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What is Carriage Inwards and Carriage Outwards?

Ahuja Sahil
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Carriage Inwards and Carriage Outwards

“Carriage” can be seen as freight or transportation cost, it is the carrying costs related to the purchase and sale of goods. Often the buyer is responsible for the cost of carriage inwards whereas the seller is responsible for carriage outwards. Carriage inwards and carriage outwards are essentially delivery expenses (revenue expenditure) related to buying and selling of goods.

Charges may be incurred while goods are purchased or when they are sold. Depending on the type of asset in question, carriage expense may or may not be capitalized. For example, in the case of carriage-paid to acquire a fixed asset, it is treated as a capital expenditure and added to the amount of the fixed asset.

Carriage Inwards and Carriage Outwards Summary

 

When Goods are Brought In

It is the freight and shipping cost incurred by a business while purchasing a new product. The product may be for company use or for resale, the word “Inwards” shows that the cost is incurred while the goods are being brought into the business. Carriage inwards is also called freight-in and transportation-in.

Mostly the buyer is responsible for carriage inwards.

In case of procurement of fixed assets carriage inwards is capitalized which means the cost of carriage is added to the fixed asset. In case of purchasing inventory for resale, the amount is treated as a direct expense (added to COGS) and is shown on the debit side of a trading account.

Related Topic – Journal Entry for Carriage Inwards

 

When Goods are Sent Out

It is the freight and shipping cost incurred by a business while selling a product. The word “Outwards” shows that the cost is incurred while the goods are being sent out of the business. Carriage outwards is also called freight-out and transportation-out.

Mostly the seller is responsible for carriage outwards.

Carriage outwards is a revenue expense for the business and should be shown on the debit side of an income statement.

 

Short Quiz for Self-Evaluation

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>Read Journal Entry for Carriage Outwards

 

What are Notes to Accounts?

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Notes to Accounts

Also known notes to financial statements, footnotes, notes to accounts are supporting information that is usually provided along with a company’s final accounts or financial statements. Many such notes are required to be provided by law, including details related to provisions, reserves, depreciation, investments, inventory, share capital, employee benefits, contingencies, etc.

Other information supplied along with the financial statements may be a product of the accounting standards being followed by the business. Notes to accounts help users of accounting information to understand the current financial position of a company and act as a support for its estimated future performance.

It acts as supplementary information furnished along with the final accounts of a company and may be tremendous in size depending on the company, accounting framework and nature of the business. The information supplied depends on the accounting standards used such as IFRS or GAAP.

 

Example – Notes to Accounts

Financial statements filed quarterly/annually by the companies with their local statutory body such as the SEC in the USA are accompanied by the notes to accounts.

Below is a live excerpt submitted by Walmart Inc. as on January 31st, 2018, it is a trimmed piece of the footnote and should only be seen as a reference for understanding.

Notes to Accounts - Example

 

Most Common Notes to Accounts

Accounting Policies/Changes Footnotes show all impactful accounting principles being used and significant changes (if any).
Acquisitions and Mergers Any M&A related transaction including all acquired assets, liabilities, goodwill, etc.
Contingencies and Litigations Notes to financial statements include any contingent liabilities along with its details and timeline.
Depreciation Adopted method of depreciation on fixed assets, capitalized interest & impairments are disclosed.
Exceptional Items Any exceptional item such as a huge loss, an unexpected rise in expense, etc.
Fair Value Measurements Notes to financial statements also show related amount and reasons of fair value measurements.
Goodwill Changes in goodwill and acquisition of goodwill (if any) are mentioned.
Inventories and Investments Stock evaluation method is described and for investments, any gains/losses due to being realized are described.
Leases Future outflow of lease payments is estimated and mentioned in the footnotes.
Long-Term Debt All obligations due to be paid in the next 5 years including loans, interest on loans, etc.
Non-Cash Transactions Any event concluding to a profit or loss in future is specified.
Receivables and Payables Notes to accounts contain significant receivables and payables including the parties concerned.
Risk and Possibilities Any likely risk that may affect the company in future such as a govt. policy, expected technology advancement is also stated.
Shareholder’s capital Notes to accounts generally represent the issue of shares, buyback programs, convertible shares, arrears, etc.

 

 

Short Quiz for Self-Evaluation

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>Read Off-Balance Sheet Items

 

Treatment of Prepaid Expenses in Final Accounts

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Prepaid Expenses

At times, during business operations, a payment made for an expense may belong fully or partially to the upcoming accounting period. Such a payment (partly or fully) is treated as a prepaid expense (unexpired expense) for the current period. It is treated as an adjustment in the financial statements and this article will describe the treatment of prepaid expenses in final accounts.

Some common examples of prepaid expenses are prepaid rent, prepaid insurance premium, etc.

Journal Entry for Prepaid Expense

Prepaid Expense A/C Debit Debit the increase in asset
 To Expense A/C Credit Credit the decrease in expense

Payment for “insurance premium” is commonly issued in advance hence it will be used to explain the treatment of prepaid expenses in final accounts (or) financial statements.

 

Treatment of Prepaid Expenses in Final Accounts

Explanation with Example

Company – Unreal Corporation

Insurance prem. paid on 30th Jun YYYY – 1200 for a year (50% prepaid for next year)

Premium prepaid – 600

Accounting Cycle Ends – 31 Dec YYYY

 

Journal Entry on 30th June YYYY

Insurance Premium A/C 1200
 To Bank A/C 1200

(Payment made for insurance premium from the bank)


Adjustment entry

Prepaid Insurance Premium A/C 600
 To Insurance Premium A/C 600

(Transferring insurance premium prepaid to its respective “Prepaid Insurance A/C”)

Related Topic – How to Post a Journal Entry to a Ledger?

In the above example, both the respective journal entries are posted to the ledger accounts and the balances are transferred and carried forward wherever necessary.

