-This question was submitted by a user and answered by a volunteer of our choice.

For a better understanding of the concept, let us first have an insight into the meaning of debit and credit accounts.

The following image shows the Balance Sheet Equation:

In the above equation, all the accounts covered on the left-hand side of the equation are classified as debit accounts, and on the right-hand side are classified as credit accounts.

In other words, Assets are classified as Debit accounts, which means that all the asset accounts would always have a debit balance.

On the other hand, Liabilities and Equity are classified as Credit accounts, which means that all Liability accounts and Capital account would usually have a credit balance.

The Income Statement Equation is given below:

In the Income Statement, Surplus, gains, and revenue are credit accounts, and expenses, losses, or deficits are debit accounts.

The Golden Rules of Accounting may also help in getting a better insight into the concept:

Debit Balance

In simple terms, while balancing the ledger when the Debit side total > Credit side total the difference = Debit Balance. Most of the time, it maintains a “positive balance”.

This is because when you add a debit to a debit it gives you a debit i.e. when you add a positive number with another positive number you get a higher positive number and when you add a credit to a debit it reduces the debit balance. But in most cases, it remains positive.

Let us take up the example of a Plant and Machinery account. Even though we credit the depreciation from this account, the balance remains positive.

Credit Balance

In simple terms, while balancing a ledger  Credit side total > Debit side total the difference = credit balance. All the credit accounts, most of the time maintain a credit balance i.e. they have a “negative balance”. 

This is because when you add a credit to another credit you get a higher balance of credit. Similarly, when you debit the credit account it reduces the credit balance. But most of the time it still gives a credit balance i.e. remains negative. However, we do not put a negative sign while we account for it.

The ledger given below might be of some help to understand this better:

Conclusion

The following are the key takeaways from the article:

• Assets are classified as Debit accounts, which means that all the asset accounts have a debit balance.
• On the other hand, Liabilities and Equity are classified as Credit accounts, which means that all Liability accounts and Capital account would usually have a credit balance.
• While balancing a ledger if the Credit side total > Debit side total the difference then there is a credit balance.
• However, while balancing the ledger when the Debit side total > Credit side total the difference there is a Debit Balance. 

-This question was submitted by a user and answered by a volunteer of our choice.

List of Current Assets and Current Liabilities

Placement in the Balance Sheet

>Related Long Quiz for Practice Quiz 20 – Current Assets

>Related Long Quiz for Practice Quiz 22 – Current Liabilities

-This question was submitted by a user and answered by a volunteer of our choice.

No, Prepaid Expense is Not a Fictitious Asset.

Meaning of Prepaid Expense

A prepaid expense is an expense incurred by an entity in advance before receiving such goods or services. The payment pertains to the future reporting period and is recorded as an asset. The payment made earlier shall be treated as an expense in the year of receipt of goods or services. The asset recorded earlier shall be written off proportionately to the expense accrued.

Meaning of Fictitious Asset

Fictitious means “Fake” or “Untrue” and Asset means anything that gets an economic benefit or adds value to the organization. A fictitious asset is not an actual asset as it does not have a monetary value. In other words, it cannot be realized.

Prepaid assets aren’t fictitious assets

Prepaid expenses and fictitious assets are both of a revenue nature. Prepaid expenses are expenses incurred in advance. Since the expense has not yet become due it is recorded as an asset. If such expense becomes due in the next reporting period it shall be treated as a current asset otherwise a non-current asset when not paid on time.

For Example,

Amit had a showroom on a rental basis and was supposed to pay an amount of 10,000 each month as a rental expense. Amit had a surplus fund and hence, had paid 2 months advance rent concerning the next reporting period.

The amount of 20,000 paid shall be treated as a prepaid expense in the current reporting period and presented as a current asset in the balance sheet and the next reporting period at the end of each month, it shall be written off and treated as an expense in the income statement.

Fictitious assets are spread over more than one reporting period and hence are recorded as non-current assets but these are not actual assets so they are treated as fictitious assets. They may or may not provide any future benefit.

Journal Entry

Preliminary expenses are fictitious assets since these are already incurred but are spread over more than one reporting period and they do not provide any future benefit.

The Accounting Treatment of Prepaid Expenses as per modern rules of accounting will be:

At the time of incurring the expense the journal entry will be

Prepaid expenses are debited since they increase the value of the current asset as it will be paid in the future. This benefits the company. The cash account is credited as it is an expenditure and reduces the value of the asset.

At the time such expense becomes due

The expenses account has been debited since it is being used from the prepaid expenses for the month. The prepaid expenses are credited since their value is slowly decreasing.

The prepaid expenses are reduced from the expenses in the profit and loss account as it is being utilized during the operating year and it slowly reduces the value of the current asset.

The prepaid expenses are shown under the current assets on the asset side of the balance sheet since they will be used within the operating period.

>Related Long Quiz for Practice Quiz 30 – Fictitious Assets

>Related Long Quiz for Practice Quiz 36 – Prepaid Expenses

-This question was submitted by a user and answered by a volunteer of our choice.

Charging Depreciation in the Year of the Sale

The answer to your question is yes, one can charge depreciation in the year of sale.

I guess reading the below para you will be able to interpret as to why it can be charged in the year of sale.

First of all, what does depreciation mean?

It is a measure of wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes.

It is allocated to charge a fair proportion of depreciable amount in each accounting period during the expected useful life of an asset.

Thus, even in the year of the sale, the asset shall continue to wear and tear and so it shall be apt to charge the depreciation from the beginning of the accounting period till the date of its sale i.e for the period it has been used in the year of sale.

Example

I guess the below example will be of great help to you.

The book value of an asset as of 01 /01/YYYY is 70,000 depreciation is charged on an asset @ 10%. on 01/07/YYYY the asset is sold for an amount of 35,000.

The accounting treatment for the same shall be:

Charging depreciation of an amount of 3,500 (70,000 x 10% x 6/12) for 6 months i.e for the period in use (from 01/01 to 30/06):

Now at the time of sale, the entity shall record a loss of 31,500 which is nothing but the difference between the written down value and the value of sale proceeds as shown below:

I believe now you understand as to why we should charge depreciation in the year of sale as well and also the above example will help you understand the accounting treatment for the same as well.

>Related Long Quiz for Practice Quiz 39 – Depreciation

-This question was submitted by a user and answered by a volunteer of our choice.

Yes, there are a few assets that show the credit balance. Those assets generally hold zero or unfavourable balances.

Assets that have a credit balance

From accounting perspective assets and expenses generally have a debit balance whereas liabilities, revenue and capital have a credit balance. Yet there exist a couple of assets that do have a credit balance those assets are known as contra assets.

