Fixed production overheads	Indirect costs of production that remain relatively constant regardless of the volume, such as depreciation and maintenance of factory buildings and the cost of factory management and administration
Variable production overheads	Indirect costs that vary directly, or nearly directly, with the volume, such as indirect materials and indirect labour

Paragraph 9 fixes how the fixed overheads are allocated, and it is the rule students never expect.

The allocation of fixed production overheads is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.

The consequence: where actual production is below normal capacity, the fixed overhead per unit is not increased; the unallocated portion is charged as an expense of the period. So a year of low production does not inflate the value of the stock, which is exactly what a naive absorption would do. The actual level may be used where it approximates normal capacity.

What is NOT included in cost

A question on AS 2 almost always asks this, and the four are:

Excluded	Why
Abnormal amounts of wasted materials, labour or other production costs	They are not a cost of bringing the inventory to its present condition; they are a loss
Storage costs, unless necessary in the production process before a further production stage	Storing finished goods is a cost of holding, not of making
Administrative overheads that do not contribute to bringing the inventories to their present location and condition	They are period costs
Selling and distribution costs	The goods are not yet sold

AS 2: Scope, and the Cost of Inventories

And interest and other borrowing costs are ordinarily excluded, being dealt with by the borrowing costs standard, save for the qualifying assets that standard permits.

Worked: building a cost

A manufacturer's figures for the period.

	Rs
Purchase price of materials	5,00,000
Less: trade discount	(20,000)
Import duty, not recoverable	40,000
GST recoverable as input tax credit	90,000
Freight inward	15,000
Direct labour	1,80,000
Variable production overheads	60,000
Fixed production overheads incurred	1,20,000
Abnormal wastage of material	25,000
Storage of finished goods	18,000
Administrative overheads, general	70,000
Selling and distribution	45,000

Normal capacity is 10,000 units and actual production was 8,000 units.

The cost of production.

	Rs
Purchase price less trade discount	4,80,000
Add: import duty, not recoverable	40,000
Add: freight inward	15,000
Cost of purchase	5,35,000
Add: direct labour	1,80,000
Add: variable production overheads	60,000
Add: fixed production overheads absorbed, 1,20,000 x 8,000 over 10,000	96,000
Cost of production of 8,000 units	8,71,000

Cost a unit is Rs 108.875.

And what was excluded, with the reason.

Excluded	Rs	Why
GST recoverable	90,000	Recoverable from the taxing authorities, paragraph 7
Abnormal wastage	25,000	Paragraph 13, an abnormal amount
Storage of finished goods	18,000	Not necessary before a further production stage
General administrative overheads	70,000	Do not bring the inventory to its present location and condition
Selling and distribution	45,000	The goods are not yet sold
Unabsorbed fixed overhead, 1,20,000 less 96,000	24,000	Paragraph 9; charged as an expense of the period

The Rs 24,000 of unabsorbed fixed overhead is the line that separates a good answer from an average one.

Quick revision


Paragraph 5	Lower of cost and net realisable value
Paragraph 6	Cost = costs of purchase + costs of conversion + other costs of bringing to present location and condition
Purchase	Price, non-recoverable duties, freight inward, less trade discount; not recoverable taxes, not cash discount
Conversion	Direct labour and a systematic allocation of production overheads
Fixed overhead	Allocated on normal capacity; the unabsorbed part is a period expense
Excluded	Abnormal wastage; storage of finished goods; general administration; selling and distribution
Outside the scope	Construction work in progress; service providers' work in progress; financial instruments held as stock; producers' agricultural and mineral inventories at net realisable value

Test yourself

Give AS 2's definition of inventories.
What three components make up cost?
Is GST recoverable as input tax credit part of the cost of stock?
On what basis are fixed production overheads allocated, and what happens to the unabsorbed part?
Name four costs excluded from the cost of inventories.

AS 2: Scope, and the Cost of Inventories

Answer in one sentence

1. Assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services.

2. Costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

3. No, because paragraph 7 excludes duties and taxes subsequently recoverable by the enterprise from the taxing authorities.

4. On the normal capacity of the production facilities, and the portion not absorbed because actual production fell short is charged as an expense of the period.

5. Abnormal amounts of wasted materials, labour or production costs; storage costs not necessary before a further production stage; administrative overheads that do not bring the inventory to its present location and condition; and selling and distribution costs.

Contents This chapter on its own page

Chapter Ten

AS 2: Net Realisable Value, the Cost Formulas, and Disclosure

Syllabus topic 5, "AS – 2 Valuation of Inventories."

Net realisable value: paragraph 3.2

Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

Three elements and two subtractions.


Estimated selling price	In the ordinary course of business, not a forced-sale price
Less estimated costs of completion	What must still be spent to finish the item
Less estimated costs necessary to make the sale	Commission, freight outward, packing for despatch

Worked. A half-finished item will sell for Rs 500. Rs 120 must be spent to finish it and Rs 30 of selling commission will be payable.

	Rs
Estimated selling price	500
Less: estimated costs of completion	(120)
Less: estimated costs to make the sale	(30)
Net realisable value	350

Why a write-down happens: paragraph 20

The cost may not be recoverable if the inventories are damaged, if they have become wholly or partly obsolete, if their selling prices have declined, or if the estimated costs of completion or of sale have increased.

And the reason the practice exists, in the Standard's own words: it is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.

The comparison is item by item: paragraph 21

Inventories are usually written down to net realisable value on an item-by-item basis. In some circumstances it may be appropriate to group similar or related items, which may be the case with items relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately. It is not appropriate to write down inventories based on a classification of inventory, for example, finished goods, or all the inventories in a particular business segment.

Worked, and the two answers differ.

Item	Cost, Rs	Net realisable value, Rs	Lower, Rs
A	40,000	46,000	40,000
B	60,000	52,000	52,000
C	30,000	34,000	30,000
Total	1,30,000	1,32,000	1,22,000

Item by item, the correct answer, is Rs 1,22,000. On the totals it would be Rs 1,30,000, because the total cost is lower than the total net realisable value, and that answer is wrong by Rs 8,000 because it lets A's and C's unrealised gains cover B's real loss. Paragraph 21 forbids it, and this is the single most useful thing in AS 2 for an examination.

Paragraph 22 fixes the evidence on which the estimate rests. Estimates of net realisable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realise, and they take into consideration fluctuations of price or cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date.

AS 2: Net Realisable Value, the Cost Formulas, and Disclosure

The last clause is the useful one. A price obtained in April is evidence of what the stock was worth on 31 March, if it confirms a condition that existed then; a fall caused by something that happened in April is not.

Two special rules

Paragraph 23: inventory held against a firm contract. The net realisable value of the quantity held to satisfy firm sales or service contracts is based on the contract price. Where the contracts are for less than the quantity held, the excess is valued at general selling prices.

Paragraph 24: raw materials. Materials held for use in production are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. Where the price of materials has fallen and the finished products' cost will exceed net realisable value, the materials are written down, and replacement cost may then be the best available measure of their net realisable value.

Paragraph 24 is the rule students get wrong. A fall in the price of a raw material does not by itself require a write-down; the test is whether the finished product can still be sold at or above its cost.

The cost formulas: paragraphs 14 to 17

AS 2 permits three, and no others.

Formula	When	Paragraph
Specific identification	For items not ordinarily interchangeable, and for goods segregated for a specific project	14 and 15
First in first out (FIFO)	For the rest	16
Weighted average cost	For the rest	16

Paragraph 16 is the rule: the cost of inventories other than those covered by specific identification should be assigned by using the first in first out (FIFO) or weighted average cost formula, and the formula used should reflect the fairest possible approximation to the cost incurred in bringing the items to their present location and condition.

Paragraph 17 explains each.

	AS 2's own explanation
FIFO	Assumes that the items purchased or produced first are consumed or sold first, so the items remaining in inventory are those most recently purchased or produced
Weighted average	The cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period; the average may be calculated on a periodic basis, or as each additional shipment is received

LIFO is not permitted. AS 2 names only the three above, and last in first out is not among them. Saying so is worth a mark.

AS 2: Net Realisable Value, the Cost Formulas, and Disclosure

Paragraph 15 has a limit on specific identification: it is not appropriate where there are large numbers of items that are ordinarily interchangeable, because selecting which items remain could then be used to produce a predetermined effect on the profit.

Techniques for measuring cost: paragraphs 18 and 19

Two techniques may be used for convenience if the results approximate actual cost.

Technique	How
Standard cost	Takes into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation, and is regularly reviewed and revised
Retail method	Used in retail for large numbers of rapidly changing items with similar margins; the cost is found by reducing from the sales value the appropriate percentage gross margin, an average percentage for each retail department being used

Disclosure: paragraph 26

The financial statements should disclose: (a) the accounting policies adopted in measuring inventories, including the cost formula used; and (b) the total carrying amount of inventories and its classification appropriate to the enterprise.

And paragraph 27 gives the classifications, which are the same ones Schedule III uses: raw materials and components, work in progress, finished goods, stock in trade, stores and spares, loose tools, and others.

Quick revision


Net realisable value	Estimated selling price in the ordinary course, less costs of completion and costs to make the sale
The comparison	Item by item, paragraph 21; grouping only for similar or related items; never on a classification
Firm contract	Net realisable value at the contract price for the quantity contracted
Raw materials	Not written down if the finished product will still sell at or above cost
Three formulas	Specific identification; FIFO; weighted average. LIFO is not permitted
Two techniques	Standard cost and the retail method, if they approximate actual cost
Disclosure	The policy including the cost formula, and the total carrying amount with its classification

Test yourself

Define net realisable value and compute it for an item selling at Rs 500 with Rs 120 of completion cost and Rs 30 of selling cost.
Cost is Rs 1,30,000 and net realisable value Rs 1,32,000 in total, with one item's net realisable value below its cost by Rs 8,000. At what figure is the stock carried, and why?
Which cost formulas does AS 2 permit, and which well-known one does it not?
The price of a raw material has fallen below cost. Must it be written down?
What must be disclosed about inventories?

Answer in one sentence

1. The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale, so Rs 500 less Rs 120 less Rs 30, which is Rs 350.

AS 2: Net Realisable Value, the Cost Formulas, and Disclosure

2. At Rs 1,22,000, because paragraph 21 requires the comparison item by item, so the unrealised gains on the other items may not be set against the real loss on that one.

3. Specific identification, first in first out, and weighted average cost; last in first out is not permitted.

4. Not necessarily; it is written down only if the finished products in which it will be incorporated are expected to be sold below their cost.

5. The accounting policies adopted in measuring inventories including the cost formula used, and the total carrying amount with the classification appropriate to the enterprise.

Contents This chapter on its own page

Chapter Eleven

AS 9: Revenue Recognition

Syllabus topic 6, "AS - 9 Revenue Recognition."

What revenue is: paragraph 4.1

Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends.

Two things in the definition are examined.

"Gross inflow", so revenue is the amount charged to the customer, not the profit on it.

"In an agency relationship, the revenue is the amount of commission and not the gross inflow", which is the Standard's own sentence and is the single most-asked point in AS 9. A travel agent who collects Rs 1,00,000 of fares and keeps Rs 8,000 has revenue of Rs 8,000.

What is outside the Standard: paragraphs 2 and 3

Paragraph 2 excludes four kinds of revenue to which special considerations apply:

	Excluded
(i)	Revenue from construction contracts
(ii)	Revenue from hire-purchase and lease agreements
(iii)	Revenue from government grants and other similar subsidies
(iv)	Revenue of insurance companies from insurance contracts

Paragraph 3 lists items that are not revenue at all, and this list is the one to learn.

	Not revenue
(i)	Realised gains on the disposal of, and unrealised gains on the holding of, non-current assets, for example an appreciation in the value of fixed assets
(ii)	Unrealised holding gains on current assets, and the natural increases in herds and agricultural and forest products
(iii)	Realised or unrealised gains from changes in foreign exchange rates and on translation
(iv)	Realised gains from discharging an obligation at less than its carrying amount
(v)	Unrealised gains from restating the carrying amount of an obligation

Item (ii) is why the sibling farm accounting paper is governed by Ind AS 41. The natural increase in a herd is not revenue under AS 9, and Ind AS 41 deals with the biological transformation that produces it.

Source one: the sale of goods

Paragraph 6.1 gives the key criterion.

A key criterion is that the seller has transferred the property in the goods to the buyer for a consideration. The transfer of property in most cases results in or coincides with the transfer of significant risks and rewards of ownership. However, there may be situations where the two do not coincide, and revenue is then recognised at the time of the transfer of significant risks and rewards.

Paragraph 11 states it as the main principle, and it has two limbs, both of which must be satisfied.

	Condition
(i)	The seller has transferred the property in the goods for a price, or all significant risks and rewards of ownership have been transferred and the seller retains no effective control of the goods to a degree usually associated with ownership
(ii)	No significant uncertainty exists regarding the amount of the consideration that will be derived from the sale

AS 9: Revenue Recognition

Worked cases.

Situation	Recognise?
Goods delivered and invoiced, payment due in 60 days	Yes; property has passed and the amount is certain
Goods sent on approval, the buyer not yet having accepted	No; the property has not passed
Goods sent on consignment to an agent	No; the agent has not bought them
An order received with an advance	No; nothing has been delivered, and the advance is a liability
Goods delivered, but the price depends on an inspection not yet done	No; limb (ii) fails, the amount being uncertain
Goods sold with a right of return, the return rate being reliably estimable	Yes, with a provision for the expected returns

Source two: the rendering of services

Paragraph 7.1 gives two methods, and paragraph 12 says the one used must be whichever relates the revenue to the work accomplished.

Method	Defined by	When it applies
Proportionate completion	Paragraph 4.3: a method which recognises revenue proportionately with the degree of completion of services under a contract	Performance consists of the execution of more than one act; revenue is recognised by reference to the performance of each act, on the basis of contract value, associated costs, number of acts or other suitable basis
Completed service contract	Paragraph 4.2: a method which recognises revenue only when the rendering of services under a contract is completed or substantially completed	Performance consists of a single act; or the services yet to be performed are so significant that performance cannot be deemed complete until they are done

And the practical rule inside paragraph 7.1(i): where services are provided by an indeterminate number of acts over a specific period, revenue is recognised on a straight line basis over that period, unless some other method better represents the pattern of performance.