Treatment of Prepaid Expenses in Ledger Accounts

Related Topic – More Accounting Questions Related to Revenue & Income

Treatment of Prepaid Expenses in Final Accounts (or) Financial Statements

1. The prepaid portion of the expense (unexpired) is reduced from the total expense in the profit & loss account.

2. The prepaid expense is shown on the assets side of the balance sheet under the head “Current Assets”.

Treatment of Prepaid Expenses in Final Accounts

A Payment of 1200 made for the insurance premium is shown in the P&L A/C
B 600 adjusted as “prepaid insurance premium” since it belongs to the following year
C The prepaid insurance premium is shown as a “Current Asset” on the balance sheet

Related Topic – What is Unexpired Cost?

Additional points related to the treatment of prepaid expenses in final accounts;

1. If the prepaid expense is shown inside the adjusted trial balance it indicates that the related adjustment entry has already been posted i.e. In this case, prepaid expenses are shown only on the balance sheet.

2. In the next accounting year prepaid expense account is transferred to the expense account i.e. at the beginning of the next period, a reversal entry is passed.

Insurance Premium A/C 600
 To Prepaid Insurance Premium A/C 600

 

Short Quiz for Self-Evaluation

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>Related Long Quiz for Practice Quiz 36 – Prepaid Expenses

>Read Journal Entry for Outstanding Expenses

 

What is Overcapitalization?

Ahuja Sahil
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Overcapitalization

It is a financial situation where a company has more than enough total capital as compared to the needs of its business operations. In case of overcapitalization, the total equity (owner’s capital + debt) of a company exceeds the actual worth of its assets.

An overcapitalized company may often be burdened by interest payments or payment of profits as dividends to shareholders. It may not be always correct to recognize excess capital as overcapitalization as most such firms suffer from lack of liquidity, a more reliable indicator would be the earnings capacity of the business.

Overcapitalization may occur when the return on investment earned by a company is exceptionally lower with respect to other similar companies in the same industry.

 

Causes and Effects of Overcapitalization

Causes

1. Poor planning of initial equity requirements may result in the overestimation of funds.

2. A high amount of preliminary expenses may be a reason for overcapitalization as they are shown as assets i.e. fictitious assets in the balance sheet.

3. Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company.

4. Acquisition of unproductive assets or buying them at inflated prices may also result in the overcapitalization of a company.

5. A sudden change in the business environment due to a shift in the domestic, international or political environment may reduce the earnings of a company.

6. Underutilization of funds and poor management

 

Effects

1. Overcapitalization may result in a decline in the earnings capacity of the company which may consequently lead to fewer profits & lesser dividends.

2. Degraded earnings would hint towards the instability of business operations which may consequently lead to a downfall of share prices causing a ripple effect.

3. Investors may lose confidence in an overcapitalized company as there may be no assurance of any income due to low earning capacity.

Overcapitalization

Possible Solutions to Overcapitalization

1. Repayment of long-term debts to reduce the interest payments may help an overcapitalized firm to relieve the problem.

2. Debt restructuring with banks and other lenders to reduce the interest obligation is another possible remedy.

3. Reduction in face value & buyback of shares.

4. All official expenses should be minimized and a conservative dividend declaration should be planned.

5. In extreme conditions, the company may choose to merge or be acquired.

 

Short Quiz for Self-Evaluation

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>Read Undercapitalization

 

What is Undercapitalization?

Ahuja Sahil
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Undercapitalization

It is a financial situation where a company doesn’t have enough capital or reserves as compared to the size of its operations. Undercapitalization is often seen with new companies, it is a result of inadequate planning of funds for future growth. Even larger corporations with struggling operations and huge debts may be undercapitalized.

An example – A startup growing quickly enough may be undercapitalized as it may not be able to convert profits into cash as quickly as needed, consequently, it may lack sufficient capital to pay off its creditors due to lack of cash flow.

Undercapitalization may occur when the return on investment earned by a company is exceptionally higher with respect to other similar companies in the same industry. In such a scenario the firm is said to have neither the cash flow nor the ability to raise fresh capital.

 

Causes and Effects of Undercapitalization

Causes

1. An extraordinary increase in earnings of a company due to some reason.

2. Underestimation of initial equity required to run smooth operations of a business.

3. Ultra high efficiency in operations and increased sales with the help of new technology and techniques.

4. Fuelling the company mainly with short-term capital instead of cheaper long-term options.

5. Inability to mitigate probable future risks for e.g. no insurance against a likely event.

4. Purchase of assets at a very low price.

Effects

Undercapitalization can lead to serious effects on growth and future of a company as the firm might not be able to meet its short-term debt, operate smoothly & eventually collapse.

In case of an expansion opportunity, the business will not be able to avail the benefit of expansion and grow even further as it would not have sufficient capital.

Undercapitalization

Possible Solutions of Undercapitalization

1. Fresh share capital can be raised via the primary capital market to curb undercapitalization.

2. A company may decide to go for a stock split which would eventually display a reduction in dividend per share and earnings per share.

3. A company may issue bonus shares which would have the same effect as in the previous point.

4. Startups and small businesses should prepare monthly cash flow projections & equity forecasts to avoid being undercapitalized.

 

Short Quiz for Self-Evaluation

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>Read Overcapitalization

 

What are Off-Balance Sheet (OBS) Items?

Ahuja Sahil
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Off-Balance Sheet (OBS)

Also known as Off-Balance sheet items, Off-Balance sheet assets or liabilities, and Incognito Leverage. They are either a liability or an asset which are not shown on a company’s balance sheet as the business is not a legal owner of the respective item.

Off-Balance sheet items are generally shown in the notes to accounts along with the financial statements. These assets and liabilities may be used by a company; however, the legal ownership may or may not belong to them. In this case, the consumption of assets and payment of liabilities may ultimately be an indirect responsibility.

The term is very common with asset management companies, brokerage firms, wealth managers, etc. In this case, the assets being managed by firms do not belong to them but to the clients, so they are not recorded on the balance sheet.

 

Examples and Reasons for Off-Balance Sheet Items

Contingent liabilities are different from off-balance sheet items as the former is only mentioned when the liability is likely and the obligation can be quantified.