Contra Asset

A contra asset is referred to as an asset that generally has a zero or negative balance. Such an asset is used to offset or reduce the balance of the respective asset account with which it is paired to. Hence reducing or offsetting the amount of the respective asset account with the contra asset account gives us the net value of the respective asset.

It acts as an asset holding credit balance. Contra assets are useful for the organization because it allows them to follow the matching principle by initially recording an expense in the contra asset account.

Assets with a negative balance

• Accumulated Depreciation
• Bad debts allowance
• Reserve for old and obsolete inventory
• Allowance for doubtful debts

For Example – Max purchased an air conditioner from eBay for 4,00,000. The salvage value of the air- conditioner is 30,000 and has an expected useful life of 10 years. On 31-12-YYYY, how much balance will be shown in the Accumulated Depreciation account.

Calculation

Annual Depreciation = (Value of Asset – Salvage value)/Estimated life of the asset.

= (4,00,000 – 30,000)/10  => 37,000

Net Asset value = Total asset value – Accumulated Depreciation

= 4,00,000 – 1,48,000  => 2,52,000

Placement in the Balance Sheet

Here in the balance sheet “Accumulated Depreciation” shows a negative balance which is a contra asset and it is deducted from the respective asset account. Hence providing us with the Net value of the asset.

-This question was submitted by a user and answered by a volunteer of our choice.

Why is Debit written as Dr?

They say Debit is denoted by “Dr” but if you see the word “Debit”  you will realise that there is no “R” in it then from where is it derived or what does it signify?

This is a question which normally every person studying accountancy or is responsible for bookkeeping has but one does not get a satisfying answer to the same. There is no exact reason as to why this abbreviation is used but based on the research and records available three answers seemed logical.

These are;

1. Dr stems from the word Debtor.
2. Dr refers to Debit Record but there are no traces of this theory back in history.
3. Some say that it’s derived from the Latin word “debere” and it also has an r in the word but there is no specific record to prove this theory as well.

My personal opinion out of all of the above is that 1st theory is somewhat acceptable.

Why is Credit Written as Cr?

In the word “Debit”,  there were no traces of the letter “R” but that’s not the case for credit and the word credit has a letter “R”. But since debit has no “r” we can not consider this theory acceptable. As these abbreviations are used in a pair also they are derived in a pair.

There are no specific records to justify the same but based on available information the below-mentioned statements seems logical.

These are;

1. Cr stems from the word Creditor.
2. Cr refers to Credit records but there are no traces of this theory back in history.
3. Some say that it’s derived from the Latin word “credere” and it seems acceptable as both “debere” and “credere” contains the letter “r”.

But the most accepted theory is that Cr stems from the word Creditor.

Conclusion

I believe there is no perfect answer to this question as there are no records available referring to which one can give an exact reason. But according to me, it’s an abbreviation derived from the words Debtor and Creditor.

-This question was submitted by a user and answered by a volunteer of our choice.

To understand the Presentation of Accumulated Depreciation in the Trial Balance, it is crucial first to understand the concept and meaning of Depreciation.

What is Depreciation?

Depreciation is the fall in the value of an asset due to use, wear and tear, or obsolescence. It is a non-cash expense for the business.

There are various methods that are used to calculate depreciation including the Written Down Value method, Straight Line Method, Sum of the digits method and various others.

The business maintains a provision for depreciation account to prepare for this expense. An amount is set aside every financial year in the form of this provision.

What is Accumulated Depreciation?

Accumulated depreciation is the aggregate or the total amount of fall in the value of the asset since the asset was put to use. In other words, it is the total depreciation that an entity has expensed in its profit and loss statement till that date.

It is a Contra asset account as it reduces the balance in the asset account. If the accumulated depreciation is subtracted from the original value of the asset, the present value of the asset can be found.

Accumulated Depreciation in the Trial Balance

A Trial Balance of the business shows the closing balances of all the general ledgers.

The accumulated depreciation is shown as a “credit item” in the trial balance. Accumulated depreciation is nothing but the sum total of depreciation charged until a specified date.

Since in every reporting period, a part of a fixed asset is written off i.e. depreciated, such accumulated depreciation has a credit balance.

The image given below shows how Accumulated Depreciation is shown in the Trial Balance:

Illustrative Example

Prepare a trial balance of Mr Allen on the basis of given heads of accounts;

Solution :

The Trial Balance of Mr. Allen is given below:

Accumulated Depreciation always has a credit balance.

Conclusion

The above discussion is summarised below:

• Depreciation is the fall in the value of an asset due to use, wear and tear, or obsolescence.
• It is a non-cash expense for the business.
• Accumulated Depreciation is the total depreciation that an entity has expensed in its profit and loss statement till that date.
• Accumulated Depreciation is the total amount of Depreciation charged during the life of an asset.
• It is a Contra asset account as it reduces the balance in the asset account.
• The accumulated depreciation is shown as a “credit item” in the trial balance.
• When the accumulated depreciation is subtracted from the original cost of the asset, the remaining value is the present valueof such asset.

-This question was submitted by a user and answered by a volunteer of our choice.

Purpose of subsidiary books

Big business concerns have recorded numerous financial transactions in one accounting period and journalizing them all in one single book can be very difficult such organizations choose subsidiary books for maintaining many transactions of similar nature in chronological order. The following are the purpose of maintaining a subsidiary book.

1. The main purpose of maintaining subsidiary books is to create a differentiation between cash and credit transactions that occurs in an organization. All the credit transactions are further recorded in the various subsidiary books (say- purchase of goods on credit is recorded in purchase book). All the cash transactions are recorded in the cash book.

2. Subsidiary books are maintained when numerous (say-5000) transactions take place in a single day. This helps the accountant (or), bookkeeper, to keep a track of the total purchases and sales which takes place on a particular day.

3. Subsidiary books eliminate the problem of recording all the financial transactions in a single journal and later on posting them in the various ledger which makes the task difficult and confusing. There are chances of missing multiple transactions that create problems in the later accounting process.

4. The format of subsidiary books is designed in such a way that even a non-commerce graduate can easily understand and interpret the functioning of every business transaction with a nill accounting knowledge when compared to the Journal Entries.

5. The totals of all subsidiary books are generally done on a timely basis. This helps the organization to know the total amount of purchases and sales (both cash and credit) that takes place in one day, month, quarter (or) year.

6. Another important purpose of maintaining subsidiary books is that it provides information on the price per unit of goods purchased in a bulk amount. This acts as an aid for large organizations to make future decisions. Subsidiary books attract huge trade discounts and price negotiations from the suppliers.