An annual maintenance contract is the standard example: an indeterminate number of visits over twelve months, so one twelfth a month.

Source three: interest, royalties and dividends

Paragraph 8.1 defines each.

	What it is
Interest	Charges for the use of cash resources or amounts due to the enterprise
Royalties	Charges for the use of assets such as know-how, patents, trademarks and copyrights
Dividends	Rewards from the holding of investments in shares

And paragraph 13 gives the basis of recognition for each, which is the table an examiner wants.

	Recognised
Interest	On a time proportion basis, taking into account the amount outstanding and the rate applicable
Royalties	On an accrual basis in accordance with the terms of the relevant agreement, unless the substance makes another systematic and rational basis more appropriate
Dividends	When the owner's right to receive payment is established

AS 9: Revenue Recognition

The dividend rule is the one that catches students. A dividend is not accrued over the year it was earned in; it is recognised only when the right to receive it is established, which for a final dividend is when it is declared at the annual general meeting.

Paragraph 8.5 adds that where interest, royalties or dividends from foreign countries require exchange permission and uncertainty in remittance is anticipated, recognition may need to be postponed.

Uncertainty: paragraph 9

Paragraph 9.1 states the twin requirement: revenue must be measurable, and at the time of the sale or the rendering of the service it must not be unreasonable to expect ultimate collection.

Paragraph 9.2 deals with the case where collectability cannot be assessed with reasonable certainty at the time of raising the claim, giving as examples a claim for price escalation, export incentives and interest. Recognition is postponed to the extent of the uncertainty.

And the distinction that is the most useful thing in paragraph 9. Where the uncertainty arises after the revenue has already been recognised, the amount is not reversed; a separate provision is made for the doubt. So a sale properly recognised and later doubtful becomes a bad debt provision, not a reduction of turnover.

Disclosure: paragraph 14

Where recognition is postponed because of uncertainty, the circumstances must be disclosed.

And paragraph 10 prescribes the presentation of turnover, in the form:

	Rs
Turnover, gross	x
Less: excise duty	x
Turnover, net	x

The excise duty deducted is the total for the year except the part relating to the difference between the closing and opening stock, which is recognised separately with an explanatory note.

Quick revision


AS 9 is about	Timing, not amount
Revenue	The gross inflow from the ordinary activities; in an agency, the commission only
Not revenue	Gains on non-current assets; unrealised holding gains; natural increases in herds and agricultural products; exchange gains
Sale of goods	Property or significant risks and rewards transferred, and no significant uncertainty about the consideration
Services	Proportionate completion or completed service contract, whichever relates revenue to the work accomplished
Interest	Time proportion
Royalties	Accrual, per the agreement
Dividends	When the right to receive is established
Uncertainty before recognition	Postpone
Uncertainty after recognition	Provide separately, do not reverse

Test yourself

What is AS 9 mainly concerned with, and what is it not?
A travel agent collects Rs 1,00,000 and keeps Rs 8,000. What is his revenue?
Give the two conditions in paragraph 11 for recognising revenue on a sale of goods.
On what basis are interest, royalties and dividends recognised?
A sale properly recognised in March becomes doubtful in May. What is done?

AS 9: Revenue Recognition

Answer in one sentence

1. With the timing of recognition of revenue in the statement of profit and loss; not with the amount, which is usually fixed by agreement between the parties.

2. Rs 8,000, because in an agency relationship the revenue is the amount of commission and not the gross inflow.

3. That the seller has transferred the property in the goods for a price, or all significant risks and rewards of ownership with no effective control retained; and that no significant uncertainty exists about the amount of the consideration.

4. Interest on a time proportion basis by reference to the amount outstanding and the rate; royalties on an accrual basis in accordance with the agreement; and dividends when the right to receive payment is established.

5. The revenue already recognised is not reversed; a separate provision is made for the doubtful amount.

Contents This chapter on its own page

Chapter Twelve

Physical Stock Taking, and Recording It

Syllabus topic 7, "Inventory Valuation and Experiential Learning- Physical Stock Taking Activity and Recording."

In one line

Physical stock taking is counting, weighing or measuring what is actually there at a date, recording it, and reconciling the result with the books.

Why it is done

	Reason
1	To establish the quantity for the closing stock in the final accounts
2	To find shortages, damage, obsolescence and theft, which the books cannot show
3	To verify the accuracy of the stock records, and so of the system that produced them
4	To support the auditor's opinion, since he attends to obtain evidence of existence and condition
5	To support an insurance claim, where one arises

The two systems

	Periodic system	Perpetual system
Records kept	No running record; stock is known only by counting	A continuous record in a stock ledger, updated on every receipt and issue
How the closing stock is found	By counting at the year end	From the ledger, verified by counting
Cost of goods sold	Derived: opening stock plus purchases less closing stock	Recorded directly as issues are made
Discrepancies	Invisible; a shortage is buried in the cost of goods sold	Visible, as the difference between the ledger and the count
Counting	The whole stock, at the year end, with the business usually stopped	Continuous or cyclical, a part at a time, without stopping

The last row is the practical advantage of the perpetual system, and it is the reason large concerns keep one: the count can be spread over the year and no shutdown is needed.

Continuous stock taking

A part of the stock is counted every day or week, so that every line is counted at least once, and important lines several times, in the year.

Advantages
No shutdown of the business
Errors are found and corrected early
The count is done by trained staff, not by a scratch team once a year
A surprise element, because nobody knows which lines will be counted
It makes the records reliable, which lets an auditor rely on them

How a count is conducted

Step
1	Plan and instruct. Written instructions, staff assigned in pairs, areas marked out, a cut-off time fixed
2	Stop movement, or record it. No receipts or issues during the count, or all movements documented separately
3	Count, weigh or measure, and record on pre-numbered count sheets or tags
4	Identify damaged, obsolete and slow-moving items and list them separately, because they affect the valuation
5	Identify goods that are there and are not ours: goods on consignment, on approval, held for repair, or belonging to a customer
6	Identify goods that are ours and are not here: goods with a consignee, in transit, at a bonded warehouse, or with a job worker
7	Recount where two counters differ, and where a count differs materially from the record
8	Account for every count sheet, used, unused and spoilt, by its number
9	Value the counted quantities under AS 2, at the lower of cost and net realisable value
10	Reconcile with the stock ledger and investigate every difference

Physical Stock Taking, and Recording It

Steps five and six are the ones an examiner asks about, and they are the two directions of the same idea: the count establishes what is OURS, not what is here.

The cut-off

Cut-off is the rule that a transaction is recorded in the period in which it occurred, and at a stock count it is where most errors are made.

Situation	Treatment
Goods received before the count and the invoice not yet entered	Include in stock, and record a creditor
Goods received after the count, invoice already entered	Exclude from stock; the purchase belongs to the next period, or the creditor is reversed
Goods despatched before the count and not yet invoiced	Exclude from stock, and record the sale
Goods invoiced before the count but not yet despatched	Include in stock only if the property has not passed; otherwise exclude

A cut-off error double counts or omits, and it moves the profit by the whole margin.

Recording it: the count sheet

Field
Sheet number, pre-printed and accounted for
Location or bin
Item code and description
Unit of measurement
Quantity counted, in ink, by the first counter
Quantity verified, by the second counter
Condition: good, damaged, obsolete, slow moving
Signatures of both counters and of the supervisor
Date and time

The reconciliation, and its entries

	Rs
Value as per the stock ledger	x
Value as per the physical count	x
Difference	x

Every difference is investigated and one of these is the answer: an unrecorded receipt or issue, a posting error, a wrong unit of measure, a cut-off error, normal wastage within the allowed limit, abnormal loss, or theft.

And the entries.

Where the count is LESS than the record, and the shortage is normal: Cost of goods sold, or the appropriate expense, is debited and the stock account credited.

Where the shortage is ABNORMAL: An abnormal loss account is debited and the stock account credited, and the loss is shown separately in the profit and loss account, because AS 2 paragraph 13 excludes abnormal amounts from the cost of inventories.

That last sentence is the connection back to AS 2 and it is worth making: a normal loss is absorbed into the cost of what remains; an abnormal loss is not, and is written off.

Physical Stock Taking, and Recording It

Quick revision


What it establishes	The quantity; AS 2 gives the rate
Two systems	Periodic, count only at the year end; perpetual, a running record verified by counting
Continuous stock taking	A part counted regularly, without a shutdown, with a surprise element
Two directions of ownership	Goods here that are not ours; goods ours that are not here
Cut-off	The commonest source of error, and it moves the profit by the whole margin
Count sheets	Pre-numbered, and all accounted for
Normal shortage	Absorbed into cost
Abnormal shortage	Written off separately, AS 2 paragraph 13

Test yourself

Give four reasons for taking a physical stock.
Distinguish the periodic system from the perpetual system.
Name two categories of goods that are physically present and are not included, and two that are absent and are included.
What is cut-off, and why does a cut-off error matter?
How does a normal shortage differ in treatment from an abnormal one?

Answer in one sentence

1. To establish the quantity for the closing stock, to find shortages damage and obsolescence, to verify the accuracy of the stock records, and to give the auditor evidence of existence and condition.

2. Under the periodic system no running record is kept and the stock is known only by counting, while under the perpetual system a stock ledger is maintained continuously and the count verifies it.

3. Present but excluded: goods held on consignment for another and goods received on approval; absent but included: goods with a consignee and goods with a job worker.

4. The rule that a transaction is recorded in the period in which it occurred; an error double counts or omits an item and moves the profit by the whole margin on it.

5. A normal shortage is absorbed into the cost of the remaining stock, while an abnormal shortage is written off separately, because AS 2 paragraph 13 excludes abnormal amounts from the cost of inventories.

Contents This chapter on its own page

Chapter Thirteen

The Stock Ledger Account, and FIFO

Syllabus topic 8, "Practical Problems on preparation of Stock Ledger Account using First in First Out (FIFO Method) and Weighted Average Cost method."

The form

A stock ledger account, also called a stores ledger card, has three groups of three columns.

Group	Columns
Receipts	Quantity, Rate, Amount
Issues	Quantity, Rate, Amount
Balance	Quantity, Rate, Amount

With a date and a particulars column in front. The balance columns after every line must equal the previous balance plus the receipt less the issue, in both quantity and amount, and that is the running check.

The FIFO assumption

AS 2 paragraph 17: the FIFO formula assumes that the items purchased or produced first are consumed or sold first, so the items remaining in inventory at the end of the period are those most recently purchased or produced.

It follows that
Issues are priced at the oldest rates still in stock
The closing stock is at the most recent rates
In a rising market the closing stock is higher and the profit higher
In a falling market the closing stock is lower and the profit lower

The assumption is about the FLOW OF COST, not about the physical movement. A company may issue whatever it likes physically; FIFO is a rule for pricing.

The transactions

Sunder Traders deals in a single product. Its transactions for April were:

Date	Particulars	Units	Rate, Rs
1 April	Opening balance	200	50
5 April	Purchase	300	55
10 April	Issue	250
15 April	Purchase	250	61
20 April	Issue	300
25 April	Purchase	200	63
28 April	Issue	150

The stock ledger, first in first out

Date	Particulars	Receipts qty	Rate	Amount, Rs	Issues qty	Rate	Amount, Rs	Balance qty	Amount, Rs
1 April	Balance	200	50	10,000				200	10,000
5 April	Purchase	300	55	16,500				500	26,500
10 April	Issue				200	50	10,000
					50	55	2,750	250	13,750
15 April	Purchase	250	61	15,250				500	29,000
20 April	Issue				250	55	13,750
					50	61	3,050	200	12,200
25 April	Purchase	200	63	12,600				400	24,800
28 April	Issue				150	61	9,150	250	15,650

The balance in layers at each stage, which is the working the answer should show.

After	The balance consists of
5 April	200 at Rs 50 and 300 at Rs 55
10 April	250 at Rs 55
15 April	250 at Rs 55 and 250 at Rs 61
20 April	200 at Rs 61
25 April	200 at Rs 61 and 200 at Rs 63
28 April	50 at Rs 61 and 200 at Rs 63

The closing stock is 250 units valued at Rs 15,650.

The proof

	Rs
Opening balance	10,000
Add: purchases, 16,500 + 15,250 + 12,600	44,350
Less: cost of issues, 12,750 + 16,800 + 9,150	(38,700)
Closing stock	15,650

And in quantity: 200 opening plus 750 purchased less 700 issued is 250 units.

The Stock Ledger Account, and FIFO

Run both proofs. They cost two lines and they catch the one error that a stock ledger is prone to, which is pricing an issue out of a layer that had already been exhausted.

The three traps

1. Collapsing the balance into one line. After 5 April the balance is not "500 units at Rs 53"; it is 200 at Rs 50 and 300 at Rs 55, and the next issue must come out of the Rs 50 layer first. Writing an average rate in the balance column turns FIFO into weighted average without noticing.

2. Splitting an issue and forgetting to split the entry. The issue of 250 on 10 April is priced from two layers, so it needs two lines in the issue columns, of Rs 10,000 and Rs 2,750. One line with a made-up rate loses the marks for the working.

3. A return. Goods returned to the supplier come out of the layer they were bought into; goods returned by a department come back at the rate they were issued at. Where a question has a return, say which rule you used.

When FIFO is appropriate

Suited to	Because
Perishable goods and goods with a shelf life	The physical flow matches the cost flow
Slow-moving, high-value, identifiable items	Though specific identification may be better still
Periods of stable prices	The choice then makes little difference

Its criticism, in a period of rising prices: the issues are priced at old, low rates, so the cost of goods sold is understated and the profit overstated, while the closing stock is at current rates and is realistic. Weighted average sits between the two, and the next chapter shows by how much.