Often the companies use it as a type of creative accounting to pump up their accounting ratios or to avoid breaking a commitment made to lenders with respect to the total amount it may borrow. Legal entities or special purpose entities are usually created as subsidiaries.

Examples of Off-Balance Sheet Items

Real life example – Unreal Corp. raised a loan with a Lender X on a condition that their debt to equity ratio would not increase, however, during the tenure of the loan the company might need new heavy machinery for which it may not have enough cash. In such a scenario the company may create a special purpose entity (SPE) and let the SPE lease it back to the parent company.

To avoid window dressing the accounting profession has always tried to reduce Off-Balance sheet objects to ensure more & more transparency. In the USA, SOX (Sarbanes-Oxley Act) was introduced in 2002 to stop scandals arising out of any such loopholes.

 

Short Quiz for Self-Evaluation

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>Read Contra Liability

 

What is Net Profit Ratio?

Ahuja Sahil
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Net Profit Ratio

Also known as Net Profit Margin ratio, it establishes a relationship between net profit earned and net revenue generated from operations (net sales). Net profit ratio is a profitability ratio which is expressed as a percentage hence it is multiplied by 100.

Net sales include both Cash and Credit Sales, on the other hand, net profit is the net operating profit i.e. the net profit before interest and taxes. Net profit ratio helps to find out net profit earned in comparison to revenue earned from operations.

NP ratio helps to determine the overall efficiency of the business’ operations, furthermore, it is an indicator of how well a company’s trading activities are performing.

 

Formula to Calculate Net Profit Ratio

Formula Net Profit Ratio

Note  – It is represented as a percentage so it is multiplied by 100.

 

Net Profit = Operating Income – (Direct Costs + Indirect Costs)

Net Sales  = (Cash Sales + Credit Sales) – Sales Returns

*Non operating incomes and expenses are not considered for calculation.

 

Example

Ques. Calculate NP Ratio from the below information

Sales 7,00,000
Sales Returns 1,00,000
Direct Costs 2,00,000
Indirect Costs 1,50,000

Net Profit Ratio = (Net Profit/Net Sales)*100

Net Sales = Sales – Returns

7,00,000 – 1,00,000

= 6,00,000

Net Profit = Operating Income – (Direct Costs + Indirect Costs)

*Considering income was only earned via sales and no other misc fee etc. were recevied.

6,00,000 – (2,00,000 + 1,50,000)

= 3,00,000

NP Ratio = (3,00,000/6,00,000)*100

= 50%

This means that for every 1 unit of net sales the company earns 50% as net profit. Alternatively, the company has a net profit margin of 50%, i.e. 0.50 unit of Net Profit for every 1 unit of revenue generated from operations.

 

High and Low Net Profit Ratio

This ratio is the main indicator of a firm’s profitability, a trend analysis is usually done between two different accounting periods to assess improvement or deterioration of operations.

High – A high ratio may indicate low direct and indirect costs which will result in a higher net profit of the organization.

Low – A low ratio may indicate unnecessarily high direct and indirect costs which will result in a lower net profit of the organization, thus reducing the numerator to lower than the desired number.

 

Short Quiz for Self-Evaluation

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>Read Gross Profit Ratio

 

What is Gross Profit Ratio?

Ahuja Sahil
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Gross Profit Ratio

Also known as the Gross Profit Margin ratio, it establishes a relationship between gross profit earned and net revenue generated from operations (net sales). The gross profit ratio is a profitability ratio expressed as a percentage hence it is multiplied by 100.

Net sales consider both Cash and Credit Sales, on the other hand, gross profit is calculated as Net Sales minus COGS. The gross profit ratio helps to ascertain optimum selling prices and improve the efficiency of trading activities.

It also helps find out the lowest selling price of goods per unit to an extent that the business will not suffer a loss.

 

Formula to Calculate Gross Profit Ratio

Formula Gross Profit RatioNote  – It is represented as a percentage so it is multiplied by 100.

 

Gross Profit = Net Sales – COGS

COGS = Opening Stock + Purchases + Direct Expenses* – Closing Stock

*Only used if they are specifically provided

Net Sales  = Cash Sales + Credit Sales – Sales Returns

 

Example

Ques. Calculate the GP ratio from the below information

Sales 7,00,000
Sales Returns 1,00,000
Cost of Goods Sold 3,00,000

Gross Profit Ratio = (Gross Profit/Net Sales)*100

Net Sales = Sales – Returns

7,00,000 – 1,00,000

= 6,00,000

Gross Profit = Net Sales – COGS

6,00,000 – 3,00,000

= 3,00,000

GP Ratio = (3,00,000/6,00,000)*100

= 50%

This means that for every 1 unit of net sales, the company earns 50% as gross profit. Alternatively, the company has a gross profit margin of 50%, i.e. 0.50 units of gross profit for every 1 unit of revenue generated from operations.

 

High and Low Gross Profit Ratio

A business is rarely judged by its Gross Profit ratio, it is only a mild indicator of the overall profitability of the company.

High – A high ratio may indicate high net sales with a constant cost of goods sold or it may indicate a reduced COGS with constant net sales.

Low – A low ratio may indicate low net sales with a constant cost of goods sold or it may also indicate an increased COGS with stable net sales.

 

>Read Net Profit Ratio

 

What is the difference between Journal Entry and Journal Posting?

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Difference Between Journal Entry and Journal Posting

Journal entry is recorded in a journal which is also known as the primary book of accounts, this is where all transactions are recorded for the first time in a progressive order. The words are often used around each other, however, there is a difference between journal entry and journal posting.

Journal posting is done inside a ledger which is also known as the principal book of accounts, this is where all ledger accounts are maintained.

 

Journal Entry

1. The act of recording a financial event in a journal is called “journalising”, however, the entry recorded in the journal is called a “journal entry”. It is a record of a transaction’s debit and credit aspect with the help of double entry bookkeeping system.

2. One of the main difference between journal entry and journal posting is “timing”, the journal entry is the next step to preparing vouchers, it immediately precedes journal posting.