Uses of Subsidiary Books

The following are the uses of maintaining a subsidiary book-

1. Subsidiary books are classified into several types so instead of having one single book for recording all the transactions we have various books. Therefore the work can be easily divided among the several members of an organization. This, in turn, improves the quality of work, precision and results in fewer mistakes.

2. Recording of business transactions in the subsidiary books saves time and reduces clerical hours. The best part of the subsidiary book is that there is no need for journalizing a transaction and passing a narration after every transaction. Hence, various accounting processes can be performed at a single time.

3. If a person maintains any part of subsidiary books for a longer period (say for many years) then he obtains full knowledge and understanding of the work. In simple words, he becomes an expert on that particular subsidiary book (for example- a sales book). This improves his transparency, efficiency and accuracy.

4. When all the business transaction of a similar nature is recorded in the subsidiary books as per chronological order then it becomes simple for the accountant/clerk to trace any transaction whenever and wherever needed.

5. Subsidiary Books makes further accounting process run smoothly. If the trial balance does not agree due to any errors or omissions then it can be easily detected and corrected. This is only possible because of the existence of the subsidiary book.

-This question was submitted by a user and answered by a volunteer of our choice.

Return Inwards

The return inwards arises when goods sold are returned back by the customers. They might return the entire order or only a part of it. It is also known as Sales Returns. Such returns are deducted from sales on the credit side of the Trading Account.

Journal entry for Return Inwards 

When there is a return inwards, the following journal entry is passed-

(Goods returned by the customer)

As per Modern rules of Accounting,

As per Traditional rules of Accounting,

For example, 

ABC Ltd. is a dealer in smartphones and the company sells them on Amazon which has a 30-day replacement guarantee scheme especially when the customer buys a certain electronic item. Hence when the customer returns the smartphone that he purchased it becomes a return inward and hence, it will be deducted from ABC’s sales. 

Return Outwards

The return outwards arises when the goods purchased are returned. It is also known as Purchase Returns. Such returns are deducted from purchases on the debit side of the Trading Account.

Journal entry for Return Outwards

When there is a return outward, the following journal entry is passed-

(Goods returned to the seller)

As per Modern rules of Accounting,

As per Traditional rules of Accounting,

For Example,

ABC Ltd. is a watch dealer and the company has placed an order with a supplier to supply 20 Smart Watches but he sent 5 watches of a different model so ABC returned them. This is a case of return outward as ABC is sending goods back to the supplier and hence it shall be deducted from the purchases.

Accounting Treatment of Return Inwards and Return Outwards

1. Return Inwards

• Return inwards are deducted from sales in the Trading Account, giving net sales.
• It is not shown in the Balance Sheet.

2. Return Outwards

• Return outwards are deducted from purchases in the Trading Account, giving net purchases.
• It is also not shown in the Balance Sheet.

Conclusion

The key takeaways from the above discussion are:

• When the goods sold by a business are returned by the customers, it is known as Returns Inward or Sales Return.
• When the goods purchased by a business are returned to the suppliers, it is known as Returns Outward or Purchase Return.
• Return inwards are deducted from sales in the Trading Account, giving net sales.
• Return outwards are deducted from purchases in the Trading Account, giving net purchases.

-This question was submitted by a user and answered by a volunteer of our choice.

Introduction

In the world of business, most of the transactions take place on credit rather than cash. This involves risk as the guarantee to repay might be low due to the financial instability of the company. To minimize this risk many organization decides to allocate a certain portion towards provision for all the future expenses and losses.

Provisions are created for future losses and this helps to give accurate financial reports as future liabilities are calculated in advance. This makes the organization’s financial statements look more precise. Provisions are necessary by the accounting standards and regulatory authorities to ensure transparency and accuracy in financial reporting. Provision is created from company profit to meet all the uncertain future obligations.

Provision is created because it accounts for particular company expenses and payments for the current year.

Meaning of Provision for Doubtful Debts

Provision for doubtful debts is created based on historical data of bad debts, economic conditions, and the creditworthiness of customers. Provision for doubtful debts is an accounting practice where a company sets aside some amount for the possibility that the accounts receivable might not be recoverable.

In other words, the term provision for doubtful debts refers to the estimated (or) predicted value of bad debts that arise from the sundry debtors that have been issued but have turned out to be uncollectible. It takes place when a credit sale to the customer is made. Provision for Doubtful debt is a contra account and it is also known as Provision for bad debts.

Reason for creating Provision for Doubtful Debts

• In Accounting, Provision for Doubtful debts is created to abide by the conservatism convention and prudence principle which states that “don’t account for future anticipated profits but account for all possible losses”.
• Provision for Doubtful debts is an expense that occurs in the normal course of business.
• Various organizations create a provision for all the future expected expenses and losses that may arise due to credit sales so the organization needs to make a percentage of such provision on the net value of sundry debtors to comply with all the future uncertainties.

Example

ABC Ltd. furnishes you with the following information about Total sales for the current accounting year,

The company decided to create a 5% provision for doubtful debts on sundry debtors. Comment upon its decision.

Calculation of Provision for Doubtful Debts-

Step 1– Calculate the Net value of sundry debtors

Net Sundry Debtors = Sundry Debtors – Bad Debts

= 4,00,000 – 40,000 => 3,60,000

Step 2 – Create a 5% provision on the net value of sundry debtors

Provision for Doubtful Debts = 3,60,000 * 5/100

= 18,000

The decision to create a provision for doubtful debts will help the company mitigate (or) reduce all the future obligations and uncertainties that arise due to the bad debts.

-This question was submitted by a user and answered by a volunteer of our choice.

The normal balance of dividends is “Debit”.

Firstly, you should know what a normal balance in accounting means.

What is the normal balance of dividends?

Normal Balances in Accounting

Some accounts have  “Debit” Balances while the others have  “Credit” balances. The normal account balance is nothing but the expectation that the specific account is debit or credit. Few accounts increase with a “Debit” while there are other accounts, the balances of which increases while those accounts are “Credited”.

You can have a glance over the list of accounts having debit and credit balances normally specified below;

Since you are now aware of normal balances in accounting. I will move ahead with the next concept.

Why do dividends have a debit balance?

Generally, the company or corporates pay dividends to its investors. It is paid out of the company’s retained earnings or free reserves and since it reduces the balance of reserves it is “Debited”. It is also recorded under financing activity under the cash flow statement.

But one needs to note that the dividends declared are basically a temporary account i.e at the end of the reporting period the balance in the dividend account is transferred to Retained Earnings. And the dividend account is closed.

The company also has an option to directly give effect for dividends declared in the retained earnings. Here, there is no need to prepare the dividend account.

Conclusion

Since dividend payments are a reduction of retained earnings for an entity it has a debit balance as its reduction of share holder’s equity. As per the modern rules, we debit the decrease in the capital.