Quick revision


Nine columns	Receipts, issues and balance, each with quantity, rate and amount
The assumption	The earliest items are consumed first; the closing stock is at the latest rates
The balance	Kept in layers, never as one averaged line
Two proofs	Opening plus purchases less issues equals the closing value; and the same in quantity
Rising prices	Closing stock higher, profit higher
Sunder Traders	Closing stock 250 units, Rs 15,650

Test yourself

Draw the columns of a stock ledger account.
State the FIFO assumption in AS 2's own terms.
Why must the balance be kept in layers?
Compute the value of the issue on 10 April in the worked example, showing the layers.
What does FIFO do to the profit in a period of rising prices, and why?

Answer in one sentence

1. A date and particulars column, then three groups of three: receipts with quantity, rate and amount, issues with the same three, and balance with the same three.

The Stock Ledger Account, and FIFO

2. That the items purchased or produced first are consumed or sold first, so the items remaining in inventory at the end of the period are those most recently purchased or produced.

3. Because the next issue must be priced out of the oldest layer still in stock, and an averaged balance destroys the information needed to do that.

4. Two hundred units from the opening layer at Rs 50, which is Rs 10,000, and fifty units from the 5 April purchase at Rs 55, which is Rs 2,750, a total of Rs 12,750.

5. It overstates the profit, because issues are priced at the older and lower rates so the cost of goods sold is understated, while the closing stock is carried at the current higher rates.

Contents This chapter on its own page

Chapter Fourteen

The Stock Ledger Account, Weighted Average Cost

Syllabus topic 8, "Practical Problems on preparation of Stock Ledger Account using First in First Out (FIFO Method) and Weighted Average Cost method."

The method

AS 2 paragraph 17: under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period, and the average may be calculated on a periodic basis, or as each additional shipment is received.

So the Standard permits two versions, and a question usually intends the second.

Version	When the average is computed
Periodic weighted average	Once, at the end of the period, on the whole of the opening stock and the purchases
Moving, or perpetual, weighted average	Afresh on every receipt, and used to price every issue until the next receipt

The stock ledger uses the moving version, because a stock ledger prices each issue as it happens. Say which you are using in one line above the ledger.

The formula

Weighted average rate = Total value of the balance / Total quantity of the balance, recomputed immediately after every receipt.

And the two rules that follow.

On a receipt: add the quantity and the value, then divide to get the new rate.
On an issue: price it at the rate then in force and do not recompute, since removing units at the average rate leaves the average unchanged.

The same transactions as the FIFO chapter

Date	Particulars	Units	Rate, Rs
1 April	Opening balance	200	50
5 April	Purchase	300	55
10 April	Issue	250
15 April	Purchase	250	61
20 April	Issue	300
25 April	Purchase	200	63
28 April	Issue	150

The stock ledger, weighted average cost

Date	Particulars	Receipts qty	Rate	Amount, Rs	Issues qty	Rate	Amount, Rs	Balance qty	Rate	Amount, Rs
1 April	Balance	200	50	10,000				200	50.00	10,000
5 April	Purchase	300	55	16,500				500	53.00	26,500
10 April	Issue				250	53.00	13,250	250	53.00	13,250
15 April	Purchase	250	61	15,250				500	57.00	28,500
20 April	Issue				300	57.00	17,100	200	57.00	11,400
25 April	Purchase	200	63	12,600				400	60.00	24,000
28 April	Issue				150	60.00	9,000	250	60.00	15,000

The three averages, computed.

After the receipt on	Value, Rs	Quantity	Rate, Rs
5 April	26,500	500	53.00
15 April	28,500	500	57.00
25 April	24,000	400	60.00

The closing stock is 250 units at Rs 60.00, which is Rs 15,000.

The proof

	Rs
Opening balance	10,000
Add: purchases	44,350
Less: cost of issues, 13,250 + 17,100 + 9,000	(39,350)
Closing stock	15,000

The two methods compared

	FIFO	Weighted average
Cost of issues, Rs	38,700	39,350
Closing stock, Rs	15,650	15,000
Difference		650

Prices rose through the month, so FIFO gives the higher closing stock and the lower cost of issues, and therefore a higher gross profit by Rs 650.

The Stock Ledger Account, Weighted Average Cost

Say it as a proposition. In a rising market FIFO shows a higher profit and a higher closing stock than weighted average; in a falling market it shows a lower profit and a lower closing stock. Weighted average always lies between the extremes, because it is an average.

And the total is the same in the end. Over the whole life of the stock the total cost charged is the same under both; only the timing differs, and a question that asks which method is "better" is asking about timing, not about total profit.

The traps

Trap	The rule
Recomputing the average on an issue	The average does not change when units leave at the average rate
Using a simple average of the rates	The weights are the quantities
Rounding the rate too early	Carry two decimals at least, and where the rate does not divide evenly, say so and carry the fraction to the value column
Mixing the periodic and moving versions	Pick one and say which
A return to the supplier	Reduces both quantity and value at the rate in force, and the average is recomputed

The rounding trap is real. Where an average does not come out even, the value column, not the rate column, carries the truth: compute the issue as quantity times value over quantity, and let the balance value be the previous value less that figure. The rates in the worked example are whole numbers only because the figures were chosen so.

Which method to choose


AS 2 permits both, and requires the one chosen to reflect the fairest possible approximation to the cost incurred	Paragraph 16
The choice is an accounting policy and must be disclosed	AS 2 paragraph 26(a), and AS 1
Consistency requires the same method year to year, and a change with a material effect must be disclosed with its amount	AS 1 paragraph 26
Weighted average suits homogeneous, interchangeable goods bought in bulk at varying prices, such as oil, grain, chemicals or fuel
FIFO suits goods with a shelf life, where the physical flow follows the cost flow

Quick revision


Formula	Balance value over balance quantity, recomputed on every receipt
On an issue	Price at the rate in force; do not recompute
Two versions	Periodic and moving; the stock ledger uses moving
Rising prices	Weighted average gives a lower closing stock and profit than FIFO
Over the whole life	The total cost charged is the same; only the timing differs
Sunder Traders	Closing stock 250 units at Rs 60, Rs 15,000, against FIFO's Rs 15,650

The Stock Ledger Account, Weighted Average Cost

Test yourself

State the weighted average formula and say when it is recomputed.
Why is the average not recomputed on an issue?
Compute the rate after the 15 April purchase and show the working.
Which method gives the higher profit in a rising market, and why?
Is the total cost charged over the life of the stock different under the two methods?

Answer in one sentence

1. The value of the balance divided by the quantity of the balance, recomputed immediately after every receipt.

2. Because removing units at the rate that is already the average leaves the average of what remains unchanged.

3. The balance was Rs 13,250 for 250 units, the purchase added Rs 15,250 for 250 units, giving Rs 28,500 for 500 units, which is Rs 57.00.

4. FIFO, because it prices the issues at the older and lower rates, so the cost of goods sold is lower and the closing stock is carried at the current higher rates.

5. No, the total is the same and only the timing of the charge differs, so a question about which is better is a question about timing.

Contents This chapter on its own page

Chapter Fifteen

Valuation of Inventory under AS 2, Worked

Syllabus topic 9, "Short practical problems on Valuation of Inventory as per AS 2."

Question one: the basic valuation

A trader's closing stock at 31 March consists of five items.

Item	Units	Cost a unit, Rs	Estimated selling price a unit, Rs	Estimated selling costs a unit, Rs
A	400	120	150	10
B	300	200	190	15
C	500	80	95	8
D	200	250	240	20
E	600	60	62	5

Value the closing stock as required by AS 2.

Step one: the net realisable value a unit

Net realisable value = estimated selling price less estimated costs of completion less estimated costs necessary to make the sale.

Item	Selling price, Rs	Less: selling costs, Rs	Net realisable value, Rs
A	150	10	140
B	190	15	175
C	95	8	87
D	240	20	220
E	62	5	57

Step two: the lower of cost and net realisable value, item by item

Item	Cost a unit, Rs	Net realisable value a unit, Rs	Lower, Rs	Units	Value, Rs
A	120	140	120	400	48,000
B	200	175	175	300	52,500
C	80	87	80	500	40,000
D	250	220	220	200	44,000
E	60	57	57	600	34,200
				Total	2,18,700

The closing stock is Rs 2,18,700, and three of the five items have been written down: B by Rs 25 a unit, D by Rs 30 and E by Rs 3.

Why the other answer is wrong

A student who compares the totals gets a different figure.

	Rs
Total cost, 48,000 + 60,000 + 40,000 + 50,000 + 36,000	2,34,000
Total net realisable value, 56,000 + 52,500 + 43,500 + 44,000 + 34,200	2,30,200

	Rs
Lower of the two totals, which is wrong	2,30,200
Correct figure, item by item	2,18,700
The stock would be overstated by	11,500

Why it is wrong. Comparing the totals lets the unrealised gains on A and C, which AS 2 does not permit to be recognised at all, cover the real losses on B, D and E. Paragraph 21 says in terms that it is not appropriate to write down inventories based on a classification, and the total is the widest classification of all.

Question two: raw materials, paragraph 24

A manufacturer holds raw material costing Rs 4,00,000 whose replacement cost has fallen to Rs 3,60,000. The finished products into which it will go cost Rs 6,00,000 to complete, and their net realisable value is:

(a) Rs 12,00,000, or (b) Rs 9,00,000.

The rule. Materials are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost.

Case (a).

	Rs
Cost of the material	4,00,000
Add: cost to complete	6,00,000
Cost of the finished product	10,00,000
Net realisable value of the finished product	12,00,000

Valuation of Inventory under AS 2, Worked

The finished product will sell above its cost, so the material is NOT written down and is carried at Rs 4,00,000, although its replacement cost has fallen.

Case (b).

	Rs
Cost of the finished product	10,00,000
Net realisable value of the finished product	9,00,000

The finished product will sell below its cost, so the material IS written down, and paragraph 24 says the replacement cost may then be the best available measure of its net realisable value. The material is carried at Rs 3,60,000.

Same fall in price, two different answers, and the test is not the material's own price at all.

Question three: a firm contract, paragraph 23

A company holds 1,000 units costing Rs 90 each. Six hundred are committed under a firm sales contract at Rs 85 a unit. The general selling price is Rs 100 and selling costs are Rs 4 a unit.

The rule. The net realisable value of the quantity held to satisfy firm sales contracts is based on the contract price, and where the contracts are for less than the quantity held, the excess is valued at general selling prices.

	Units	Net realisable value a unit, Rs	Cost a unit, Rs	Lower, Rs	Value, Rs
Committed under contract	600	81	90	81	48,600
Uncommitted	400	96	90	90	36,000
Total	1,000				84,600

The committed units' net realisable value is the contract price of Rs 85 less selling costs of Rs 4, which is Rs 81. The uncommitted units' is Rs 100 less Rs 4, which is Rs 96. So the same stock is valued at two different rates, and that is what paragraph 23 requires.

Question four: abnormal loss

A concern's records show 5,000 units. A count finds 4,850. Normal wastage in this trade is 1 per cent. The cost is Rs 40 a unit.

	Units
As per the records	5,000
Normal wastage at 1 per cent	50
Expected	4,950
Actually counted	4,850
Abnormal loss	100

	Rs
Closing stock, 4,850 units at Rs 40	1,94,000
Abnormal loss written off, 100 units at Rs 40	4,000

The normal wastage of 50 units is absorbed into the cost of what remains, so the remaining units continue to be carried at cost. The abnormal loss of 100 units is written off separately, because AS 2 paragraph 13 excludes abnormal amounts from the cost of inventories.

The order of work, for any AS 2 valuation question

Step
1	Compute net realisable value a unit: selling price less costs of completion less costs to sell
2	Where there is a firm contract, use the contract price for the committed quantity
3	Compare cost and net realisable value ITEM BY ITEM
4	For raw materials, apply paragraph 24: do not write down unless the finished product will sell below cost
5	Separate any abnormal loss and write it off
6	Total, and state the figure with the basis: "at the lower of cost and net realisable value, item by item"

Valuation of Inventory under AS 2, Worked

Quick revision


The rule	Lower of cost and net realisable value, item by item
On totals	Forbidden; in the worked example it overstates by Rs 11,500
Raw materials	Not written down unless the finished product will sell below cost
Firm contract	Net realisable value at the contract price for the committed quantity, general prices for the rest
Normal loss	Absorbed into the cost of what remains
Abnormal loss	Written off separately, paragraph 13

Test yourself

Value the five items in question one and state the basis.
By how much would comparing the totals overstate the stock, and why is it wrong?
A raw material's replacement cost has fallen. When is it written down?
Six hundred of 1,000 units are committed at Rs 85 and the market is Rs 100. How are they valued?
How does a normal loss differ from an abnormal one in treatment?

Answer in one sentence

1. Rs 2,18,700, at the lower of cost and net realisable value applied item by item, with items B, D and E written down.

2. By Rs 11,500, because it lets the unrealised gains on A and C, which AS 2 does not permit to be recognised, cover the real losses on B, D and E.

3. Only where the finished products into which it will be incorporated are expected to be sold below their cost, in which case replacement cost may be the best measure of its net realisable value.

4. The 600 committed units at the contract price of Rs 85 less Rs 4 of selling costs, which is Rs 81, being lower than the Rs 90 cost; and the 400 uncommitted units at cost of Rs 90, the general net realisable value of Rs 96 being higher.

5. A normal loss is absorbed into the cost of the remaining stock, while an abnormal loss is written off separately because paragraph 13 excludes abnormal amounts from the cost of inventories.

Contents This chapter on its own page

Chapter Sixteen

Practice Questions: Concepts, Standards and Inventory

Syllabus topic 2, 8, 9, "Practical Problems on preparation of Stock Ledger Account using First in First Out (FIFO Method) and Weighted Average Cost method."; "Short practical problems on Valuation of Inventory as per AS 2."; "Meaning and Classification - Capital, Revenue: Expenditure and Receipts, Profit and Loss."

Question 1 (15 marks)

Ganesh Stores deals in one product. Its transactions for May were:

Date	Particulars	Units	Rate, Rs
1 May	Opening balance	150	40
6 May	Purchase	250	44
12 May	Issue	200
18 May	Purchase	300	48
22 May	Issue	350
27 May	Purchase	100	52
30 May	Issue	100

Prepare the stock ledger account under (a) the first in first out method and (b) the weighted average cost method, and comment on the difference in the closing stock.