3. Simple Journal Entry – Example

Ist Account Debit
 To IInd Account Credit

There are two types of journal entries, simple journal entry and compound journal entry.

 

Journal Posting

1. The act of transferring a journal entry into a ledger account is called journal posting. It includes transferring of debits and credits from journal book to the ledger accounts.

2. Journal posting is the next step to a journal entry, it precedes balancing the ledger.

3. Ledger posting – example

  • A business bought furniture worth 1000 in cash, journal posting for this transaction in the respective ledger accounts would be as follows,

Example of Journal posting in Ledger

>Read What is the Accounting Cycle?

 

Difference between Depreciation, Depletion and Amortization

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Depreciation Vs Depletion Vs Amortization

All assets with an estimated useful life eventually end up being exhausted. Different types of assets such as fixed, intangible & mineral assets are systematically reduced within their useful life. The difference between depreciation, depletion and amortization depends on the type of asset in question.

Depreciation, Depletion and Amortization are three primary ways to apply such reductions in assets. To begin with, here is a quick reference table;

Difference between Depreciation, Depletion and Amortization

Depreciation

It is to spread or allocate the cost of a tangible fixed asset over its estimated economic useful life. In other words, it may be seen as a reduction in the cost of a fixed asset due to normal usage, wear and tear, new technology, and other related reasons.

Example – A company charging 10% depreciation on all their buildings, 25% depreciation on laptops, etc.

Related Topic – Why is Depreciation not charged on land?

Amortization

Prorating cost of an “Intangible Asset” over the period during which benefits of this asset are estimated to last is called Amortization. The concept of amortization is also used with leases & debt repayment.

Amortization is for Intangible assets whereas depreciation is for tangible fixed assets. Examples of intangible assets are copyrights, patents, software, goodwill, etc.

 

Depletion

When dealing with a natural resource also referred as a mineral asset the concept of depreciation or amortization cannot be applied. “Depletion” is a form of a systematic reduction in the value of a natural resource based on the rate at which it is being used.

For example – A coal mine has 10 Million tonnes of coal and the coal extraction is happening at the rate of 1 Million tonnes per year. In this case, depletion rate would be 10% p.a. since at this rate of extraction the coal mine is being depleted at 10% per year.

 

>Related Long Quiz for Practice Quiz 39 – Depreciation

>Read Explain Obsolescence and Depletion

 

What is Depletion and Obsolescence?

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Depletion

It is a systematic reduction in the value of a natural resource as an asset. In accounting, depletion is mainly associated with the extraction of natural resources i.e. mineral assets. For example – extraction of coal from a mine, extraction of limestone from a quarry, unearthing oil from an oil well, etc. The cost of extracting the mineral is spread between the number of years the natural reserve is expected to last.

For instance, if an oil well is anticipated to last for 20 years and the predicted benefits are worth 20,000,000 (20 Million) then the depletion amount (assuming uniform extraction) would be 1,000,000 (1 Million) each year. It is different from depreciation & amortization, however, the fundamental logic of the application is similar.

Such assets are commonly termed as wasting assets since they are eventually used up and will have no remaining value.

Depletion Accounting – It is a form of applying depreciation on such wasting assets, the percentage to be applied is calculated based on the rate at which the natural resource is being used. For example, an oil well would be depreciated based on the rate at which the oil is being extracted from it.

 

Related Topic – Depreciation Vs Depletion Vs Amortization

Obsolescence

Continuous improvement, innovation, market trends, etc. in the market lead to the production of new and improved assets. It causes a reduction in the monetary value of assets which are currently being used. This whole process of an asset becoming out of date and losing its economic value is called Obsolescence.

The concept of obsolescence is useful while applying depreciation or evaluating stock (inventory). A fixed asset may become obsolete even before the end of its predicted useful life. While evaluating inventory all obsolete (outdated) items are supposed to be charged to the Income statement.

 

Short Quiz for Self-Evaluation

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>Read Difference between Depreciation and Amortization

 

What is an Offset Account?

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Offset Account

To understand an offset account it is important to understand the meaning of the word “Offset”. It means, to show a consideration or amount that reduces or balances the effect of an opposite amount, it has an equal and opposite effect. In simpler terms, offset means a counteracting or opposite force.

Example – Accumulated Depreciation Account, Drawings Account, etc.

It is an account that reduces the gross amount of another related account to derive a net balance. For example, a “fixed asset account” carrying a debit balance may have a related offset account such as a “provision for depreciation account” which accumulates the annual charge for depreciation carrying a credit balance.

An offset account is also known as a Contra Account.

 

Example

Suppose capital account has a credit balance of 1,00,000 and the owner has withdrawn 25,000 for personal use (drawings). In this case, drawings account is an offset for the capital account.

Capital Account Credit Balance
Drawings Account Debit Balance

Capital Account – 1,00,000 (Credit)

Drawings Account (Offset) – 25,000 (Debit)

In this case, Net capital of the business = Capital Account – Drawings Account

= 1,00,000 – 25,000

= 75,000 (Credit)

 

In some countries the concept is used in banking and financial sector, usually, a consumer’s bank account is paired with his loan account to calculate net loan balance.

Net Loan Balance = Loan Amount (main account) – Bank Balance (offset account)

And then interest rate charged by the bank is on the net loan balance.

 

Short Quiz for Self-Evaluation

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Accounting and Journal Entry for Closing Stock

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Closing Stock

Goods that remain unsold at the end of an accounting period are known as closing stock. They are valued at the end of an accounting year and shown on the credit side of a trading account and the asset side of a balance sheet. Accounting and journal entry for closing stock is posted at the end of an accounting year.

Closing stock is valued at cost or market value whichever is lower. It may be shown inside or outside a trial balance. Most often it is shown outside the trial balance. It is an important ingredient in calculating gross profit/loss and includes raw materials, work in progress & finished goods.