But the company also has an option to directly record this transaction through its retained earnings and in such a case the dividend declared account is not created and so the question of it having a debit or credit balance does not arise.

-This question was submitted by a user and answered by a volunteer of our choice.

Meaning of Provision for Discount on Debtors

Debtors are the entities who have purchased goods from the company on credit. They owe money to the business for such goods purchased.

In order to receive early payment from the debtors in the succeeding period, business entities provide incentives to the debtors who are ready to pay the outstanding amount before their credit period ends.

So, at the end of every period, entities will have to estimate the amount of discount that may be availed by the debtors in the succeeding period. This estimate will be based on past experience.

Accordingly, a provision will have to be created in the current period as the amount of discount is an expected loss for the entity. This provision is referred to as “Provision for Discount on Debtors”.

Journal Entry for Provision for Discount on Debtors

The Journal entry for Provision for Discount on Debtors is given below:

(Being Provision for Discount on Debtors charged to Profit and Loss Account)

Example of the Journal entry

ABC Ltd. has Sundry Debtors of 50,000. Out of these, 5,000 turn out to be bad debts. The company decides to offer a discount of 5% to the remaining debtors amounting to 45,000 if they pay the owed amount before the credit period ends.

(Being Provision for Discount on Debtors charged to Profit and Loss Account)

Treatment of Provision for Discount on Debtors in Final Accounts

Extracts of the Profit & Loss account and Balance Sheet have been attached for better understanding.

Conclusion

The following may be concluded from the above article:

• Debtors are the entities who owe money to the business on credit purchases.
• Discount is provided to such debtors as an incentive for early payment.
• The company maintains a provision for such discount as this discount may or may not be allowed.
• This estimate is generally based on experience.
• It is presented on the Debit side of the Profit & Loss account.
• It is Deducted from Sundry Debtors under the head Current Assets (after deducting Bad Debts & Provision for Doubtful Debts).

-This question was submitted by a user and answered by a volunteer of our choice.

I have answered this question on the assumption that “Trading Expenses are those expenses which are covered in the Trading Account”.

Meaning of Trading Expenses

Trading Expenses are direct expenses incurred for the purchase and production of goods. They are related to the core business operations of the business entity and directly related to the purchase and production of the finished goods.

So, all the expenses incurred from the time of purchasing raw materials/goods till the time the finished goods are brought to a saleable condition are referred to as trading expenses.

For example: carriage inward, manufacturing expenses, wages, etc.

Features of Trading Expenses

Presentation in Financial Statements

A snippet of the Trading account has been attached for better understanding.

Conclusion

Hence, trading expenses are debited to the trading account to accurately reflect the costs incurred in the process of buying and selling goods or financial instruments.

This helps in determining the gross profit derived from trading activities before other expenses are considered.

-This question was submitted by a user and answered by a volunteer of our choice.

What is Rent Received in Advance?

Rent Received in Advance is an amount received by the landlord from the tenant before the actual due date. It’s an income received in advance.

Income received in advance refers to the amount received by a person or an entity before rendering services or transfer of title to goods.

Rent received in advance is typically recorded on the landlord’s balance sheet as a liability until it is earned, at which point it is recognized as rental income on the income statement.

It’s important for landlords to accurately track and manage rent received in advance to ensure proper financial reporting and compliance with accounting standards.

For Example,

A landlord may have the policy to charge the last month’s rent in advance for his convenience to cover himself from loss of income on the expiry of the lease term. A lot of landlords across the globe follow this policy.

Whether it is Taxable?

The answer to this question is that it depends. It depends on the accounting policy an entity or a person follows.

If a person follows the accrual system of accounting then the rent received in advance shall be treated as a liability in the year of receipt and it will be taxable in the year of realization.

The image shown below is the perfect example of the same:

However, If a person follows the Cash System of Accounting then such rent received shall be treated as an income in the year of receipt and it would be taxable in the year of receipt itself.

The image shown below explains the same:

The accounting treatment in each of the cases shall be:

In the Accrual System of Accounting

In the above journal entry, it is reflected that rent will not be recorded in the income statement that is it will be taxable in the year of accrual and so it shall be the taxable income in the next accounting period.

 In Cash System of Accounting

In this case, it is reflected from the above journal entry since the cash system is followed the rent is recorded as an income and since it will be reflected in an income statement it is a taxable income in the year of receipt.

>Related Long Quiz for Practice Quiz 31 – Income received in Advance

-This question was submitted by a user and answered by a volunteer of our choice.

To begin with, let me help you understand the meaning of the term Contingent Assets.

Meaning of Contingent Assets

Contingent Assets are possible assets or potential economic benefits because they do not currently exist but may arise in the near future. The shift from possible assets to real assets for the entity is dependent on the occurrence or non-occurrence of future events which are not under its control.

A tabular depiction of the recognition/disclosure principles for contingent assets has been presented below:

Examples of Contingent Assets

Example 1

ABC Ltd filed a legal suit against its supplier XYZ Ltd for compensation against damages on non-supply of contracted goods. There is a possibility of ABC Ltd winning the case, as it has concrete evidence of contract violation by XYZ Ltd. The lawsuit has not been settled till the accounting year-end.

–In this case, it is probable ( > 50% – 95% probability) that there would be an inflow of economic benefits (compensation for damages) to ABC Ltd in the near future. So, it will be disclosed as a contingent asset in the notes to accounts or board reports (as applicable).

Example 2

Suppose in the above example, the court orders XYZ Ltd to pay 100,000/- as compensation for damages. ABC Ltd has not yet received the money until the accounting year-end. Can it recognize this as a contingent asset?

–The court has ordered the payment for damages. Although ABC Ltd has not received the payment till the accounting year-end, it is virtually certain ( > 95% of probability) that it will receive the compensation amount in the near future.

ABC Ltd will now recognize the compensation amount as an asset in the financial statements and not disclose it as a contingent asset, as it is virtually certain.

Example 3.

Jute Ltd entered into a sale contract of 500,000 for the supply of jute during 20×2-20×3 with Textiles Ltd. During the transit, the truck carrying the jute for delivery met with an accident which destroyed the entire jute. The jute destroyed was covered under an insurance policy. The cost of the jute destroyed was 400,000. The policy prescribed acceptance of the amount of claim, amounting to 80% of the goods destroyed ie. 320,000 (80% * 400,000).

Before the end of the accounting year, Jute Ltd received informal information from the insurance company that their claim had been processed and the payment had been dispatched for the claim amount.