---

Question 2 (8 + 7 marks)

(a) A trader's closing stock consists of four items. Value it as required by AS 2, and state what a comparison of the totals would have given. (8)

Item	Units	Cost a unit, Rs	Selling price a unit, Rs	Selling costs a unit, Rs
P	300	150	190	12
Q	250	220	210	18
R	400	90	100	6
S	500	70	68	4

(b) Classify each of the following as capital or revenue, and say what the effect on the profit would be if it were treated the other way. (7)

Rs 80,000 spent on overhauling a second-hand machine before putting it to use.
Rs 25,000 spent on annual repairs to the same machine a year later.
Rs 1,50,000 received on the sale of a delivery van whose book value was Rs 1,20,000.
Rs 60,000 of wages paid to workmen who installed a new plant.
Rs 5,00,000 received as a loan from a bank.
Rs 40,000 of legal fees on defending the company's title to its factory land.
Rs 15,000 of carriage paid on goods purchased for resale.

---

Question 3 (8 + 7 marks)

(a) State the three fundamental accounting assumptions named in AS 1, give the Standard's own definition of each, and state what disclosure the Standard requires of them. (8)

(b) Answer in one or two sentences each: (7)

On what basis are dividends recognised as revenue under AS 9?
Is GST recoverable as input tax credit part of the cost of inventories?
On what basis are fixed production overheads allocated to the cost of inventories?
Which cost formulas does AS 2 permit?
What must be disclosed about inventories under AS 2?
In an agency relationship, what is the agent's revenue?
Which section of the Companies Act makes an accounting standard binding on a company?

---

Answers

Answer 1

(a) Stock ledger account, first in first out

Date	Particulars	Receipts qty	Rate	Amount, Rs	Issues qty	Rate	Amount, Rs	Balance qty	Amount, Rs
1 May	Balance	150	40	6,000				150	6,000
6 May	Purchase	250	44	11,000				400	17,000
12 May	Issue				150	40	6,000
					50	44	2,200	200	8,800
18 May	Purchase	300	48	14,400				500	23,200
22 May	Issue				200	44	8,800
					150	48	7,200	150	7,200
27 May	Purchase	100	52	5,200				250	12,400
30 May	Issue				100	48	4,800	150	7,600

Practice Questions: Concepts, Standards and Inventory

The closing stock is 150 units at Rs 7,600, consisting of 50 units at Rs 48 and 100 units at Rs 52.

(b) Stock ledger account, weighted average cost

Date	Particulars	Receipts qty	Rate	Amount, Rs	Issues qty	Rate	Amount, Rs	Balance qty	Rate	Amount, Rs
1 May	Balance	150	40	6,000				150	40.00	6,000
6 May	Purchase	250	44	11,000				400	42.50	17,000
12 May	Issue				200	42.50	8,500	200	42.50	8,500
18 May	Purchase	300	48	14,400				500	45.80	22,900
22 May	Issue				350	45.80	16,030	150	45.80	6,870
27 May	Purchase	100	52	5,200				250	48.28	12,070
30 May	Issue				100	48.28	4,828	150	48.28	7,242

The three averages.

After the receipt on	Value, Rs	Quantity	Rate, Rs
6 May	17,000	400	42.50
18 May	22,900	500	45.80
27 May	12,070	250	48.28

The proof, on both methods.

	FIFO, Rs	Weighted average, Rs
Opening balance	6,000	6,000
Add: purchases	30,600	30,600
Less: cost of issues	(29,000)	(29,358)
Closing stock	7,600	7,242

The comment.

Prices rose steadily from Rs 40 to Rs 52 through the month. Under FIFO the issues are priced at the older and lower rates, so the cost of issues is Rs 29,000 and the closing stock carries the newest rates. Under weighted average the issues absorb part of every price rise as it occurs, so the cost of issues is higher at Rs 29,358 and the closing stock lower.

The difference of Rs 358 is the whole of it, and it will show as Rs 358 more gross profit under FIFO in this month. Over the life of the stock the total cost charged is identical under both; only the timing differs.

Both methods are permitted by AS 2 paragraph 16, the choice is an accounting policy that must be disclosed under paragraph 26(a), and consistency requires the same one to be followed year to year.

Answer 2

(a) Valuation of the closing stock

Item	Cost a unit, Rs	Selling price, Rs	Less: selling cost, Rs	Net realisable value a unit, Rs	Lower, Rs	Units	Value, Rs
P	150	190	12	178	150	300	45,000
Q	220	210	18	192	192	250	48,000
R	90	100	6	94	90	400	36,000
S	70	68	4	64	64	500	32,000
						Total	1,61,000

The closing stock is Rs 1,61,000, at the lower of cost and net realisable value applied item by item, with Q written down by Rs 28 a unit and S by Rs 6.

What a comparison of the totals would have given.

Practice Questions: Concepts, Standards and Inventory

	Rs
Total cost, 45,000 + 55,000 + 36,000 + 35,000	1,71,000
Total net realisable value, 53,400 + 48,000 + 37,600 + 32,000	1,71,000

The two totals are equal, so a student comparing them concludes that no write-down is needed and values the stock at Rs 1,71,000, which overstates it by Rs 10,000.

Why it is wrong. The unrealised gains on P and R, which AS 2 does not permit to be recognised at all, exactly offset the real losses on Q and S. Paragraph 21 says in terms that it is not appropriate to write down inventories on a classification, and the total is the widest classification there is.

(b) Capital or revenue

	Item	Classification	Effect if treated the other way
1	Overhaul of a second-hand machine before use	Capital	Profit understated by Rs 80,000, and fixed assets understated by the same
2	Annual repairs to it a year later	Revenue	Profit overstated by Rs 25,000, and fixed assets overstated
3	Sale proceeds of a van, book value Rs 1,20,000	Capital receipt of Rs 1,20,000 and a revenue credit of Rs 30,000	Treating the whole Rs 1,50,000 as income would overstate the profit by Rs 1,20,000
4	Wages of workmen installing a new plant	Capital	Profit understated by Rs 60,000
5	Loan received from a bank	Capital receipt	Profit overstated by Rs 5,00,000, and the liability omitted
6	Legal fees defending the title to land already owned	Capital	Profit understated by Rs 40,000
7	Carriage on goods purchased for resale	Revenue, and part of the cost of goods sold under AS 2	Profit overstated by Rs 15,000

Items 1 and 2 are the pair to notice. The same overhaul on the same machine is capital before it is put to use and revenue afterwards, because the first brings the asset to its usable condition and the second merely maintains it.

Answer 3

(a) The fundamental accounting assumptions, AS 1 paragraph 10

Assumption	AS 1's own definition
Going concern	The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future; it is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations
Consistency	It is assumed that accounting policies are consistent from one period to another
Accrual	Revenues and costs are accrued, that is, recognised as they are earned or incurred and not as money is received or paid, and recorded in the financial statements of the periods to which they relate

Paragraph 9 explains why they are not stated: they underlie the preparation of financial statements and are usually not specifically stated because their acceptance and use are assumed.

Practice Questions: Concepts, Standards and Inventory

And paragraph 27 gives the disclosure rule. If all three are followed, no specific disclosure is required. If any one is not followed, the fact should be disclosed.

Two further points that carry marks. Section 128(1) of the Companies Act 2013 requires a company's books to be kept on the accrual basis and according to the double entry system, so for a company the accrual assumption is also a statutory duty. And most textbooks classify consistency as a convention while AS 1 treats it as a fundamental assumption; either is acceptable if you say which you are following.

(b) Answers in one or two sentences

1. When the owner's right to receive payment is established, which for a final dividend is when it is declared at the annual general meeting.

2. No, because AS 2 paragraph 7 excludes duties and taxes subsequently recoverable by the enterprise from the taxing authorities.

3. On the normal capacity of the production facilities, with the portion not absorbed because actual production fell short being charged as an expense of the period.

4. Specific identification for items not ordinarily interchangeable, and otherwise first in first out or weighted average cost; last in first out is not permitted.

5. The accounting policies adopted in measuring inventories, including the cost formula used, and the total carrying amount with the classification appropriate to the enterprise.

6. The amount of the commission, not the gross inflow of cash, receivables or other consideration.

7. Section 133 empowers the Central Government to prescribe them, and section 129(1) requires the financial statements to comply with what is so notified.

Marking yourself

If your answer	Then
Collapsed the FIFO balance into one averaged line	The balance is kept in layers, or the next issue cannot be priced
Recomputed the weighted average on an issue	The average does not change when units leave at the average rate
Valued Question 2 at Rs 1,71,000	You compared the totals; paragraph 21 requires item by item, and the answer is Rs 1,61,000
Treated the whole Rs 1,50,000 van proceeds as income	Only the Rs 30,000 excess over book value is a profit
Called the overhaul before use revenue	It brought the asset to its usable condition, so it is capital
Said consistency is only a convention	AS 1 paragraph 10 names it a fundamental accounting assumption

Contents This chapter on its own page

Chapter Seventeen

Why a Manufacturing Concern Needs a Fourth Account

Syllabus topic 1, "Introduction and meaning."

In one line

A manufacturing concern prepares four final accounts because the cost of the goods it sells has to be computed before the gross profit can be found.

The trader and the manufacturer

	A trader	A manufacturer
What he buys	Finished goods	Raw materials
What he sells	The same goods	Goods he has made
The cost of what he sold	Opening stock plus purchases less closing stock	Opening stock plus cost of production less closing stock
Stocks he holds	One: goods	Three: raw materials, work in progress, finished goods
Final accounts	Three: trading, profit and loss, balance sheet	Four: manufacturing, trading, profit and loss, balance sheet

The last two rows are the answer to the question "why four accounts".

The three stocks

A manufacturer's stock exists in three states at once, and each is valued and carried separately.

Stock	What it is	Where it appears
Raw materials	Bought and not yet put into production	In the manufacturing account, and in the balance sheet
Work in progress	Put into production and not yet finished	In the manufacturing account, and in the balance sheet
Finished goods	Made and not yet sold	In the trading account, and in the balance sheet

The finished goods stock belongs to the TRADING account, not to the manufacturing account. The manufacturing account ends when the goods are made; what happens to them afterwards is trading. That single placement is the commonest error in the whole module.

The four accounts and what each produces

Account	Question it answers	Figure it produces	Where that figure goes
Manufacturing	What did it cost to make the goods?	Cost of production	To the trading account
Trading	What did the goods sold cost, and what was the margin?	Gross profit	To the profit and loss account
Profit and loss	What is left after running the business?	Net profit	To the capital account in the balance sheet
Balance sheet	What does the business own and owe?	The position	Nowhere; it is the end

Draw that chain in an answer. Four accounts, three figures handed on, and each account exists because the next one needs what it produces.

The chain, in figures

Taking the worked example this module builds towards.

	Rs
Raw materials consumed	5,70,000
Add: direct wages	2,60,000
Prime cost	8,30,000
Add: factory overheads	2,50,000
Add: opening work in progress	40,000
Less: closing work in progress	(50,000)
Less: sale of scrap	(12,000)
Cost of production, to the trading account	10,58,000

	Rs
Opening stock of finished goods	90,000
Add: cost of production	10,58,000
Less: closing stock of finished goods	(1,20,000)
Cost of goods sold	10,28,000

	Rs
Sales	15,00,000
Less: cost of goods sold	10,28,000
Gross profit, to the profit and loss account	4,72,000

Why a Manufacturing Concern Needs a Fourth Account

Notice where the cost of production entered. It sits exactly where a trader would have written "purchases", and that is the whole structural difference.

Why bother, when the trading account could do it all

A fair question, and it has three answers.

	Reason
1	It separates the cost of making from the cost of selling and administering, so the manufacturing efficiency can be judged on its own
2	It gives the cost of production, which is what a price is set on, what a make-or-buy decision compares, and what a tender is built from
3	It values the closing stock of finished goods, which must be at cost of production and cannot be known without the account

Reason three is the one to give first, because it is not a matter of convenience: AS 2 requires finished goods to be valued at cost, and the cost of production is that cost. Without a manufacturing account the closing stock cannot be valued correctly at all.

Where the manufacturing account is not prepared

Some concerns do not prepare one and combine it with the trading account.


A small manufacturer	Where the factory costs are few, the two accounts are combined and the result is called a manufacturing and trading account
A trader	Has nothing to manufacture
A service business	Produces no goods; its costs go straight to the profit and loss account

MU's syllabus asks for the separate account, so prepare four unless the question says otherwise.

Quick revision


Why four accounts	A manufacturer must compute the cost of making the goods before he can find the gross profit
Three stocks	Raw materials, work in progress, finished goods
Finished goods stock	Belongs to the trading account
The manufacturing account produces	The cost of production
It takes the place of	Purchases, in the trading account
The three reasons	Separates making from selling; gives a cost for pricing and decisions; values the closing finished goods stock as AS 2 requires

Test yourself

Why does a manufacturer need four final accounts and a trader three?
Name the three stocks and say which account each opening and closing figure belongs to.
What single figure does the manufacturing account produce, and where does it go?
Give three reasons for preparing a separate manufacturing account.
What is a manufacturing and trading account?

Answer in one sentence

1. Because a manufacturer makes what he sells, so the cost of making it must be worked out in an account of its own before the cost of goods sold and the gross profit can be found.

2. Raw materials and work in progress, both of which appear in the manufacturing account, and finished goods, which appears in the trading account; all three appear in the balance sheet as assets.

Why a Manufacturing Concern Needs a Fourth Account

3. The cost of production, which goes to the trading account and stands where a trader's purchases would.

4. It separates the cost of making from the cost of selling and administering; it gives the cost of production needed for pricing and for decisions; and it produces the cost at which AS 2 requires the closing finished goods stock to be valued.

5. A single combined account used by small manufacturers, in which the manufacturing and the trading sections are shown together rather than as two accounts.

Contents This chapter on its own page

Chapter Eighteen

The Manufacturing Account

Syllabus topic 4, "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."

In one line

The manufacturing account collects every cost of making the goods and produces the cost of production, which it transfers to the trading account.