 

Journal Entry for Closing Stock

  1. When closing stock is not shown in the trial balance.

This is the most common scenario where the closing stock is not shown in the trial balance, it is only provided as additional information. It will be shown in the trading account & balance sheet. Below is the journal entry for closing stock in this case.

Closing Stock A/C Debit
 To Trading A/C Credit

(Closing stock brought in the books of accounts)

 

Closing stock appearing in the trading account

Closing Stock shown in trading account

Closing stock appearing in the balance sheet

Closing Stock in Balance Sheet

 

2. When closing stock is shown inside the trial balance.

Uncommon, but possible scenario where the closing stock is shown in the trial balance, it is only possible when the closing stock is already adjusted against purchases.

Below is the journal entry for closing stock when it is reduced from purchases.

Closing Stock A/C Debit
 To Purchases A/C Credit

In this case, it will be shown in the balance sheet but not in the trading account.

 

Closing stock appearing in the trial balance

Closing stock shown in trial balance

 

Short Quiz for Self-Evaluation

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>Read Why is Closing Stock Not Shown in Trial Balance?

 

Accounting and Journal Entry for Income Tax

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Journal Entry for Income Tax

Income tax is a form of tax levied by the government on the income generated by a business or person. Accounting and journal entry for income tax is done in a distinct way for different types of business establishments i.e. Sole Proprietorship, Partnership, and Private Limited Company.

Private limited companies have a comparatively complex structure for the accounting of income tax which is not covered in this article.

 

Journal Entries in Case of – Sole Proprietorship

For a Sole Proprietor, income tax is not an expense incurred to generate revenue hence it is not treated as an expense to be paid out of profits. In this case, income tax is treated as a personal expense resulting in drawings from the business concluding to a reduction of capital.

Journal entry for income tax in case of a sole proprietorship contains 2 steps as follows;

Step 1 – When Tax is Paid

(Paying tax via the bank)

Income Tax Account Debit
 To Bank Account Credit

 

Step 2 – When Adjustment of Income Tax is Done

(Adjusting income tax as drawings)

Drawings A/C Debit
 To Income Tax A/C Credit

 

Journal Entries in Case of – Partnership Companies

For a Partnership Firm, income tax is payable by the business itself and not individually by the partners. In this case, income tax is reduced from the net profits. It is shown in the profit and loss appropriation account.

Journal entry for income tax in case of a partnership firm includes debiting the Income Statement/P&L Account.

Profit and Loss A/C Debit
 To Income Tax A/C Credit

 

Short Quiz for Self-Evaluation

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>Read Accounting and Journal Entry for Manager’s Commission 

 

What is a Liability, Examples, Types, its Placement, etc?

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Liability – Accounting Definition

In a business scenario, a liability is an obligation payable to a third party. It may or may not be a legal obligation and arises from transactions and events that occurred in the past. It is usually payable to an external party (e.g. lenders, long-term loans).

There are mainly three types of liabilities except for internal liabilities. Current liabilities, Non-Current liabilities & Contingent Liabilities are the three main types of liabilities. The settlement of liability is expected to result in an outflow of funds from the company.

“Total Liabilities” are always equal to “Total Assets”.

(Capital + Liabilities) = Assets

 

Accounting for a Liability Account

While dealing with a liability account it is important to know that it would always carry a credit balance.

As per the modern classification of accounts or American/Modern Rules of accounting an increase in liability is credited whereas a decrease is debited.

Debit and Credit Rule for a Liability

 

Liabilities Shown in Financial Statements

Liabilities are shown on the left-hand side of a vertical balance sheet. They would always equal to the assets of a company. This is the reason why a balance sheet always tie-up.

liabilities shown in the balance sheet

 

Types of a Liability

1. Current Liabilities – Also known as short-term liabilities they are payable within 12 months or within the operating cycle of a business. Examples – trade creditors, bills payable, outstanding expenses, bank overdraft etc.

2. Non-current Liabilities – Also termed as fixed liabilities they are long-term obligations and the business is not liable to pay these within 12 months. Examples – long-term loans, bonds payable, debentures, etc.

3. Contingent liabilities – are liabilities that may come into existence depending on the outcome of a future occurrence. In case the event does not happen, an organization is not liable to pay anything. They are shown as a footnote to the balance sheet. Examples of contingent liabilities are

  • Lawsuit proceedings
  • Product warranty claims
  • Guarantee for loans

4. Owner’s funds/Capital/Equity – Last among types of liabilities is the amount owed to proprietors as capital, it is also called owner’s equity or equity.

 

Internal and External Liabilities

Internal – It is payable to internal parties such as promoters (owners), employees etc. Example – Capital, Salaries, Accumulated profits, etc.

External – It is payable to external parties such as lenders, vendors, etc. Example – Borrowings, Creditors, Taxes, Overdraft, etc.

 

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What are Different types of Liabilities?

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Liability

A liability is an obligation payable by a business to either internal (e.g. owner) or an external party (e.g. lenders). There are mainly four types of liabilities in a business; current liabilities, non-current liabilities, contingent liabilities & capital.

A liability may be part of a past transaction done by the firm, e.g. purchase of a fixed asset or current asset. The settlement of liability is expected to result in an outflow of funds from the business.

In totality, total liabilities are always equal to the total assets.

(Capital + Liabilities) = Assets | So, Liabilities = Assets – Capital

 

Types of Liabilities

1. Current Liabilities – Obligations which are payable within 12 months or within the operating cycle of a business are known as current liabilities. They are short-term liabilities usually arisen out of business activities. Examples of current liabilities are trade creditors, bills payable, outstanding expenses, bank overdraft etc.

2. Non-current or Fixed Liabilities – Second among types of liabilities is non-current or fixed liabilities; they are long-term obligations of a business and are not payable within a year or an accounting period. They are generally used for the purchase of fixed assets. For example, long-term loans, bonds payable, debentures, etc.