–In this scenario, there exists a possible asset (claim amount). Also, the inflow of economic benefits is probable ( > 50% – 95% probability) because Jute Ltd. has received informal information from the insurance company about the processing of the claim.  Therefore, Jute Ltd can treat and disclose this as a contingent asset in the notes to accounts or board reports (as applicable).

Example 4.

A Road & Highway Developer enters into a contract with the Road & Highway Authority of India to complete a highway project. The agreed cost of the total project was 10 million, but the actual cost turned out to be 15 million. As per the terms of the contract, the Authority was mandatorily required to hand over the land within a specific time period. But the Authority failed to do so. On account of the delay in handing over of land, an excess cost of 5 million was incurred by the Developer.

To recover the incremental cost incurred, the Developer filed litigation against the Authority for reimbursement of 5 million. The court has not yet given its final verdict. However, the Developer is sure that he will win the case.

In this example, the Developer will disclose 5 million as a contingent asset in the notes to accounts or board report (as applicable) till the court does not give its final verdict. This is because there is a probability of the Developer winning the case as there has been a violation of terms by the Authority.

Once the litigation is announced in favour of the Developer by the court, this will be recognized as an asset in the balance sheet of the Developer.

Hope these examples have made your understanding of contingent assets very clear.

>Related Long Quiz for Practice Quiz 18 – Contingent Assets

Prepaid rent includes the word rent. Therefore, one might think that it is an expense, right? But, Prepaid rent is a current asset and not an expense. Let us break it down for you.

What are Current Assets?

Current assets are the assets that a business owns and expects to realize within 12 months or the operating cycle. Some examples of current assets are Bills Receivables, Cash, Cash at Bank, Inventories, etc.

What are Prepaid Expenses?

You can think of prepaid expenses as the costs that have been paid but are yet to be utilized. For example, prepaid rent, prepaid insurance, prepaid salaries, etc.

In the balance sheet, all the prepaid expenses that have not yet been consumed are recorded as current assets.

Accrual Vs Cash Basis

In the accrual basis of accounting, the expenses and revenues are recorded in the books when they are incurred or earned irrespective of the cash has been paid or received.

When you make the payment of rent before its due date, it is known as prepaid rent. Rent is usually paid in advance for multiple reasons, such as availing a discount, the landlord demanding a prepayment, etc.  For a better understanding of the concept, let us have a look at the example given below.

Example of Prepaid Rent

Company X signs an agreement to rent a warehouse for 1,000 per month from March for 7 months. The landlord demands payment of the total amount in February. The journal entries to be recorded are as follows:

(Being rent paid before the due date)

(Being prepaid rent adjusted as it expires)

Note: The total amount of rent 7,000 (1,000 x 7) is initially recorded in the balance sheet under current assets as prepaid rent. The reason for recording it as a current asset is that the rent which will be due at the end of each month is already paid for and the benefit is yet to be availed.

Each month the prepaid rent account is reduced by the amount of rent paid for that month. The prepaid rent (asset account) will be reduced by 1,000 (7,000/7) each month and the amount shall be debited to rent (expense account) for each month.

Prepaid Rent Expense or Asset?

Prepaid rent is recorded under current assets in the balance sheet because businesses often pay the rent before the due date, and it is utilized within a few months of its payment, usually within the same financial period. The benefits of the payment in advance are realised later on.

Prepaid Rent Shown in the Balance Sheet

In the Balance Sheet, the Prepaid expense is shown as a Current Asset under the Assets head of the Balance Sheet.

Conclusion

The key takeaways from the above article are:

• Prepaid rent is a current asset and not an expense.
• Prepaid expenses are the costs that have been paid but are yet to be utilized.
• Prepaid rent is recorded under current assets in the balance sheet.

>Related Long Quiz for Practice Quiz 20 – Current Assets

>Related Long Quiz for Practice Quiz 36 – Prepaid Expenses

>Read

-This question was submitted by a user and answered by a volunteer of our choice.

Meaning of Closing Stock

Closing stock refers to the value of the goods or products that remain unsold and are held by a business at the end of a specific accounting period, such as a month, quarter, or year. It represents the final inventory of goods that have not yet been sold but are ready for sale.

Accounting Treatment of Closing Stock

According to accounting concepts and principles, every accountant should record closing stock/inventory and other current assets (say- short-term investments, marketable stocks and securities) as per the conservatism (or) prudence concept.

This concept states that closing inventory (or) other current assets must be recorded at Cost (or) Net Realizable Value (NRV) whichever is the least. Conservatism concept follows a rule that “never anticipate for future profit but the record for all possible losses occurring in an organization”.

Example- At the end of the financial year, if the value of closing stock in the books appears to be 45,000 but, its market value is 60,000. Then the surplus amount of 15,000 (60,000-45,000) will be treated as an anticipated profit that will be obtained when the stock is sold in the next accounting period.

According to the principle of conservatism, the closing stock must be valued at cost or Net Realizable Value (NRV) whichever is least. Hence Closing stock must be valued at 45,000 in the books of accounts.

Reason for showing closing stock on the credit side of trading account

Closing stock is shown on the credit side (revenue side) of the trading account but closing stock is not revenue. It is just shown on the revenue side because of the application of the matching concept which states that “all expenses must match with the revenues of the current period”.

The value of opening stock, purchases and direct expenses is charged as an expense to the trading account by showing them on the debit side. The income produced by selling them is matched by showing it as sales, direct revenue on the credit side of the trading account.

Hence, if there are any unsold units left with the organization, then their cost should not be charged to the trading account. Further, their value must be reduced by recording them on the credit side of the trading account to find true or genuine gross profit.

I would further like to add an example to make the above explanation easy and understandable.

Example- ABC Co. purchased 150 units of goods for 50 per unit. After a few months, they sold 100 units for 100 per unit. Calculate the value of Gross Profit based on the given two cases.

Case 1- If the Closing stock is not shown on the trading account

Case 2- If the Closing stock is shown on the trading account.

Case 1- If the closing stock is not shown on the credit side

In case 1, total revenue of the firm = 10,000 (sales) is matched with total expenses of the firm = 7,500 (purchases) then the gross profit will be 2,500 (10,000-7,500). This gross profit is untrue because the accountant has violated the matching principle of accounting by not recording 50 unsold units as closing stock.

Case 2- If the closing stock is shown on the credit side

In case 2, total revenue of the firm = 15,000 (sales + closing stock) is matched with total expenses of the firm = 7,500 (purchases) then the gross profit will be 7,500 (15,000-7,500). This gross profit is true (or) genuine because the accountant has followed the matching principle of accounting by recording 50 unsold units as closing stock.