The form

Rajesh Manufacturers Manufacturing account for the year ended 31 March 2027

Particulars	Rs	Rs
Raw materials consumed
Opening stock of raw materials	60,000
Add: purchases of raw materials	5,60,000
Add: carriage inward	30,000
Less: closing stock of raw materials	(80,000)
Raw materials consumed	5,70,000	5,70,000
Direct or factory wages, including Rs 20,000 outstanding		2,60,000
PRIME COST		8,30,000
Add: factory overheads
Power and fuel	70,000
Factory rent	60,000
Repairs to plant	40,000
Depreciation on plant and machinery	60,000
Depreciation on factory building	20,000
Total factory overheads	2,50,000	2,50,000
		10,80,000
Add: opening work in progress		40,000
		11,20,000
Less: closing work in progress		(50,000)
Less: sale of scrap		(12,000)
COST OF PRODUCTION, transferred to the trading account		10,58,000

Raw materials consumed, which is the first working

Raw materials consumed = opening stock of raw materials + purchases + carriage inward and other direct expenses of purchase, less returns outward, less closing stock of raw materials.

Four points on it.

Carriage inward is in, because AS 2 paragraph 7 makes it part of the cost of purchase.
Returns outward are deducted from purchases, before the consumption is worked out.
Trade discount is already deducted from the purchase figure; cash discount is not, being a financing item for the profit and loss account.
Materials used for a purpose other than production, such as materials used to build an asset, are taken out and capitalised.

What is a factory overhead

The test is whether the expense was incurred in the factory or on the making of the goods.

In the manufacturing account	In the profit and loss account
Factory rent, rates, insurance and lighting	Office rent, rates, insurance and lighting
Factory salaries and supervision	Office salaries, directors' fees
Power and fuel	Telephone and general office expenses
Repairs to plant and factory building	Repairs to office furniture
Depreciation on plant and factory building	Depreciation on office furniture and delivery vehicles
Consumable stores, loose tools written off	Advertising, carriage outward, bad debts
Factory canteen and welfare	Discount allowed, interest, general expenses

Where an expense is shared, it is apportioned and the question gives the basis: "rent Rs 1,20,000, of which three fourths relates to the factory" means Rs 90,000 to the manufacturing account and Rs 30,000 to the profit and loss account.

The three deductions

1. Closing work in progress. The opening work in progress is added because it was completed this year; the closing is deducted because it has not been.

2. Sale of scrap. Scrap arises in production and its proceeds reduce the cost of what was produced. It is credited to the manufacturing account, not shown as income in the profit and loss account.

The Manufacturing Account

Unless the question says the scrap is a separate trade, in which case it is income.

3. Goods manufactured for the concern's own use. Where a company makes a machine for itself, the cost of that machine is deducted from the cost of production and capitalised, because it was not made for sale.

Two treatments a question may ask for

Manufacturing profit. Some concerns transfer the goods to the trading account at market price rather than at cost, so that the profit on manufacturing can be seen separately from the profit on selling.

	Rs
Cost of production	10,58,000
Transferred to trading at market price, say	11,50,000
Manufacturing profit	92,000

And where that is done, the closing stock of finished goods is carried at the transfer price, which contains an unrealised profit, so a provision for unrealised profit on stock is created and the balance sheet shows the stock net of it.

MU's syllabus does not name manufacturing profit, so give it only if a question transfers at market price.

Stock of consumable stores. Where the question gives opening and closing stocks of stores, the consumption is computed exactly as for raw materials and only the consumption is charged.

The order of the account, as a checklist


1	Raw materials consumed
2	Direct wages, including any outstanding
3	Direct expenses, such as royalty on production or hire of a special machine
4	PRIME COST
5	Factory overheads, after apportionment
6	Add opening work in progress
7	Less closing work in progress
8	Less sale of scrap
9	Less cost of goods made for the concern's own use
10	COST OF PRODUCTION, to the trading account

Quick revision


Two sub-totals	Prime cost and cost of production
Prime cost	Raw materials consumed + direct wages + direct expenses
Raw materials consumed	Opening + purchases + carriage inward less returns less closing
Factory overheads	Everything incurred in the factory or on making the goods
Added	Opening work in progress
Deducted	Closing work in progress, sale of scrap, goods made for own use
Finished goods stock	Not here; it belongs to the trading account
Result	Cost of production, to the trading account

Test yourself

Name the two sub-totals and say what each contains.
Give the formula for raw materials consumed.
Rent of Rs 1,20,000 is three fourths for the factory. How is it treated?
Where do the proceeds of scrap go, and why?
Why does the finished goods stock not appear in this account?

Answer in one sentence

1. Prime cost, being raw materials consumed plus direct wages plus direct expenses; and cost of production, being prime cost plus factory overheads adjusted for work in progress and less scrap.

The Manufacturing Account

2. Opening stock of raw materials plus purchases plus carriage inward and other direct purchase expenses, less returns outward, less closing stock of raw materials.

3. Rs 90,000 is charged to the manufacturing account as a factory overhead and Rs 30,000 to the profit and loss account as an office expense.

4. They are credited to the manufacturing account, because scrap arises in production and its proceeds reduce the cost of what was produced.

5. Because the manufacturing account ends when the goods are made, and what happens to finished goods afterwards is trading.

Contents This chapter on its own page

Chapter Nineteen

The Trading Account

Syllabus topic 4, "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."

In one line

The trading account matches the sales of the year against the cost of the goods sold and produces the gross profit.

The form

Rajesh Manufacturers Trading account for the year ended 31 March 2027

Particulars	Rs	Rs
Sales		15,00,000
Less: returns inward		nil
Net sales		15,00,000
Less: cost of goods sold
Opening stock of finished goods	90,000
Add: cost of production, from the manufacturing account	10,58,000
Less: closing stock of finished goods	(1,20,000)
Cost of goods sold	10,28,000	10,28,000
GROSS PROFIT, transferred to the profit and loss account		4,72,000

What goes into it

Debit side, or deducted	Credit side, or the starting figure
Opening stock of finished goods	Sales, less returns inward
Cost of production, from the manufacturing account	Closing stock of finished goods
Purchases of finished goods, where the concern also buys goods for resale
Carriage inward on such purchases
Direct expenses relating to the goods sold, where the question so describes them

Where the concern both manufactures and buys in, both lines appear: the cost of production and the purchases of finished goods, each with its own stock movement if the question separates them.

The four things that do NOT belong here

Item	Where it belongs
Office and administrative expenses	Profit and loss account
Selling and distribution expenses, including carriage outward	Profit and loss account
Factory expenses	Manufacturing account
Raw materials and work in progress stocks	Manufacturing account

The third and fourth rows are the ones a manufacturing question tests, because a trader's trading account has no such thing to get wrong.

Gross profit and the gross profit ratio

Gross profit = Net sales less cost of goods sold.

	Rs
Net sales	15,00,000
Cost of goods sold	10,28,000
Gross profit	4,72,000

As a percentage of net sales that is 31.47 per cent, and where a question gives the gross profit ratio instead of a figure, it is used to find whichever of the three is missing.

Given	Find
Sales and the gross profit ratio	Gross profit, then cost of goods sold
Cost of goods sold and the ratio	Sales, as cost of goods sold over (100 less the ratio) times 100
Sales and cost of goods sold	The ratio

Goods taken by the proprietor, and goods lost

Two adjustments belong to this account and are commonly set.

Goods withdrawn by the proprietor for personal use.

Drawings A/c Dr; To Purchases A/c (or to the trading account)

The goods leave the business at cost, the drawings reduce the capital in the balance sheet, and the trading account is relieved of the cost.

Goods lost by fire, theft or accident.

Situation	Treatment
Not insured	The whole cost is a loss, debited to the profit and loss account and credited to the trading account
Fully insured and the claim admitted	The cost is credited to the trading account and the claim shown as a debtor
Partly insured	The claim admitted is a debtor and the balance is a loss to the profit and loss account

The Trading Account

In every case the trading account is credited with the cost of the goods gone, so that the cost of goods sold is not inflated by goods that were never sold.

Quick revision


Produces	Gross profit
Starts from	Net sales, after returns inward
The manufacturer's difference	Cost of production stands where purchases would
Stocks here	Finished goods only, opening and closing
Not here	Office and selling expenses; factory expenses; raw material and work in progress stocks
Goods taken by the proprietor	Credited to the trading account, debited to drawings
Goods lost	Credited to the trading account; the loss or the claim goes elsewhere

Test yourself

What does the trading account produce, and from what two figures?
What is the one structural difference between a manufacturer's trading account and a trader's?
Which stocks appear here and which do not?
Goods costing Rs 30,000 are withdrawn by the proprietor. Give the entry and its two effects.
Goods costing Rs 50,000 are destroyed by fire and the insurer admits Rs 35,000. How is it treated?

Answer in one sentence

1. The gross profit, from net sales less the cost of goods sold.

2. The cost of production, brought from the manufacturing account, stands where a trader would write purchases.

3. The opening and closing stocks of finished goods appear here; the raw material and work in progress stocks belong to the manufacturing account.

4. Drawings A/c Dr Rs 30,000 to Purchases or the trading account; the trading account is relieved of the cost, so the gross profit rises, and the proprietor's capital falls by Rs 30,000.

5. The trading account is credited with the full cost of Rs 50,000, Rs 35,000 is shown as a debtor for the insurance claim, and the remaining Rs 15,000 is charged to the profit and loss account as a loss.

Contents This chapter on its own page

Chapter Twenty

The Profit and Loss Account

Syllabus topic 4, "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."

In one line

The profit and loss account starts from the gross profit and charges everything the business spent on running itself, to produce the net profit.

The form

Rajesh Manufacturers Profit and loss account for the year ended 31 March 2027

Particulars	Rs	Rs
Gross profit brought down		4,72,000
Less: administrative expenses
Office salaries	1,50,000
Office rent	48,000
Insurance, net of Rs 6,000 prepaid	18,000
General expenses	48,000
Depreciation on office furniture	10,000
Total administrative expenses	2,74,000	2,74,000
Less: selling and distribution expenses
Advertising	60,000
Carriage outward	24,000
Bad debts	8,000
Additional provision for doubtful debts	2,000
Total selling and distribution expenses	94,000	94,000
Less: financial expenses
Interest on bank loan, outstanding	24,000	24,000
NET PROFIT, transferred to the capital account		80,000

The three groups of expense

Group them; an examiner marks the grouping as well as the figures.

Group	What it contains
Administrative	Office salaries, office rent and rates, office insurance and lighting, printing and stationery, telephone, audit fee, legal charges, general expenses, depreciation on office assets
Selling and distribution	Advertising, salesmen's salaries and commission, carriage outward, packing for despatch, bad debts, provision for doubtful debts, discount allowed, delivery van running costs and depreciation
Financial	Interest on loans and on capital, bank charges, discount on bills

And the incomes, which are credited:


Discount received, commission received, rent received
Interest and dividend received
Bad debts recovered
Profit on the sale of a fixed asset
Provision for doubtful debts no longer required, written back

The three that are neither

Item	Where it goes
Drawings	Deducted from capital in the balance sheet; never an expense
Income tax of a proprietor	The same; it is his personal liability, not the firm's expense
Capital expenditure wrongly in the trial balance	Taken to the balance sheet as an asset

Drawings is the row that costs marks. A proprietor's drawings, whether in cash or in goods, are a withdrawal of capital and never an expense of the business, which follows directly from the business entity concept.

Bad debts and the provision, which is the adjustment most often set

Three figures can appear and they are dealt with in this order.


1	Bad debts already written off during the year, standing in the trial balance
2	Further bad debts to be written off, given as an adjustment: deduct them from debtors and add them to the bad debts charge
3	The provision for doubtful debts to be maintained, computed on the debtors after the further bad debts

And the charge to the profit and loss account is:

	Rs
Bad debts already written off	x
Add: further bad debts	x
Add: new provision required	x
Less: old provision brought forward	(x)
Charge to the profit and loss account	x

The Profit and Loss Account

In the worked example there were no further bad debts, the debtors were Rs 2,40,000, the provision required at 5 per cent was Rs 12,000, the old provision was Rs 10,000, so only the Rs 2,000 shortfall is charged, beside the Rs 8,000 of bad debts already written off.

Charging the whole Rs 12,000 is the standing error, and it overstates the expense by the amount of the old provision.

Net profit, and where it goes

Net profit = gross profit + indirect incomes less indirect expenses.

And it does not stay in this account. It is transferred to the capital account in the balance sheet, where the proprietor's capital is increased by it and reduced by his drawings.

	Rs
Capital at the beginning	12,00,000
Add: net profit	80,000
Less: drawings	(60,000)
Capital at the end	12,20,000

A net loss is deducted instead, and the same three-line working is shown.

Quick revision


Starts from	Gross profit brought down
Three groups	Administrative, selling and distribution, financial
Never here	Factory expenses; drawings; the proprietor's income tax
Bad debts working	Old bad debts + further bad debts + new provision less old provision
Produces	Net profit, to the capital account
The capital working	Opening capital + net profit less drawings

Test yourself

What does this account start from and what does it produce?
Name the three groups of expense with two examples of each.
Why are drawings not an expense?
Debtors are Rs 2,40,000, a 5 per cent provision is required and Rs 10,000 stands in the books. What is charged?
Where does the net profit go?

Answer in one sentence

1. It starts from the gross profit brought down from the trading account and produces the net profit.

2. Administrative, such as office salaries and office rent; selling and distribution, such as advertising and carriage outward; and financial, such as interest on loans and bank charges.

3. Because the business entity concept treats the business as separate from its owner, so money he takes out is a withdrawal of his capital and not a cost of running the business.

4. Rs 2,000, being the Rs 12,000 provision required less the Rs 10,000 already standing.

5. To the capital account in the balance sheet, where it increases the proprietor's capital, which his drawings then reduce.

Contents This chapter on its own page

Chapter Twenty-One

The Balance Sheet of a Proprietary Firm

Syllabus topic 2, 4, "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."; "Final Accounts of Manufacturing Concern (Proprietary Firm)."

In one line

The balance sheet of a proprietary firm lists what the firm owns and what it owes at a date, with the proprietor's capital as the balancing claim.