3. Contingent liabilities – are those liabilities that may or may not be incurred by a business depending on the outcome of a future occurrence. In case the occurrence does not happen, an organization is not liable to pay anything. They are required to be disclosed as soon the amount can be estimated and are shown as a footnote to the balance sheet. Examples of contingent liabilities are;

  • Lawsuit proceedings
  • Product warranty claims
  • Guarantee for loans

4. Owner’s funds/Capital/Equity – Last among types of liabilities is the amount owed to proprietors as capital, it is also called as owner’s equity or equity. Capital, as depicted in the accounting equation, is calculated as Assets – Liabilities of a business. It is an internal liability of the business and includes reserves and profits.

 

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>Related Long Quiz for Practice Quiz 22 – Current Liabilities

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Accounting and Journal Entry for Manager’s Commission

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Journal Entry for Manager’s Commission

In addition to salaries, companies may offer a fixed percentage of their net profit to managers as commission. This is done to motivate and encourage them to generate more revenue for the company. Accounting and journal entry for manager’s commission involves the below 3 steps,

 

Step 1 – Manager’s commission is shown as a payable since it is calculated at the very end of an accounting period.

Manager’s Commission A/C Debit
 To Oustanding Commission A/C Credit

 

Step 2 – Accounting for manager’s commission includes the actual payment made to pay off the liability created in Step 1.

Outstanding Commission A/C Debit
 To Bank A/C Credit

 

Step 3 – Journal entry for manager’s commission includes transferring commission paid to the income statement/profit and loss account.

Profit and Loss A/C Debit
 To Manager’s Commission A/C Credit

 

Features of Manager’s Commission

  1. The outstanding commission is a current liability like any other outstanding expense, hence it is shown on the liability side in the balance sheet.
  2. Manager’s commission is an operating expense just as any other expense like salary, rent etc.
  3. Manager’s commission paid is shown on the debit side of the profit and loss account as it is an expense for the company.
  4. There are 2 ways to calculate the amount payable as the manager’s commission.

 

Calculation of Manager’ Commission – Case I

In this case, the commission rate is calculated on the “net profit of the company” and the calculated amount is finally paid as a manager’s commission.

Manager’s commission is calculated on net profits (before charging manager’s commission)

Formula to calculate Manager's Commission before charging such commission

Example for Case I – Commission rate – 10%, Net Profit – 1,50,000

Manager’s Commission Amount = (10/100)*1,50,000

= 15,000

 

Calculation of Manager’ Commission – Case II

In this case, the commission rate is calculated on “net profit of the company minus manager’s commission”.

In this case, manager’s commission is calculated on net profits (after charging manager’s commission)

Formula to calculate Manager's Commission after charging such commission

Example for Case I – Commission rate – 10%, Net Profit – 1,50,000

Manager’s Commission Amount = (10/100+10)*1,50,000

= 13,636.36

 

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What is Working Capital Turnover Ratio?

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Working Capital Turnover Ratio

Working Capital Turnover Ratio is used to determine the relationship between net sales and working capital of a business. It shows the number of net sales generated for every single unit of working capital employed in the business.

Companies may perform different types of analysis such as trend analysis, cross-sectional analysis, etc. to find out effective utilization of its resources, in this case, working capital.

In a practical scenario, net sales may not be provided, which can then be calculated on the basis of the cost of revenue from operations or cost of goods sold. Working capital is calculated by subtracting current liabilities from current assets.

 

Formula to Calculate Working Capital Turnover Ratio

Working Capital Turnover Ratio

Net Sales = Sales – Returns

Working Capital = Current Assets – Current Liabilities

(or)

Working Capital Turnover Ratio - 2

COGS = Net Sales – Gross Profit (or) Opening Stock + Purchases – Closing Stock

 

Example

Question. Calculate working capital turnover ratio from the following data.

Current Assets 1,00,000
Current Liabilities 50,000
Sales 2,00,000
Sales Returns 50,000

 

Answer. Net Sales = Sales – Sales Returns

Net Sales = 2,00,000 – 50,000

Net Sales = 1,50,000

Working Capital = Current Assets – Current Liabilities

WC = 1,00,000 – 50,000

WC = 50,000

Working Capital Turnover Ratio = Net Sales/Working Capital

= 1,50,000/50,000 = 3/1 or 3:1 or 3 Times

This shows that for every 1 unit of working capital employed, the business generated 3 units of net sales.

 

High and Low Working Capital Turnover

High – A high ratio is desired, it shows a high number of net sales for every unit of working capital employed in the business. However, a very high ratio is not desirable as it may signal that the company is operating on low working capital w.r.t revenue from operations.

In case of a very high ratio, it is also certain that the company may not be able to meet the sudden increase in demand due to limited working capital.

Low – Lower working capital turnover ratio means that the business is not generating sufficient sales relative to the working capital employed.

A lower than the desired ratio shows that the working capital is not optimally used to generate sales & optimization may be required.

 

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What are Different Types of Ledgers?

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Types of Ledgers

A ledger is a book where all ledger accounts are maintained in a summarized way. All accounts combined together make a ledger book. Predominantly there are 3 different types of ledgers; Sales, Purchase and General ledger.

A ledger is also known as the principal book of accounts and it forms a permanent record of all business transactions.

 

1. Sales Ledger or Debtors’ Ledger

First among different types of ledgers is “Sales or Debtors’ ledger”. It is a grouping of all accounts related to customers to whom goods have been sold on credit (Credit Sales). Sum of all the money owed to a business by their customers is shown here and is termed as Accounts Receivable, Trade Debtors or Sundry Debtors.

The accounts are mostly arranged in alphabetical order, however, nowadays all the ledger accounts are maintained with the help of accounting ERPs.

 

2. Purchase Ledger or Creditors’ Ledger

It is a grouping of all accounts related to sellers from whom goods have been purchased on credit (Credit Purchases). Sum of all the money owed by a business to their sellers is shown here and is termed as Accounts Payable, Trade Creditors or Sundry Creditors.

The total monetary amount inside the purchase ledger is shown in the trial balance and the balance sheet at its appropriate place.

Cash Sales and Cash Purchases are booked into the Cash Book.