A snippet of the trading account will help you to develop a better understanding of the concept

Overview of Expenses

The costs paid by a business in order to generate revenue are called expenses. In other words, it is an outflow of funds in exchange for the acquisition of a product or service. For example, rent payments, interest payments, electricity bills, administration expenses, selling expenses, etc.

There are different types of expenses based on their nature and the term of benefit received.

• Direct & Indirect Expenses – All expenses related to the direct cost of goods and services produced are called direct expenses. Whereas, expenses that do not form part of direct costs are called indirect expenses.
• Capital Expense – Expenses incurred for acquiring capital assets, like building, machinery, etc., are called capital expenses.
• Revenue Expense – expenses incurred for day-to-day business operations are revenue expenses.

In accounting terms, expenses tend to increase productivity while decreasing owner’s equity. Thus, an increase in expenses should be debited in the books of accounts.

Related Topic – Capitalized Expenditure

As per the Modern Rules of Accounting

Expense is Debited (Dr.) when increased & Credited (Cr.) when decreased.

Why is it like this?

This is a rule of accounting that cannot be broken under any circumstances.

How is it done?

Suppose, you rent a local shop that sells apples & you make a yearly payment towards the shop’s rent (in cash). As a result, this expense would be added to the income statement for the current accounting year because due to this payment the total expenses of your business have increased.

Below is the timeline of how it would be recorded in the financial books.

Step 1 – While making the payment the below journal entry is recorded in the books of accounts. (Rule Applied – Dr. the increase in expense)

(Payment in cash for shop’s rent)

Step 2 – At the time when the expense is transferred to “Profit & Loss A/c”.

(Shop’s rent expense is transferred to the income statement)

Related Topic – Liability is Debited or Credited?

As per the Golden Rules of Accounting

Expense is Debited (Dr.)

As per the golden rules of accounting for (nominal accounts) expenses and losses are to be debited.

A nominal account represents any accounting event that involves expenses, losses, revenues, or gains. It is what you would call a profit and loss or an income statement account. As opposed to personal and real accounts, nominal accounts always start out with a zero balance at the beginning of a new accounting year.

Example

Suppose, you rent a local shop that sells apples & you make a monthly payment towards the shop’s electricity bill (by the bank). Consequently, this payment would be reflected on the income statement.

Below is the timeline of how it would be recorded in the financial books.

Step 1 – In the below example of a journal entry for electricity bill payments “Electricity Charges A/c” is debited. (Rule Applied – Dr. all expenses & losses)

(Payment by the bank for the shop’s electricity bill)

Step 2 – At the time when the expense is transferred to “Profit & Loss A/c”.

(Shop’s rent expense is transferred to the income statement)

If the expense is prepaid, it is an asset to the business and is shown on the asset side of the balance sheet.

Related Topic – Is Income Debit or Credit?

Expenses Inside Trial Balance

Expenses show a debit balance in the trial balance. A trial balance example showing a debit balance for salaries and rent expenses is provided below.

>Read Contra Accounts

-This question was submitted by a user and answered by a volunteer of our choice.

Principles of Accounting

I would like to share with you the five basic principles of accounting, followed by an example each. I hope this answer enhance your basic accounting knowledge.

Business-Entity Principle

This principle states that the organization has a separate entity apart from its owner. Every accountant should consider business as distinct from its owner. This means business transactions must be recorded in business books of accounts and the owner’s transactions in his books of accounts.

For Example- Company A started a watch business by investing 1,00,000 with which he purchased raw materials for 40,000 and maintained balance in hand. He further withdrew in 8,000 for his personal use from the business.

As per the business entity principle, his capital invested will get reduced by 8,000 and these expenses should not be treated as business expenses. Now the business owes 92,000 to the owner.

Accrual Principle

The accrual principle states that the effects of transactions and events are identified at the time when they occur (say mercantile basis) and not on cash or cash equivalent either received or paid. The accrual principle records total revenue generated. Revenue includes gross inflow of cash, receivables and other consideration arising out of business activities.

For Example- Mr Alex started a Jute business. He invested 10,00,000, bought raw materials for the manufacturing of Jute bags for 6,00,000. He manufactured 50,000 Jute bags and sold the same for 8,00,000 to ABC Ltd. ABC Ltd. paid in 5,00,000 in cash and assured him to pay the rest of the amount in future.

As per the accrual principle, the total revenue of Alex is 8,00,000 (say 5,00,000 from cash and 3,00,000 by way of receivables).

Going Concern Principle

Going concern principle states that the business has a long fair life and it continues its operations until it is legally wound up in the foreseeable future. Hence it is presumed at the organization has neither the intention to shut nor the need to liquidate.

For Example- Standard Chartered Bank will close one of its bank branches in the middle east for the sake of improving its profitability and performance.

As per the going concern principle, Standard Chartered Bank will keep continuing its operations because closing down of a small portion of the business doesn’t affect the capability of the bank.

Cost Principle

The cost principle states that assets must be valued at historical cost (say the acquisition cost). If the machinery is acquired by paying 1,00,000 then the acquisition cost of the machinery is 1,00,000. It is highly objective and free from all biases.

For Example- Company B purchases a motor van for 3,00,000. The market value of the motor van is 2,50,000. At the time of preparation of the balance sheet, the motor-van must be valued at 3,00,000.

As per the cost principle, it is clear that motor van must be valued at cost and not at market value.

Conservatism Principle

Conservatism principle states that never anticipate future income and should account for all the possible losses. When there are various alternatives available for the valuation of the closing stock then the accountant should opt for that method that provides lesser value.

For Example- At the time of preparation of final accounts, the value of closing inventory shown in the books is 5,00,000. Net realisable value is 2,50,000.

As per the conservatism principle, closing inventory must be valued at cost price or net realisable value whichever is lower. Therefore, Closing stock must be shown at 2,50,000 in the books of accounts.

-This question was submitted by a user and answered by a volunteer of our choice.

Meaning of Petty Cash Book

A petty cash book is like a ledger account that records small day-to-day expenses. Once the set amount for the petty cash book is used up for minor expenses it is replenished with the same amount.

Petty cash book follows an imprest system of accounting. This means that a fixed amount of money is set aside to cover small and routine expenses.

Examples of petty cash books include office supplies, refreshments, postage, transportation, small repairs, etc.

Why is the petty cash book important?

• A petty cash book is important since it helps in tracking the small expenses that might be unnoticed or not recorded. This helps in keeping the company organized in its expenses. This shows the company’s responsibility and accountability.
• It helps the company run within its budget rather than spending too much as the minor expenses are being monitored by recording them.
• It is a convenient way to handle small expenses rather than the formal process of issuing cheques etc.

Type of Account

“Petty cash” is an asset and is shown under the category of current assets in the balance sheet. It is a current asset since the petty cash expenses occur within the operating year.