The form

Rajesh Manufacturers Balance sheet as at 31 March 2027

Liabilities	Rs	Assets	Rs
Capital account		Fixed assets
Opening balance 12,00,000		Plant and machinery, 6,00,000 less depreciation 60,000	5,40,000
Add: net profit 80,000		Factory building, 4,00,000 less depreciation 20,000	3,80,000
Less: drawings 60,000	12,20,000	Office furniture, 1,00,000 less depreciation 10,000	90,000
Long-term liabilities		Current assets
Bank loan	2,00,000	Closing stock: raw materials 80,000, work in progress 50,000, finished goods 1,20,000	2,50,000
Current liabilities		Sundry debtors, 2,40,000 less provision 12,000	2,28,000
Sundry creditors	1,80,000	Prepaid insurance	6,000
Bills payable	60,000	Cash and bank	2,10,000
Outstanding factory wages	20,000
Outstanding interest on bank loan	24,000
Total	17,04,000	Total	17,04,000

The two orders

A balance sheet may be arranged either way, and the question sometimes says which.

Order of permanence	Order of liquidity
Fixed assets first, then current assets, ending in cash	Cash first, then the rest of the current assets, then the fixed assets
Capital and long-term liabilities first, then current liabilities	Current liabilities first, then long-term, then capital
Used by manufacturing and trading concerns generally	Used by banks and financial concerns

Where the question is silent, use the order of permanence, which is what the example above does, and say so in one line.

The capital account working

It is the one line that always needs a working, and it belongs on the face or immediately beneath.

	Rs
Capital at the beginning	12,00,000
Add: net profit for the year	80,000
Add: interest on capital, if allowed	nil
Add: any fresh capital introduced	nil
Less: drawings, in cash and in goods	(60,000)
Less: interest on drawings, if charged	nil
Less: the proprietor's income tax paid by the firm	nil
Capital at the end	12,20,000

Interest on capital and interest on drawings appear TWICE each. Interest on capital is an expense in the profit and loss account and an addition to capital; interest on drawings is an income and a deduction from capital. A student who puts either in only one place has an unbalanced balance sheet.

Where the adjustments land

Every adjustment made in the final accounts appears here as well, and this table is the quickest check on a completed answer.

Adjustment	In the trading, manufacturing or profit and loss account	In the balance sheet
Closing stock	Credited to the trading or manufacturing account	Current asset
Outstanding expense	Added to the expense	Current liability
Prepaid expense	Deducted from the expense	Current asset
Accrued income	Added to the income	Current asset
Income received in advance	Deducted from the income	Current liability
Depreciation	An expense	Deducted from the asset
Further bad debts	Added to bad debts	Deducted from debtors
Provision for doubtful debts	The shortfall charged	Deducted from debtors
Interest on capital	An expense	Added to capital
Interest on drawings	An income	Deducted from capital
Goods taken by the proprietor	Credited to the trading account	Deducted from capital as drawings
Goods lost by fire	Credited to the trading account; the loss charged	The admitted claim as a debtor

The Balance Sheet of a Proprietary Firm

Twelve rows, and every one of them has two landings. The next chapters take the entries.

What a proprietary firm's balance sheet does NOT have

	Why
Share capital, reserves and surplus	There are no shares; the proprietor's claim is one capital account
A statutory form	Schedule III applies to companies
A statutory audit	Not required of a proprietary firm as such, though a tax audit may be
A separate legal personality	The firm and the proprietor are the same person in law, though not in the accounts

The last row is worth a sentence. The business entity concept separates them for accounting; the law does not, and the proprietor's personal assets answer for the firm's debts.

Quick revision


Form	Two-sided, conventional; not Schedule III
Two orders	Permanence, the usual one; liquidity, used by financial concerns
Capital working	Opening + net profit + interest on capital + fresh capital, less drawings, less interest on drawings
Appear twice	Interest on capital, interest on drawings, and every adjustment
Depreciation	Deducted from the asset on the face
Provision for doubtful debts	Deducted from debtors on the face
The check	The two sides agree, and every adjustment has landed twice

Test yourself

Which two orders may a balance sheet follow, and which is usual?
Give the capital account working in full.
Where does interest on capital appear, and how many times?
Where does a prepaid expense appear in each of the two statements?
Why does a proprietary firm's balance sheet have no reserves and surplus?

Answer in one sentence

1. The order of permanence, with fixed assets first, which is usual for a manufacturing or trading concern; and the order of liquidity, with cash first, used by banks and financial concerns.

2. Opening capital, plus net profit, plus interest on capital and any fresh capital introduced, less drawings in cash and in goods, less interest on drawings and any personal tax of the proprietor paid by the firm.

3. Twice: as an expense in the profit and loss account and as an addition to the capital in the balance sheet.

4. Deducted from the expense in the profit and loss account, and shown as a current asset in the balance sheet.

5. Because there are no shares and no statutory reserves; the whole of the proprietor's claim, including every profit retained, is in one capital account.

Contents This chapter on its own page

Chapter Twenty-Two

Closing Entries

Syllabus topic 3, "Closing and Adjustment Entries in Final Accounts of Manufacturing Concern."

In one line

A closing entry transfers the balance of a nominal account to whichever of the manufacturing, trading or profit and loss account it belongs to, so that the nominal accounts end the year with no balance.

Why they exist


Nominal accounts record the incomes and expenses of one year	So they must be emptied at the end of it
The accounting period concept requires each year to stand alone
The result cannot be computed until they are gathered	The closing entries are that gathering
Real and personal accounts do NOT close	Assets, liabilities and capital carry forward, and appear in the balance sheet

That last row is the distinction the question is really testing. A student who tries to close the machinery account has confused a real account with a nominal one.

The closing entries, in order

One: to the manufacturing account

Debit the manufacturing account with every factory cost.

Manufacturing A/c Dr To Opening stock of raw materials A/c To Opening stock of work in progress A/c To Purchases of raw materials A/c To Carriage inward A/c To Factory wages A/c To Power and fuel A/c To Factory rent A/c To Repairs to plant A/c To Depreciation on plant A/c To Depreciation on factory building A/c

Credit it with what is deducted.

Closing stock of raw materials A/c Dr Closing stock of work in progress A/c Dr Sale of scrap A/c Dr To Manufacturing A/c

And transfer the result.

Trading A/c Dr To Manufacturing A/c being the cost of production transferred

Two: to the trading account

Trading A/c Dr To Opening stock of finished goods A/c To Purchases of finished goods A/c, where there are any

Sales A/c Dr Closing stock of finished goods A/c Dr To Trading A/c

And the gross profit.

Trading A/c Dr To Profit and Loss A/c being the gross profit transferred

Where there is a gross LOSS the entry reverses: Profit and Loss A/c Dr, To Trading A/c.

Three: to the profit and loss account

Profit and Loss A/c Dr To Office salaries A/c To Office rent A/c To Advertising A/c To Carriage outward A/c To Bad debts A/c To Insurance A/c To General expenses A/c To Depreciation on office furniture A/c To Interest on bank loan A/c

Discount received A/c Dr Commission received A/c Dr To Profit and Loss A/c

Four: the result to the capital account

Profit and Loss A/c Dr To Capital A/c being the net profit transferred

And for a net loss: Capital A/c Dr, To Profit and Loss A/c.

Five: drawings to capital

Capital A/c Dr To Drawings A/c

Drawings is a personal account and it is closed to capital, not to the profit and loss account, which is the whole point of the earlier chapter.

Closing Entries

The four rules that decide every closing entry

	Rule
1	An expense account has a debit balance, so it is credited to close, and the account it goes to is debited
2	An income account has a credit balance, so it is debited to close, and the account it goes to is credited
3	A closing stock has no account until you create one, so it is debited as an asset and the account it relieves is credited
4	A real or personal account is never closed; it is balanced and carried down

Which account does each expense go to

The rule is the same as the chapters on the three accounts.

Goes to	Which expenses
Manufacturing	Every factory cost, and the raw material and work in progress stocks
Trading	The finished goods stocks, sales, and purchases of finished goods
Profit and loss	Every office, selling and financial expense, and every indirect income
Balance sheet	Every asset, every liability, capital and drawings

A worked set, on the running example

	Rs
Total debited to the manufacturing account	12,00,000
Total credited to it, closing stocks and scrap	1,42,000
Cost of production transferred to trading	10,58,000

	Rs
Total debited to the trading account	11,48,000
Total credited to it, sales and closing finished goods	16,20,000
Gross profit transferred to profit and loss	4,72,000

	Rs
Gross profit credited to the profit and loss account	4,72,000
Total expenses debited to it	3,92,000
Net profit transferred to capital	80,000

Three transfers and three figures, which is the chain the first chapter of the module drew.

Quick revision


Purpose	To empty every nominal account into the account where it belongs
Closed	Nominal accounts only: expenses and incomes
Not closed	Real and personal accounts: assets, liabilities, capital, drawings to capital
An expense	Credited to close; the receiving account debited
An income	Debited to close; the receiving account credited
The three transfers	Cost of production to trading; gross profit to profit and loss; net profit to capital
Drawings	Closed to capital, never to the profit and loss account

Test yourself

Which accounts are closed and which are not?
Give the entry closing the office salaries account.
Give the entry for the closing stock of finished goods.
Where is the drawings account closed?
Give the three transfer entries and the figure each carries in the worked example.

Answer in one sentence

1. Nominal accounts, being expenses and incomes, are closed; real and personal accounts, being assets, liabilities and capital, are balanced and carried forward.

2. Profit and Loss A/c Dr; To Office salaries A/c.

3. Closing stock of finished goods A/c Dr; To Trading A/c, the debit creating the asset and the credit relieving the trading account.

Closing Entries

4. To the capital account, by Capital A/c Dr, To Drawings A/c, because drawings are a withdrawal of capital and not an expense.

5. Trading A/c Dr to Manufacturing A/c with the cost of production of Rs 10,58,000; Trading A/c Dr to Profit and Loss A/c with the gross profit of Rs 4,72,000; and Profit and Loss A/c Dr to Capital A/c with the net profit of Rs 80,000.

Contents This chapter on its own page

Chapter Twenty-Three

The Standard Adjustments, One by One

Syllabus topic 3, "Closing and Adjustment Entries in Final Accounts of Manufacturing Concern."

The twelve

1. Closing stock

Not in the trial balance, because it was never entered anywhere.

Closing stock A/c Dr; To Trading A/c (or to the Manufacturing A/c for raw materials and work in progress)

Effect one	Effect two
Credited to the trading or manufacturing account	Current asset in the balance sheet

Where the closing stock IS in the trial balance, it has already been adjusted against purchases, so it appears only in the balance sheet and not in the trading account. That variant is set to catch you.

2. Outstanding expenses

Expense A/c Dr; To Outstanding expense A/c


Added to the expense in whichever account carries it	Current liability

And where the expense is a factory cost, the addition is in the manufacturing account, which is the manufacturing-specific point.

3. Prepaid expenses

Prepaid expense A/c Dr; To Expense A/c


Deducted from the expense	Current asset

4. Accrued or outstanding income

Accrued income A/c Dr; To Income A/c


Added to the income	Current asset

5. Income received in advance

Income A/c Dr; To Income received in advance A/c


Deducted from the income	Current liability

6. Depreciation

Depreciation A/c Dr; To Asset A/c


An expense, in the manufacturing account for factory assets and in the profit and loss account for the rest	Deducted from the asset on the face of the balance sheet

7. Further bad debts

Bad debts A/c Dr; To Sundry debtors A/c


Added to the bad debts in the profit and loss account	Deducted from debtors

Do this before computing the provision, because the provision is on the debtors that remain.

8. Provision for doubtful debts

Profit and Loss A/c Dr; To Provision for doubtful debts A/c with the shortfall


Only the shortfall is charged: new provision required less old provision brought forward	Deducted from debtors, at the full new figure

Where the old provision exceeds the new requirement, the excess is written BACK, credited to the profit and loss account.

9. Interest on capital

Interest on capital A/c Dr; To Capital A/c


An expense in the profit and loss account	Added to capital

10. Interest on drawings

Drawings A/c Dr; To Interest on drawings A/c


An income in the profit and loss account	Deducted from capital, with the drawings

11. Goods taken by the proprietor

Drawings A/c Dr; To Purchases A/c, at cost


Deducted from purchases, so the trading or manufacturing account is relieved	Deducted from capital as drawings

At cost, not at selling price, unless the question says otherwise.

12. Goods lost by fire, theft or accident

Loss by fire A/c Dr, and Insurance claim A/c Dr; To Trading A/c or Purchases A/c, at cost

The Standard Adjustments, One by One


Credited to the trading account at cost, and the uninsured part charged to the profit and loss account	The admitted claim shown as a current asset

Three more a manufacturing question may add

Adjustment	Entry	The two effects
Outstanding factory wages	Factory wages A/c Dr; To Outstanding wages A/c	Added to wages in the manufacturing account; a current liability
Stock of consumable stores at the year end	Stock of stores A/c Dr; To Stores consumed A/c	Deducted from the stores charged in the manufacturing account; a current asset
Goods manufactured for the concern's own use	Asset A/c Dr; To Manufacturing A/c	Deducted from the cost of production; capitalised as a fixed asset

The order in which to work them

Always in this order, because some depend on others.

Step
1	Further bad debts, because the provision depends on the debtors that remain
2	The provision for doubtful debts, on the reduced debtors
3	Depreciation, because a question may give it as a percentage of a figure that another adjustment changes
4	Outstanding and prepaid items, on each expense in turn
5	Goods withdrawn or lost, which change purchases
6	The closing stock, last, because the goods withdrawn or lost must already be out of it
7	Interest on capital and on drawings, last of all, since drawings may have changed at step 5

Steps 1 and 2, and steps 5 and 6, are the two dependent pairs, and doing either in the wrong order gives a wrong answer that still balances.

The five-adjustment discipline

MU's note limits the examination problem to five. In practice a five-adjustment problem is almost always drawn from this shortlist:

Nearly always present	Often present
Closing stock, in three parts for a manufacturer	Outstanding wages or salaries
Depreciation, on two or three assets	Prepaid insurance or rent
Provision for doubtful debts	Outstanding interest on a loan
	Goods withdrawn by the proprietor

So a candidate who can do those seven cleanly can do almost any paper set on this module.