 

3. General Ledger

Companies usually make a single general ledger which includes 2 additional subtypes of ledgers i.e. nominal ledger and private ledger. These two may or may not be included in the list for different types of ledgers in accounting.

General Ledger

A general ledger or GL is a centralized compilation for all the ledger accounts of a business. It contains all types of accounts which can be found in an organization such as assets, liabilities, capital or equity, revenues, expenses, etc.

As per traditional or UK style accounting, GL consists of all nominal & real accounts necessary to prepare financials for a company. E.g. Building, Office equipment, Furniture and so on.

Nominal Ledger –  As the name suggests it contains all nominal accounts i.e. expense, losses, incomes and gains. Examples – Salaries, Sales, Purchases, Returns Inward/Outward, Rent, Stationery, Insurance, Depreciation, etc.

Private Ledger – Private ledger consists of accounts which are confidential in nature such as capital, drawings, salaries, etc. These accounts are only accessible by selected individuals.

Some companies do make separate general, nominal and private ledger.

 

 

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What are Qualitative Characteristics of Accounting Information?

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Qualitative Characteristics of Accounting Information

There are some qualities of accounting that make it useful for both external and internal users of accounting. Without these qualities, accounting information wouldn’t be clear, and an orderly view of the business would not be visible. 4 qualitative characteristics of accounting information are;

Qualitative Characteristics of Accounting Information

 

Comparability

Comparison is a very important part of financial information as it helps the users of accounting information to differentiate, analyze, improve, and take important decisions.

The ability to do intra-firm comparisons (within the same company), inter-firm comparisons (with other companies), and market sector comparisons (comparisons within the same market sector) make accounting information easy to work with.

Example of Comparability – QoQ (Quarter on Quarter) & YoY (Year on Year comparisons) should be possible with the accounting information.

 

Understandability

The presentation of accounting information should be simple and understandable for the users of the information. All the data must be clear and concise, it can be easily understood by everyone, including parties who are not from an accounting background.

All relevant explanatory notes should be provided along with the financial statements. Method of valuation of inventory, method of depreciation, information on reserves and surplus, contingent liabilities, and any other extraordinary items.

Example of Understandability – It should be possible for bankers, investors, employees, etc., to understand the financial information of the business.

 

Reliability

One of the most important qualitative characteristics of accounting information is the reliability of data, i.e. all information provided must be traceable and verifiable with proper source documents.

In an internal or external audit, the information inside financial statements should be confirmable back to its source. Failure of an audit may lead to disbelief in the company’s financial data.

Example of Reliability – An auditor must be able to verify a transaction back to its origin with the help of invoices, memos, purchase orders, sales orders, etc.

 

Relevance

Relevance of accounting information means it should help the user of information with their decision-making process. The information provided should not be irrelevant and unnecessary. All information should be capable of monetary computation.

Example of Relevance – A firm is expected to provide the total amount owed by the debtors on the balance sheet, whereas the total number of debtors is unimportant.

 

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What are Subsidiary Books?

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Subsidiary Books of Account

Also known as books of original entry, special purpose books, special purpose subsidiary books, and subsidiary books of accounts are various books recording financial transactions of a similar nature. They are the sub-division of the journal.

During the lifecycle of a business, the volume of transactions in a business may rise to the extent that a single journal may no longer be adequate to keep the books. This is when special purpose books or subsidiary books may be required for more efficient bookkeeping.

List of supporting books

Subsidiary Books of Accounting

Related Topic – How to treat return inwards in trial balance?

 

Types of Subsidiary Books

1.  Cash Book – A cash book is a book of prime entry that records all transactions made by a business in both cash and a bank instrument.

2. Purchase Book – A purchase book is one of the special purpose books where all the credit purchases are recorded by a business.

3. Sales Book – A sales book is one of the subsidiary books where all the credit sales are recorded by a business.

4. Purchase Returns Book – Also known as returns outward book, a purchase returns book is prepared to record goods returned by a business to its suppliers.

5. Sales Return Book – Also known as a returns inward book, a sales return book is prepared to record goods returned to a business by the customers.

6. Journal Proper – It is a book in which all miscellaneous transactions which are not recorded in any other subsidiary book are called a journal proper.

7. Bills Receivable Book – is a book that records all bills receivable to a business, the total of bills receivable book is posted on the debit side of the B/R account.

8. Bills Payable Book – is one of the subsidiary books that records all bills payable by a business, the total of bills payable book is posted on the credit side of the B/P account.

Related Topic – Is sales return a debit or credit?

 

Purpose of Subsidiary Books

For any business that grows large enough and the amount of transactions increases, it is no longer possible to record all transactions in one journal book, but rather in a number of journals. This is where subsidiary books play a crucial role and they can be seen as an extension of the journal book itself.

As a result, subsidiary books may be defined as books in which transactions are entered first, followed by ledger account preparation. They are also called day books or special journals.

In addition to overcoming the limitations of a journal book or journal entries, they have other benefits such as better organization of similar types of transactions.

Related Topic – Is cash book both a journal and ledger?

 

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What are Source Documents in Accounting?

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Source Documents or Source Vouchers

Source documents are the first document to record a transaction which works as an evidence containing details of a transaction. They are external documents or documents related to external activities which are first input in the accounting source systems.

Examples of source documents are invoice or bill, cash memo, cheque, sales order, purchase order, credit note, petty cash voucher, credit card sales voucher, etc.

Source documents arrive in a company through many different departments, mostly via sales and purchase departments. They are sometimes referred to as supporting documents.

Examples of Source Documents

Sales Order (SO) – is a document issued to the customer and generated by the firm itself. Nowadays sales orders are digitally transmitted soft copies over company’s internal network.

Purchase Order (PO) – is an official document generated by a buyer of goods/services as an offer for the seller. There are 4 different types of purchase orders Standard PO, Contract PO, Blanket PO and Planned PO.

Cash Memo – Cash memo is a document prepared by the seller when goods are sold in cash. It contains all details of the transaction such as quantity, amount, selling price, etc.