Petty cash book has a debit balance (or) positive balance since the amount is transferred from cash to petty cash and the amount being spent on petty cash expenses is reduced from the debit balance and later replenished.

Received 250 from the head cashier for all petty cash expenses. Journalise the following transaction.

As per the Modern  Approach,

According to modern rules whenever there is an increase in the value of the asset then the particular asset account is debited and when there is a decrease in the value of the asset it is credited.

The amount of petty cash will increase when debited as this leads to an increase in petty cash as an asset. This also leads to a decrease in cash account. The cash account will be credited since there is a decrease in assets.

As per the traditional approach,

As per the traditional rules, the petty cash expenses are coming in hence it is debited. As the cash is being spent on these expenses, the cash is going out, it is credited.

Example

Prepare a Petty Cash Book on the imprest system from the following data as provided below-

Petty Cash Book

The normal opening balance of cash will be placed on the Left-Hand Side under the cash receipts column. Total payments are shown on the Right Hand Side of the petty cash book.

This example shows the total amount in cash is 450 and is credited in the petty cash book amount. Later, as the expenses occur it is recorded and finally subtracted from the total cash.

Conclusion

• The petty cash book is important because it helps companies maintain financial health, manage their budget, and ensure transparency and accountability.
• It is a current asset, as it can be converted into cash, sold, or consumed within the normal operating cycle of the business, usually within one year.
• The normal balance of petty cash will show a positive balance (or) debit balance.

-This question was submitted by a user and answered by a volunteer of our choice.

To understand the calculation for Provision for Bad and Doubtful Debts, one should first be familiar with the meaning of the term Provision for doubtful debts and why it is maintained by an organization.

Provision for Bad and Doubtful Debt

Provision for bad and doubtful debt is a contra asset which means it reduces the balance of an asset specifically the receivables.

When an entity executes transactions of sales on a credit basis it creates and adds on to the amount due from sundry debtors.  These sundry debtors, as per the agreed terms are liable to make a payment for such goods purchased before the end of the credit term.

If such debtor continuously makes a default such debtor shall be considered as a bad debt for the organization. When an entity remains doubtful regarding the recovery of its revenue i.e. it has a reason to believe that such an amount due to be received may not be realized, the entity shall create a reserve or a provision for doubtful debts.

As per the Prudence Concept of accounting, an entity must not anticipate profits, but prepare for all possible future losses. By maintaining this provision, an entity prepares itself for any future losses due to bad debts.

How is it calculated?

The table given below will help you to understand step-by-step calculations to compute provision for doubtful debts

For Example,

An extract of the Trial Balance of ABC Ltd. is given below:

Adjustment: Provide a 2% reserve for bad and doubtful debts on the debtors. It was realized that our debtor worth 1000 proved to be bad and has been written off.

Hence, the company should create a new provision of 200 for the current financial year.

Generally, the provision for doubtful debts is created based on the entity’s experience in the business and various other factors. An organization must assess the risk associated with each customer. It should analyze the previous payment patterns of the debtors, their credit ratings, financial conditions, etc.

The organization may conduct an aging analysis of the receivables. In simple terms, it means to analyze the receivables based on how long the invoice has been outstanding. For example, the invoices may be current, 30-45 days past the due date, 45-60 days past the due date, 120 days past, or so on. On the basis of this analysis, the organization may determine which debtors are more likely to default and prepare the Provision for doubtful debts accordingly.

Conclusion

The above discussion may be summarised as follows:

• When a debtor does not pay the debt owed by him to the organization, it becomes a bad debt for the business.
• To prepare for such future losses, the business must maintain a Provision for Bad and Doubtful debts.
• The provision is created based on the entity’s experience in the business and various other factors.
• Generally, a percentage of the total amount due from debtors is kept aside as Provision for doubtful debts.

Meaning of Capital

Capital refers to the financial resources of a business that are used to pay for its operations. The financial assets invested in the business by the owners form a part of the capital. It includes cash or cash equivalents, plant, machinery, etc.

Generally, there are four types of capital:

• Debt Capital: The capital that is acquired by borrowing from banks or other financial institutions is called debt capital. It is to be repaid along with interest at a certain percentage of the loan.
• Equity Capital: It is the capital collected from the owners in exchange for a common or preferred stock (shares). It is to be paid only when the company goes under liquidation.
• Working Capital: The capital that is used to fund day-to-day operations is called working capital. It is calculated as the current assets minus the current liabilities.
• Trading Capital: The capital available to the business to buy and sell securities in the financial markets is called trading capital. This type applies exclusively to the financial industry.

The different types of capital help the firm in different ways to improve its business.

In accounting terms, capital is a liability for the business, i.e. it is to be repaid in the future.

Journal Entry for Capital

As per the Modern Rules of Accounting

Capital is Credited (Cr.) when increased and Debited (Dr.) when decreased.

As capital is brought into the firm, the business is obliged to pay it back to its shareholders and lenders. Therefore when more capital is brought into the firm it is credited.

Suppose cash is brought into the business as capital, it leads to an increase in assets. As per the modern rules of accounts, increases in assets are debited.

(The additional capital is credited to the capital account.)

As per the Golden Rules of Accounting

Capital is credited as per the Golden Rules.

An account is said to be personal when it is related to firms, companies, individuals, etc. Capital is a liability for the firm/company/business because it is obliged to repay its owner, hence, it is a personal account. A personal account is recorded on the balance sheet of the organization.

As per the golden rules of accounting (for personal accounts), capital is credited since the company needs to pay it back.

Example

Sam has started a new business and brought in capital in the form of cash of 30,000.

The cash account is debited since Sam brings in cash leading to an increase in assets. The capital account is credited since this leads to increase in capital and capital is a personal account.

Capital Inside Trial Balance

Capital is shown on the credit side of the trial balance. Below is an example of capital recorded inside the trial balance.

Conclusion

• The capital is credited since it’s a contribution given by the shareholders, corporate banks, etc. It needs to be returned back. It is treated similarly to a liability.
• As more capital is bought in it is credited since it increases. The cash account has been debited since there is an increase in assets as the money is coming into the firm.

-This question was submitted by a user and answered by a volunteer of our choice.

Meaning of Provision for Doubtful Debts

Almost every business entity has some debtors. Debtors are the entities that owe money to the business. In some cases, the debtors may or may not pay the money owed by them. To prevent loss in such a situation, Provision for Doubtful Debts is maintained.

It is usually provided on credit sales. As per the Prudence concept of accounting, a business must not anticipate future profits, but rather, prepare for all possible losses. Provision for doubtful debts helps the business prepare for future losses that may occur due to non-payment of dues by the debtor.