Quick revision

Adjustment	In the accounts	In the balance sheet
Closing stock	Credited to trading or manufacturing	Asset
Outstanding expense	Added to the expense	Liability
Prepaid expense	Deducted from the expense	Asset
Accrued income	Added to the income	Asset
Income in advance	Deducted from the income	Liability
Depreciation	An expense	Deducted from the asset
Further bad debts	Added to bad debts	Deducted from debtors
Provision for doubtful debts	Shortfall only charged	Deducted from debtors
Interest on capital	An expense	Added to capital
Interest on drawings	An income	Deducted from capital
Goods taken by the proprietor	Deducted from purchases	Deducted from capital
Goods lost	Credited at cost; the uninsured part a loss	The claim an asset

The Standard Adjustments, One by One

Test yourself

Closing stock appears in the trial balance. Where is it shown?
Give the entry for outstanding factory wages and its two effects.
Debtors are Rs 2,00,000, further bad debts Rs 10,000, provision required 5 per cent and the old provision Rs 6,000. What is charged and what is shown?
Why must further bad debts be dealt with before the provision?
What is MU's own limit on the number of adjustments in one problem?

Answer in one sentence

1. Only in the balance sheet as an asset, because a closing stock already in the trial balance has been adjusted against purchases and must not be credited to the trading account again.

2. Factory wages A/c Dr, To Outstanding wages A/c; the wages are increased in the manufacturing account and the outstanding amount is a current liability.

3. Debtors become Rs 1,90,000, the provision required is Rs 9,500, so Rs 3,500 is charged besides the Rs 10,000 of further bad debts, and the balance sheet shows Rs 1,90,000 less the Rs 9,500 provision, that is Rs 1,80,500.

4. Because the provision is computed on the debtors that remain, and computing it on the figure before the write-off overstates it.

5. Not more than five adjustments in one practical problem, printed as a note beneath Module 2 of her syllabus.

Contents This chapter on its own page

Chapter Twenty-Four

Adjustment Entries and Their Double Effect

Syllabus topic 3, "Closing and Adjustment Entries in Final Accounts of Manufacturing Concern."

The rule

An adjustment is a transaction that has not yet been recorded. Like every transaction, it has two aspects, so it needs two postings.

The adjustment is	It lands
An unrecorded expense	As an expense in one of the three accounts, and as a liability in the balance sheet
An unrecorded income	As an income, and as an asset
An expense paid for a later period	As a deduction from the expense, and as an asset
An income received for a later period	As a deduction from the income, and as a liability
A reduction in an asset's value	As an expense, and as a deduction from the asset
A withdrawal by the proprietor	As a deduction from purchases, and as a deduction from capital

Six shapes and every adjustment is one of them.

Why an item in the trial balance is different

The trial balance is a list of balances that have already been posted. So an item in it has already had one landing.

	Where it goes
An item in the trial balance ONLY	One landing: the expense to the profit and loss account, the asset to the balance sheet
An item in the adjustments ONLY	Two landings
An item in both	The trial balance figure is adjusted, and the adjustment supplies the second landing

Worked. Insurance Rs 24,000 appears in the trial balance; Rs 6,000 is prepaid.


The Rs 24,000 was paid and posted, so it already sits as a debit
The adjustment says Rs 6,000 of it belongs to next year
Landing one: the profit and loss account is charged with Rs 18,000, not Rs 24,000
Landing two: Rs 6,000 appears as a prepaid expense in the balance sheet

Two landings, and the trial balance figure was the starting point of both.

The classic error and how the difference names it

A balance sheet that does not agree has almost always had an adjustment posted once. And the difference is the amount of that adjustment, or twice it.

The difference equals	What was probably done
The amount of one adjustment	It was posted in the accounts and not in the balance sheet, or the reverse
Twice the amount	It was posted on the wrong side in one of the two places
The closing stock	It was credited to the trading account and not shown as an asset
The net profit	It was computed and not carried to the capital account
The drawings	They were not deducted from capital

So the first thing to do with a difference is to look for it among the adjustments, and the second is to halve it and look again.

Adjustment Entries and Their Double Effect

A worked check on the running example

Rajesh Manufacturers had five adjustments. Every one is traced here.

Adjustment	Landing one	Landing two
Closing stock: raw materials 80,000, work in progress 50,000, finished goods 1,20,000	Credited to the manufacturing account (1,30,000) and to the trading account (1,20,000)	Current asset of Rs 2,50,000
Depreciation: plant 60,000, factory building 20,000, office furniture 10,000	Rs 80,000 to the manufacturing account, Rs 10,000 to the profit and loss account	Deducted from each asset
Outstanding factory wages Rs 20,000; prepaid insurance Rs 6,000	Wages raised to Rs 2,60,000 in the manufacturing account; insurance reduced to Rs 18,000	Rs 20,000 a liability; Rs 6,000 an asset
Provision for doubtful debts at 5 per cent	Rs 2,000 shortfall charged to the profit and loss account	Rs 12,000 deducted from debtors
Interest on the bank loan at 12 per cent, outstanding	Rs 24,000 charged to the profit and loss account	Rs 24,000 a current liability

Ten landings from five adjustments, and the balance sheet agrees at Rs 17,04,000 because all ten were made.

The entries, gathered

Closing stock A/c Dr 2,50,000; To Manufacturing A/c 1,30,000; To Trading A/c 1,20,000

Depreciation A/c Dr 90,000; To Plant and machinery A/c 60,000; To Factory building A/c 20,000; To Office furniture A/c 10,000

Factory wages A/c Dr 20,000; To Outstanding wages A/c 20,000

Prepaid insurance A/c Dr 6,000; To Insurance A/c 6,000

Profit and Loss A/c Dr 2,000; To Provision for doubtful debts A/c 2,000

Interest on bank loan A/c Dr 24,000; To Outstanding interest A/c 24,000

Six entries for five adjustments, because the closing stock in a manufacturing concern is one adjustment with three parts.

The adjustments that land twice in the SAME statement

Two of the twelve do, and they are the ones students post once.

Adjustment	Both landings
Interest on capital	An expense in the profit and loss account and an addition to capital in the balance sheet
Interest on drawings	An income in the profit and loss account and a deduction from capital in the balance sheet

And two land twice within the balance sheet alone, where a question makes them do so:


A provision for doubtful debts	Deducted from debtors, and its charge is in the profit and loss account
Depreciation	Deducted from the asset, and its charge is in one of the three accounts

The check to run before writing anything down


1	Count the adjustments in the question
2	Count the landings in your answer; there should be twice as many
3	Tick each adjustment off in both places
4	Then total the balance sheet

Doing it in that order takes two minutes and finds the error while there is still time to fix it.

Adjustment Entries and Their Double Effect

Quick revision


The rule	Every adjustment lands twice
Six shapes	Unrecorded expense, unrecorded income, prepayment, income in advance, reduction in an asset, withdrawal
An item in the trial balance	Has had one landing already; the adjustment supplies the second
A difference of one adjustment	It was posted in one place only
A difference of twice	It was posted on the wrong side somewhere
The two most missed	Interest on capital and interest on drawings
The check	Count the adjustments, count the landings, tick both, then total

Test yourself

State the rule and say what an item already in the trial balance does to it.
Insurance of Rs 24,000 is in the trial balance and Rs 6,000 is prepaid. Give both landings.
A balance sheet is out by exactly the amount of the closing stock. What was probably done?
A balance sheet is out by twice the amount of an adjustment. What does that suggest?
Which two adjustments are most often posted once, and where do they land?

Answer in one sentence

1. Every adjustment lands twice; an item already in the trial balance has had one landing already, so the adjustment supplies only the second.

2. The profit and loss account is charged with Rs 18,000 rather than Rs 24,000, and Rs 6,000 appears as a prepaid expense in the balance sheet.

3. The closing stock was credited to the trading account and not shown as a current asset in the balance sheet.

4. That the item was posted on the wrong side in one of its two places, so the error is double its amount.

5. Interest on capital and interest on drawings; the first is an expense in the profit and loss account and an addition to capital, and the second an income and a deduction from capital.

Contents This chapter on its own page

Chapter Twenty-Five

A Complete Set of Final Accounts, Worked

Syllabus topic 2, 4, "Final Accounts of Manufacturing Concern (Proprietary Firm)."; "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."

The question

The following is the trial balance of Rajesh Manufacturers, a proprietary concern, as at 31 March 2027.

Particulars	Dr, Rs	Cr, Rs
Opening stock of raw materials	60,000
Opening stock of work in progress	40,000
Opening stock of finished goods	90,000
Purchases of raw materials	5,60,000
Carriage inward	30,000
Factory wages	2,40,000
Power and fuel	70,000
Factory rent	60,000
Repairs to plant	40,000
Plant and machinery	6,00,000
Factory building	4,00,000
Office furniture	1,00,000
Office salaries	1,50,000
Office rent	48,000
Advertising	60,000
Carriage outward	24,000
Bad debts	8,000
Insurance	24,000
General expenses	48,000
Sundry debtors	2,40,000
Cash and bank	2,10,000
Drawings	60,000
Capital		12,00,000
Sundry creditors		1,80,000
Bills payable		60,000
Bank loan, 12 per cent		2,00,000
Provision for doubtful debts		10,000
Sales		15,00,000
Sale of scrap		12,000
Total	31,62,000	31,62,000

Adjustments.

Closing stock: raw materials Rs 80,000, work in progress Rs 50,000, finished goods Rs 1,20,000.
Depreciate plant and machinery at 10 per cent, factory building at 5 per cent and office furniture at 10 per cent.
Factory wages outstanding Rs 20,000 and insurance prepaid Rs 6,000.
Maintain the provision for doubtful debts at 5 per cent of sundry debtors.
Interest on the bank loan for the year is outstanding.

Prepare the manufacturing account, the trading account, the profit and loss account for the year ended 31 March 2027 and the balance sheet as at that date.

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The working notes

Working note 1: depreciation.

Asset	Cost, Rs	Rate	Depreciation, Rs	Carrying amount, Rs
Plant and machinery	6,00,000	10 per cent	60,000	5,40,000
Factory building	4,00,000	5 per cent	20,000	3,80,000
Office furniture	1,00,000	10 per cent	10,000	90,000
Total	11,00,000		90,000	10,10,000

Rs 80,000 of it is a factory cost and goes to the manufacturing account; Rs 10,000 is an office cost and goes to the profit and loss account.

Working note 2: provision for doubtful debts.

	Rs
Provision required, 5 per cent of Rs 2,40,000	12,000
Less: provision already in the books	(10,000)
Charge to the profit and loss account	2,000

Working note 3: interest on the bank loan.

	Rs
12 per cent on Rs 2,00,000	24,000
Less: paid during the year	nil
Outstanding	24,000

---

The manufacturing account

Rajesh Manufacturers Manufacturing account for the year ended 31 March 2027

Particulars	Rs	Rs
Opening stock of raw materials	60,000
Add: purchases of raw materials	5,60,000
Add: carriage inward	30,000
Less: closing stock of raw materials	(80,000)
Raw materials consumed	5,70,000	5,70,000
Factory wages, 2,40,000 plus 20,000 outstanding		2,60,000
PRIME COST		8,30,000
Power and fuel	70,000
Factory rent	60,000
Repairs to plant	40,000
Depreciation on plant and machinery	60,000
Depreciation on factory building	20,000
Factory overheads	2,50,000	2,50,000
		10,80,000
Add: opening work in progress		40,000
		11,20,000
Less: closing work in progress		(50,000)
Less: sale of scrap		(12,000)
COST OF PRODUCTION		10,58,000

A Complete Set of Final Accounts, Worked

The trading account

Trading account for the year ended 31 March 2027

Particulars	Rs	Rs
Sales		15,00,000
Opening stock of finished goods	90,000
Add: cost of production	10,58,000
Less: closing stock of finished goods	(1,20,000)
Cost of goods sold	10,28,000	10,28,000
GROSS PROFIT		4,72,000

The profit and loss account

Profit and loss account for the year ended 31 March 2027

Particulars	Rs	Rs
Gross profit brought down		4,72,000
Office salaries	1,50,000
Office rent	48,000
Insurance, 24,000 less 6,000 prepaid	18,000
General expenses	48,000
Depreciation on office furniture	10,000
Administrative expenses	2,74,000	2,74,000
Advertising	60,000
Carriage outward	24,000
Bad debts	8,000
Provision for doubtful debts, working note 2	2,000
Selling and distribution expenses	94,000	94,000
Interest on bank loan, outstanding		24,000
NET PROFIT		80,000

The balance sheet

Balance sheet as at 31 March 2027

Liabilities	Rs	Assets	Rs
Capital, 12,00,000 plus profit 80,000 less drawings 60,000	12,20,000	Plant and machinery, net	5,40,000
Bank loan, 12 per cent	2,00,000	Factory building, net	3,80,000
Sundry creditors	1,80,000	Office furniture, net	90,000
Bills payable	60,000	Closing stock, 80,000 + 50,000 + 1,20,000	2,50,000
Outstanding factory wages	20,000	Sundry debtors, 2,40,000 less provision 12,000	2,28,000
Outstanding interest on bank loan	24,000	Prepaid insurance	6,000
		Cash and bank	2,10,000
Total	17,04,000	Total	17,04,000

The two sides agree at Rs 17,04,000, and the answer is proved.

The eight decisions, each of which carries a mark

	Decision	The rule
1	Carriage inward went into the manufacturing account	AS 2 paragraph 7; it is a cost of purchase
2	Carriage outward went into the profit and loss account	It is a selling cost
3	Depreciation was split between the two accounts	Factory assets to manufacturing, office assets to profit and loss
4	The sale of scrap was deducted from the cost of production	It arises in production
5	The finished goods stock went to the trading account and the other two to the manufacturing account	Each stock belongs to the account of its own stage
6	Only the Rs 2,000 shortfall in the provision was charged	The old provision was already in the books
7	Drawings were deducted from capital, not charged as an expense	The business entity concept
8	The outstanding wages went to the manufacturing account, not the profit and loss account	They are factory wages

The checks, in order

	Check	This answer
1	The trial balance totals agree	Rs 31,62,000
2	Every adjustment landed twice	Five adjustments, ten landings
3	The capital working is shown	12,00,000 + 80,000 less 60,000
4	The balance sheet agrees	Rs 17,04,000

Check four is the one that matters. If it fails, look at the size of the difference before looking anywhere else.