Invoice/Bill – It is an evidence prepared by the seller to document credit sales. It has all details about the credit sale such as the purchaser, date, price, quantity, etc.

Debit Note – A debit note is a document sent by a buyer to a seller while returning goods received on credit. This notifies that a debit has been made to their accounts.

Credit Note – A credit note is a document sent by a seller to the buyer notifying that a credit has been made to their account against the goods returned by the buyer.

Pay-in-Slip – It is a source document used for depositing cash and cheques into a bank. Pay-in-slip acts as an evidence of deposit

Cheque – It is an order in writing drawn on the bank to pay the mentioned amount payable to the bearer or the person specified on the cheque.

Petty Cash Voucher – It is used for petty cash expenses such as stamps, postage and handling, stationery, carriage, etc.

 

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What is an Accounting Period?

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Accounting Period

Also known as a financial period, period of account, accounting year, financial year, etc. the period for which a business prepares its accounts is called the accounting period for that firm.

As per the going concern concept, when a business is started, it is assumed that it will not be dissolved in the near future and will continue to operate for a foreseeable future. Therefore it is required that the lifespan of a business should be divided into equal parts. It is used for financial reporting by the business.

Internally, the company may decide to maintain accounting records monthly, quarterly, etc. However, for external users of accounting information, the financial statements are produced for a period of 12 months. There may be exceptions to this when a business is newly set up or is being dissolved.

 

Key Features of Accounting Period

  • Period of measurements should be equal.
  • Maximum 12 months after the start date.
  • It may be different from the calendar year.
  • It is uniform and consistent.

 

Financial Period of Various Countries

Accounting Period in Major Countries

Note – Fiscal year, accounting year & calendar year may be different for a company.

 

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What is Creditor’s Turnover Ratio?

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Creditor’s Turnover Ratio or Payables Turnover Ratio

Creditor’s turnover ratio is also known as Payables Turnover Ratio, Creditor’s Velocity and Trade Payables Ratio. It is an activity ratio that finds out the relationship between net credit purchases and average trade payables of a business.

It finds out how efficiently the assets are employed by a firm and indicates the average speed with which the payments are made to the trade creditors. The inverse of this ratio, when multiplied by 365, gives the average number of days a payable remains unpaid.

 

Formula to Calculate Creditor’s Turnover Ratio

Formula for Creditor's Turnover Ratio

Net Credit Purchases = Gross Credit Purchases – Purchase Return

Trade Payables = Creditors + Bills Payable

Average Trade Payables = (Opening Trade Payables + Closing Trade Payables)/2

 

Example – Payables Turnover Ratio

Ques. Calculate creditor’s turnover ratio from the information provided below;

Total Purchases – 5,00,000

Cash Purchases – 2,00,000

Creditors (Beginning of period) – 50,000 & Creditors (End of period) – 1,00,000

Ans. 

Creditor’s turnover ratio or Accounts payable turnover ratio = (Net Credit Sales/Average Trade Receivables)

Net Credit Purchases = Total Purchases – Cash Purchases

= 5,00,000 – 2,00,000

Net Credit Purchases = 3,00,000

Average Trade Payables = (Opening Trade Payables + Closing Trade Payables)/2

= (50,000 + 1,00,000)/2

= 75,000

Ratio = (3,00,000/75,000) => 4/1 or 4:1

 

High and Low Creditor’s Turnover Ratio

A high ratio may indicate

• Low credit period available to the business or early payments made by the business.
• The company may operate majorly on the cash basis.
• The company is not availing full credit period.

A low ratio may indicate

• Creditors are not paid in time.
• Increased credit period is allowed to the business.

 

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What is the Journal Entry for Credit Purchase and Cash Purchase?

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Journal Entry for Credit Purchase and Cash Purchase

To run successful operations a business needs to purchase raw material and manage its stock optimally throughout its operational cycle. Accounting and journal entry for credit purchase includes 2 accounts, Creditor and Purchase. In case of a journal entry for cash purchase, ‘Cash’ account and ‘Purchase‘ account are used.

The person to whom the money is owed is called a “Creditor” and the amount owed is a current liability for the company. Purchase orders are commonly used in large corporations to order goods on credit.

 

Accounting and Journal Entry for Credit Purchase

In case of a credit purchase, “Purchase account” is debited, whereas, the “Creditor’s account” is credited with the equal amount.

Purchase Account Debit
 To Creditor’s Account Credit

Journal entry for credit purchase

 

Golden rules of accounting applied (UK Style)

  • Purchase A/C (Type – Nominal) > Rule – Dr. all Expenses and Losses
  • Creditor’s A/C (Type – Personal) > Rule – Cr. the Giver

Modern rules of accounting applied (US-Style)

  • Purchase A/C (Type – Expense) > Rule – Dr. the Increase in Expenses
  • Creditor’s A/C (Type – Liability) > Rule – Cr. the Increase in Liability

 

Example – Journal Entry for Credit Purchase

Post a journal entry for – Goods purchased for 5,000 on credit from Mr Unreal

Example - Journal Entry for Credit Purchase

Related Topic – Journal Entry for Credit Sales and Cash Sales

 

Accounting and Journal Entry for Cash Purchase

Cash Purchase, on the other hand, is simple and easy to account for. In case of cash Purchase, the “Purchase account” is debited, whereas “Cash account” is credited with the equal amount.

Purchase Account Debit
 To Cash Account Credit

Journal entry for cash purchase

 

Golden Rules applied (UK Style)

  • Purchase A/C (Type – Nominal) > Rule – Dr. all Expenses and Losses
  • Cash’s A/C (Type – Real) > Rule – Cr. What Goes out

Modern Rules applied (US-Style)

  • Purchase A/C (Type – Expense) > Rule – Dr. the Increase in Expenses
  • Cash A/C (Type – Asset) > Rule – Cr. the Decrease in Asset

 

Example – Journal Entry for Cash Purchase

Post a journal entry for – Goods purchased for 5,000 in cash from Mr Unreal

Example - Journal Entry for Cash Purchase

 

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