Generally, a percentage of the total amount owed by the debtors is kept aside as a Provision for doubtful debts. This amount may change from year to year. It is a proactive step taken to safeguard the firm’s financial position.

Journal Entry for Provision for Doubtful Debts

The Journal Entry for Provision for Doubtful debts is given below:

(Being Provision for Doubtful debts created)

An example of the Journal entry is given below:

ABC Ltd. has Sundry debtors amounting to 51,000. Out of these, 10,000 are written off as bad debts in the current year. Create a Provision for doubtful debts at 5%.

Solution:

The amount of Provision for Doubtful Debts is calculated below :

5% of (Sundry Debtors – Bad Debts)

= 5%*(51,000 – 10,000)

= 5%*41,000

= 2,050

Journal Entry:

(Being Provision for Doubtful debts created)

Treatment of Provision for Doubtful Debts in Balance Sheet

An example below shows the treatment in the Balance Sheet to understand this concept better.

Example

An extract of the Trial Balance of ABC Ltd. is given below:

Show the treatment of Provision for Doubtful Debts in the Balance Sheet of ABC Ltd.

Solution:

The Balance Sheet of ABC Ltd. after the above adjustment is given below:

Calculation of Provision for Doubtful Debts:

5% of (Sundry Debtors – Bad Debts)

= 5%*(51,000 – 10,000)

= 5%*41,000

= 2,050

Further, 2,050 is deducted from the total amount of sundry debtors. Debtors are shown on the assets side under the current assets head of the Balance Sheet of the business.

Conclusion

The above discussion may be summarised as follows:

• Debtors are a current asset of the business as they owe money to the business.
• A Provision for Doubtful debts must be created for any loss due to non-payment by the debtors.
• Generally, a percentage of the total amount of debtors is kept aside as a provision.
• The amount of provision for doubtful debts is deducted from the total debtors in the Balance sheet.
• Debtors are shown on the assets side under the current assets head of the Balance Sheet of the business.

-This question was submitted by a user and answered by a volunteer of our choice.

Introduction

In simple words, the term Sale of services means providing services to a customer in exchange for compensation. Various organizations offer services in various domains such as Education, Consultancy, Finance, Healthcare, Transportation, and many more.

A service is anything that provides value to the customer. It may be an experience, an advice, a solution, etc. Sometimes, services are also customized as per the specific requirements of the customer.

In the case of the sale of goods, the ownership of a tangible product is transferred to the purchaser. On the other hand, a service is an intangible offering and there is no transfer of ownership. The treatment of the sale of services is similar to the sale of goods in the books of accounts. Like goods, the sale of services may be by receipt of cash or on credit.

Journal Entry

Case1- Sale of service on credit

In this case, the service is provided on credit and the debtor would pay on a later date.

1. According to the Traditional rules of accounting:

(Being services sold on credit)

2. According to the modern rules of accounting:

(Being services sold on credit)

Case 2- Sale of Services on Cash

1. According to the Traditional rules of accounting:

(Being services sold on credit)

2. According to the modern rules of accounting:

(Being services sold on credit)

Example of the Accounting Entry

Mr. K availed the financial services of XYZ Ltd. in May amounting to 20,000 with an agreement to pay the same in the following month. The journal entry in the books of XYZ  for the month of May is as follows:

(Being services sold on credit)

1. The first aspect of the entry is that Mr.K’s account is debited by 20,000. This is because Mr.K is a debtor of the company and a debtor is an asset for the company. As per the modern rules of accounting, an increase in assets is debited.

2. The second aspect of the entry is that the Sales account is credited by 20,000. This is because sales are revenue for the business and as per the modern rules of accounting, an increase in revenue is credited in the books of accounts.

Impact on Financial Statements

In the Balance sheet of the business, the debtor account would increase under the Assets head. A debtor is the current asset of the business. In case the payment is received in cash, the cash account will increase which is also a current asset of the business.

In the Trading Account of the business, the sale of services is credited. The impact of the above Journal entry on the Trading account of the business is shown below:

Conclusion

The key points from the above article are summarised as follows:

• Sale of services means providing services to a customer in exchange for compensation.
• Services may be of various types including education, financial advice, consultancy, healthcare, etc.
• The sale of services may either be on a cash or a credit basis.
• In some cases, services are also customized according to the needs of the customers.
• In the Trading account of the business, the sales are credited as it is revenue for the business.

-This question was submitted by a user and answered by a volunteer of our choice.

Closing Stock refers to the unsold goods held at the end of the financial year. To ascertain the true financial position of a company it is necessary to adjust the closing stock at the end of an accounting year.

Closing stock is crucial for accurate financial reporting because it impacts the calculation of the cost of goods sold (COGS) and the determination of a company’s gross profit. It is typically valued at either its cost price or its net realizable value, whichever is lower, in accordance with generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS).

Closing stock is reported on the balance sheet under the current assets section, as it represents inventory that a company expects to sell in the near future. Properly managing and valuing closing stock is essential for correct financial reporting and assessment of a company’s financial health.

The valuation and management of closing stock directly impact a company’s profitability. Proper management ensures that inventory is neither overvalued nor undervalued, which can affect the calculation of profits and taxes.

Tracking closing stock helps businesses manage their inventory levels effectively. It provides insights into which products are selling well and which may be slow-moving, allowing businesses to adjust their purchasing and sales strategies accordingly.

In many cases, closing stock requires a physical count of inventory items to accurately determine their quantity and condition at the end of the accounting period.

The formula to calculate closing stock is:

Closing Stock = Opening Stock + Purchases – Cost of Goods Sold

Where:

• Opening Stock is the value of inventory at the beginning of the accounting period.
• Purchases represent the total value of inventory purchased during the accounting period.
• Cost of Goods Sold (COGS) is the total cost of inventory sold during the accounting period.

Adjustment entry of closing stock

The closing stock generally does not appear in the trial balance and is seen as an adjustment entry. We need to pass an adjusting entry before the preparation of final accounts. It is important to note that an adjustment entry is always recorded twice in the books of accounts therefore, the two ways of recording the same for closing stock are as follows:

1. Credit side of the trading account.

2. The asset side of the balance sheet.

Example

The closing stock of ABC Ltd. amounts to 40,000. The journal entries in the books of the company are as follows;

(being closing stock adjusted)

Placement of closing stock in the trading a/c

Placement of closing stock in the balance sheet

Note: Sometimes, adjusted purchases are given in the trial balance which indicates that the opening as well the closing stock have been adjusted through purchases. It is important to note here that the closing stock will only be recorded on the asset side of the balance sheet and will not appear in the trading a/c.

Hope this helps.