A Complete Set of Final Accounts, Worked

Quick revision


The chain	Cost of production 10,58,000 to trading; gross profit 4,72,000 to profit and loss; net profit 80,000 to capital
Depreciation split	Rs 80,000 factory, Rs 10,000 office
Outstanding wages	To the manufacturing account
Scrap	Deducted from the cost of production
Provision	Only the shortfall
Balance sheet	Rs 17,04,000 both sides

Test yourself

What is the cost of production and where does it go?
How is the Rs 90,000 of depreciation split, and why?
Why is only Rs 2,000 charged for the provision for doubtful debts?
Where do the outstanding factory wages appear, in both places?
What is the balance sheet total, and what should you do if you do not reach it?

Answer in one sentence

1. Rs 10,58,000, transferred to the trading account where it stands in place of a trader's purchases.

2. Rs 80,000 on the plant and the factory building to the manufacturing account and Rs 10,000 on the office furniture to the profit and loss account, because a factory cost belongs to the account that computes the cost of making the goods.

3. Because Rs 10,000 of provision was already standing in the books and only the Rs 2,000 shortfall to the required Rs 12,000 is this year's charge.

4. Added to the factory wages in the manufacturing account, making Rs 2,60,000, and shown as a current liability of Rs 20,000 in the balance sheet.

5. Rs 17,04,000; look first at the size of the difference, which will usually be one adjustment posted once, or twice one posted on the wrong side.

Contents This chapter on its own page

Chapter Twenty-Six

Practice Questions: Final Accounts of a Manufacturing Concern

Syllabus topic 2, 3, 4, "Final Accounts of Manufacturing Concern (Proprietary Firm)."; "Closing and Adjustment Entries in Final Accounts of Manufacturing Concern."; "Preparation of Trading Account, Manufacturing Account, Profit & Loss Account and Balance Sheet."

Question 1 (15 marks)

The following is the trial balance of Sunita Industries, a proprietary concern, as at 31 March 2027.

Particulars	Dr, Rs	Cr, Rs
Opening stock of raw materials	45,000
Opening stock of work in progress	30,000
Opening stock of finished goods	75,000
Purchases of raw materials	4,20,000
Carriage inward	25,000
Factory wages	1,80,000
Factory power	55,000
Factory insurance	30,000
Machinery	5,00,000
Land and building, factory	3,00,000
Office equipment	80,000
Office salaries	1,20,000
Office rent	36,000
Travelling expenses	40,000
Discount allowed	12,000
Bad debts	17,000
Advertising	1,00,000
Sundry debtors	1,80,000
Cash and bank	1,25,000
Drawings	48,000
Capital		9,00,000
Sundry creditors		1,40,000
Sales		12,00,000
Provision for doubtful debts		8,000
Loan at 10 per cent		1,50,000
Commission received		20,000
Total	24,18,000	24,18,000

Adjustments.

Closing stock: raw materials Rs 55,000, work in progress Rs 40,000, finished goods Rs 90,000.
Depreciate machinery at 10 per cent, factory land and building at 4 per cent, and office equipment at 15 per cent.
Office salaries outstanding Rs 15,000 and factory insurance prepaid Rs 5,000.
Write off further bad debts of Rs 10,000 and maintain the provision for doubtful debts at 5 per cent of sundry debtors.
Interest on the loan for the year is outstanding.

Prepare the manufacturing account, the trading account, the profit and loss account and the balance sheet.

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Question 2 (8 + 7 marks)

(a) What is a manufacturing account, why is it prepared, and what are the two sub-totals it produces? (8)

(b) State where each of the following appears, giving the account and the side, and what its second effect is: (7)

Closing stock of work in progress
Sale of scrap
Carriage outward
Depreciation on a factory building
Goods withdrawn by the proprietor
Interest on capital
Outstanding factory wages

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Question 3 (10 + 5 marks)

(a) Give the closing entries required to close the following accounts, and say to which account each is closed: opening stock of raw materials, purchases of raw materials, factory wages, sales, closing stock of finished goods, office salaries, commission received, and drawings. (10)

(b) Answer in one or two sentences each: (5)

Which stocks appear in the manufacturing account and which in the trading account?
Why are drawings not an expense?
A balance sheet is out by exactly the amount of one adjustment. What was probably done?
What is MU's own limit on adjustments in one problem?
Where does prepaid factory insurance appear in the accounts?

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Answers

Answer 1

Working note 1: depreciation.

Asset	Cost, Rs	Rate	Depreciation, Rs	Carrying amount, Rs
Machinery	5,00,000	10 per cent	50,000	4,50,000
Land and building, factory	3,00,000	4 per cent	12,000	2,88,000
Office equipment	80,000	15 per cent	12,000	68,000
Total	8,80,000		74,000	8,06,000

Practice Questions: Final Accounts of a Manufacturing Concern

Rs 62,000 is a factory cost and Rs 12,000 an office cost.

Working note 2: debtors and the provision.

	Rs
Sundry debtors as per the trial balance	1,80,000
Less: further bad debts written off	(10,000)
Debtors after the write-off	1,70,000

	Rs
Provision required, 5 per cent of 1,70,000	8,500
Less: provision already in the books	(8,000)
Charge to the profit and loss account	500

Working note 3: interest on the loan.

	Rs
10 per cent on Rs 1,50,000, outstanding	15,000

Sunita Industries Manufacturing account for the year ended 31 March 2027

Particulars	Rs	Rs
Opening stock of raw materials	45,000
Add: purchases of raw materials	4,20,000
Add: carriage inward	25,000
Less: closing stock of raw materials	(55,000)
Raw materials consumed	4,35,000	4,35,000
Factory wages		1,80,000
PRIME COST		6,15,000
Factory power	55,000
Factory insurance, 30,000 less 5,000 prepaid	25,000
Depreciation on machinery	50,000
Depreciation on factory land and building	12,000
Factory overheads	1,42,000	1,42,000
		7,57,000
Add: opening work in progress		30,000
		7,87,000
Less: closing work in progress		(40,000)
COST OF PRODUCTION		7,47,000

Trading account for the year ended 31 March 2027

Particulars	Rs	Rs
Sales		12,00,000
Opening stock of finished goods	75,000
Add: cost of production	7,47,000
Less: closing stock of finished goods	(90,000)
Cost of goods sold	7,32,000	7,32,000
GROSS PROFIT		4,68,000

Profit and loss account for the year ended 31 March 2027

Particulars	Rs	Rs
Gross profit brought down		4,68,000
Add: commission received		20,000
		4,88,000
Office salaries, 1,20,000 plus 15,000 outstanding	1,35,000
Office rent	36,000
Depreciation on office equipment	12,000
Administrative expenses	1,83,000	1,83,000
Advertising	1,00,000
Travelling expenses	40,000
Discount allowed	12,000
Bad debts, 17,000 plus 10,000 further	27,000
Provision for doubtful debts, working note 2	500
Selling and distribution expenses	1,79,500	1,79,500
Interest on the loan, outstanding		15,000
NET PROFIT		1,10,500

Balance sheet as at 31 March 2027

Liabilities	Rs	Assets	Rs
Capital, 9,00,000 plus profit 1,10,500 less drawings 48,000	9,62,500	Machinery, net	4,50,000
Loan at 10 per cent	1,50,000	Land and building, net	2,88,000
Sundry creditors	1,40,000	Office equipment, net	68,000
Outstanding office salaries	15,000	Closing stock, 55,000 + 40,000 + 90,000	1,85,000
Outstanding interest on the loan	15,000	Sundry debtors, 1,70,000 less provision 8,500	1,61,500
		Prepaid factory insurance	5,000
		Cash and bank	1,25,000
Total	12,82,500	Total	12,82,500

The three decisions this question tests.

The prepaid insurance is a FACTORY insurance, so the Rs 5,000 is deducted in the manufacturing account and not in the profit and loss account. A student who deducts it below the gross profit gets the same net profit and the wrong cost of production.
The further bad debts were written off before the provision was computed, so the provision is 5 per cent of Rs 1,70,000 and not of Rs 1,80,000.
Only the Rs 500 shortfall was charged, the old provision of Rs 8,000 being already in the books.

Practice Questions: Final Accounts of a Manufacturing Concern

Answer 2

(a) The manufacturing account

It is the account in which a manufacturer collects every cost of making the goods, so as to produce the cost of production, which it transfers to the trading account where a trader's purchases would stand.

Why it is prepared.

To separate the cost of making from the cost of selling and administering, so that manufacturing efficiency can be judged on its own.
To produce the cost of production, which is what a price is set on and what a make-or-buy comparison or a tender needs.
To value the closing stock of finished goods, which AS 2 requires to be at cost and which cannot be known without this account.

The two sub-totals.

Sub-total	What it contains
Prime cost	Raw materials consumed, plus direct or factory wages, plus any direct expenses
Cost of production	Prime cost plus factory overheads, plus opening work in progress, less closing work in progress, less the sale of scrap and any goods made for the concern's own use

(b) Where each appears

	Item	First effect	Second effect
1	Closing stock of work in progress	Deducted in the manufacturing account	Current asset
2	Sale of scrap	Deducted from the cost of production	Cash or a debtor, already in the trial balance
3	Carriage outward	An expense in the profit and loss account	Cash, already recorded
4	Depreciation on a factory building	An expense in the manufacturing account	Deducted from the asset
5	Goods withdrawn by the proprietor	Deducted from purchases, at cost	Deducted from capital as drawings
6	Interest on capital	An expense in the profit and loss account	Added to capital
7	Outstanding factory wages	Added to wages in the manufacturing account	Current liability

Answer 3

(a) The closing entries

Account	Entry	Closed to
Opening stock of raw materials	Manufacturing A/c Dr; To Opening stock of raw materials A/c	Manufacturing
Purchases of raw materials	Manufacturing A/c Dr; To Purchases A/c	Manufacturing
Factory wages	Manufacturing A/c Dr; To Factory wages A/c	Manufacturing
Sales	Sales A/c Dr; To Trading A/c	Trading
Closing stock of finished goods	Closing stock A/c Dr; To Trading A/c	Trading, and the debit creates the asset
Office salaries	Profit and Loss A/c Dr; To Office salaries A/c	Profit and loss
Commission received	Commission received A/c Dr; To Profit and Loss A/c	Profit and loss
Drawings	Capital A/c Dr; To Drawings A/c	Capital, not the profit and loss account

The four rules behind them. An expense has a debit balance, so it is credited to close and the receiving account is debited. An income has a credit balance, so it is debited to close. A closing stock has no account until one is created, so it is debited as an asset and the account it relieves is credited. And a real or personal account is never closed, which is why drawings goes to capital and not to the profit and loss account.

Practice Questions: Final Accounts of a Manufacturing Concern

(b) Answers in one or two sentences

1. Raw materials and work in progress appear in the manufacturing account, and finished goods in the trading account, all three also appearing in the balance sheet as assets.

2. Because the business entity concept treats the business as separate from its owner, so money or goods he takes out are a withdrawal of his capital and not a cost of running the business.

3. That adjustment was posted in one place only, either in the accounts or in the balance sheet but not in both.

4. Not more than five adjustments in one practical problem, printed as a note beneath Module 2 of her syllabus.

5. It is deducted from the factory insurance in the manufacturing account, and shown as a current asset in the balance sheet.

Marking yourself

If your answer	Then
Deducted the prepaid insurance in the profit and loss account	It is a factory insurance, so it belongs in the manufacturing account
Computed the provision on Rs 1,80,000	The further bad debts come off first; the base is Rs 1,70,000
Charged the whole Rs 8,500 provision	Only the Rs 500 shortfall is this year's charge
Put the finished goods stock in the manufacturing account	It belongs to the trading account
Charged drawings as an expense	They are deducted from capital
Got a balance sheet total other than Rs 12,82,500	Count the adjustments, count the landings, and look at the size of the difference

Contents This chapter on its own page

Accountancy and Financial Management - I Notes | B.Com. (Accountancy) Semester 1 | Mumbai University | munotes

Contents

Module I Introduction to Accounting Concepts & Accounting Standards

Module II Final Accounts of Manufacturing Concern

Introduction to Accounting Concepts & Accounting Standards

In one line

The nine

The three AS 1 singles out

Concept against convention

Quick revision

Test yourself

Answer in one sentence

In one line

The four

The two that pull against each other

The conventions and the standards

Quick revision

Test yourself

Answer in one sentence

In one line

The five tests

Capital expenditure

Revenue expenditure

Deferred revenue expenditure

The effect of getting it wrong

The twelve items to be able to classify on sight

Quick revision

Test yourself

Answer in one sentence

In one line

The tests

Capital receipts

Revenue receipts

The four that are commonly misclassified

The consequence of getting it wrong

Quick revision

Test yourself

Answer in one sentence

In one line

The two

Where each capital profit goes

Capital loss

Why the distinction exists

Worked, in one line each

Quick revision

Test yourself

Answer in one sentence

In one line

The meaning

The chain of authority

Why standards are needed

The benefits

The limitations

The three this paper covers

Quick revision

Test yourself

Answer in one sentence

In one line

The three sets

Which Indian companies follow which

What IFRS are

Convergence, and the carve-outs

The benefits claimed for a single global standard

The difficulties

Quick revision

Test yourself

Answer in one sentence

In one line

What the standard is about

The three fundamental accounting assumptions: paragraph 10

What an accounting policy is: paragraph 11

The areas in which policies differ: paragraph 14

The considerations governing selection: paragraph 17

The disclosure requirements: paragraphs 18 to 26

What a policies note looks like

Quick revision

Test yourself

Answer in one sentence

The objective

What an inventory is: paragraph 3.1