Chapter 3 Material.docx

**MEANING OF DOUBLE ENTRY SYSTEM OF BOOK-KEEPING** The double entry system of bookkeeping can be defined as the system of recording transactions having two fundamental aspects - one involving the receiving of a benefit and the other giving the benefit - in the same set of books. In this theory, as...

**MEANING OF DOUBLE ENTRY SYSTEM OF BOOK-KEEPING** The double entry system of bookkeeping can be defined as the system of recording transactions having two fundamental aspects - one involving the receiving of a benefit and the other giving the benefit - in the same set of books. In this theory, as the two fold aspects of each transaction are recorded, therefore it is called 'double entry system'. As per dual aspect concept of accounting every transaction involves two aspects, an aspect of receiving and another aspect of giving. One who receives is a debtor and one who gives is a creditor. Under the double entry system, both the aspects of giving and receiving are recorded in terms of accounts. The account which receives the benefit is debited and the account which gives the benefit is credited. It is the ultimate result of this system that every debit must have corresponding credit and vice versa thus, on any particular day the total of the debit entries and the credit entries on the various accounts must be equal. For example, we bought machinery of ₹ 30,000 for business. It has brought two changes, machinery increases by ₹ 30,000 and cash decreases by an equal amount. While recording this transaction in the books of accounts, both the changes must be recorded. In accounting language, these two changes are termed as "a debit change" & "a credit change". Here machinery account will be debited and cash account will be credited. Thus, we see that for every transaction there will be two entries, one debit entry and another credit entry. For each debit there will be a corresponding credit entry of an equal amount. Conversely, for every credit entry there will be a corresponding debit entry of an equal amount. So, the system under which both the changes in a transaction are recorded together, one change is debited, while the other change is credited with an equal amount, is known as double entry system of book- keeping. Double entry system is based on the principle that "Every debit has a credit and every credit has a debit." **Advantages & limitations of double entry system:** The main advantages of double entry system of book keeping are as follows: 1\. The nominal aspects of transactions being recorded make it possible to prepare Trading and Profit and Loss Account from which the Gross Profit and Net Profit earned by the business during a particular period can be easily ascertained. 2\. As all personal accounts of debtors and creditors as well as real accounts are kept, it is possible to prepare Balance Sheet. 3\. The transactions being recorded in the most scientific and systematic way give the most reliable information of business. 4\. It prevents frauds because doing alterations in any account becomes difficult. 5\. It enables the trader to compare the different items, such as sales, purchases, opening stock and closing stock of one period with similar items of preceding period and the trader may thus, know whether his business is progressing or not. 6\. Trial balance can be prepared on any day to prove the arithmetical accuracy of accounting records. The main limitations of double entry system of book keeping are as follows: 1\. This system requires the maintenance of a number of books of accounts which is not practical in small concerns. 2\. This system is costly because a number of records are to be maintained. 3\. There is no guarantee of absolute accuracy of the books of accounts inspite of agreement of the trail balance. **MEANING AND CLASSIFICATION OF ACCOUNTS:** An accounting system records, retains and reproduces financial information relating to financial transaction flows and financial position. Financial transaction flows encompass primarily inflows on account of incomes and outflows on account of expenses. Elements of financial position, including property, money received, or money spent, are assigned to one of the primary groups i.e. assets, liabilities, and equity. Within these primary groups each distinctive asset, liability, income and expense is represented by its respective "account". An account is simply a record of financial inflows and outflows in relation to the respective asset, liability, capital, income and expense. It is a record of all business transaction relating to a particular person or item. In accounting we keep a separate record of each individual, asset, liabilities, expense or income. The place where such a record is maintained is termed as an 'Account'. Such as the Account of Madan, the Account of Brij, the Account of Building, the Account of Rent, the Account of Discount and likewise. All transactions entered into with Madan will be recorded in the Account of Madan and similarly, all transactions relating to Brij will be recorded in the Account of Brij. Thus, an account is a systematic record of transactions pertaining to a particular item or person, which can be measured in terms of money during a particular period of time. Account is a head under which particular type of transactions are consolidated, classified and recorded. The account may be classified in two ways: i. ii. **Classification of Accounts Based on Nature or Traditional Classification** On the basis of their nature accounts are of the following three types: i. ii. iii. Modern Classifications On the basis of this classification accounts are divided into five categories as given below: i\. Capital, ii. Assets, iii. Liabilities, iv. Expenses and v. Income **Classification of Accounts** Traditional Concepts Modern Concepts 1. 2. 3. 4. 5. **RULES OF ACCOUNTING (DEBIT AND CREDIT**) In Double Entry accounting both the aspects of the transaction are recorded. Every transaction has two aspects according to this system, both the aspects are recorded. If the business acquires something, it must have been acquired by giving something else. While recording each transaction, the total amount debited must be equal to the total amount credited. The terms 'Debit' and 'Credit' indicate whether the transaction is to be recorded on the left hand side or right hand side of the account. In its simplest form, an account looks like the English Language Letter 'T'. Because of its shape, this simple form of account is called T-account. This helps in ascertaining the ultimate position of each item at the end of an accounting period. Rules of Accounting All accounts are divided into five categories for the purpose of recording of the business transactions: i. **Two Fundamental Rules are followed to record the changes in these accounts:** 1. For recording changes in Assets/Expenses/Losses "Increase in Asset is debited, and decrease in Asset is credited." "Increase in Expenses/Losses is debited, and decrease in Expenses/ Losses is credited." 2. For recording changes in Liabilities, Capital and Revenue/Gains "Increase in Liabilities is credited and decrease in Liabilities is debited." "Increase in Capital is credited and decrease in Capital is debited. "Increase in Revenue/Gains is credited and decrease in Revenue/Gain is debited". **CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS:** The main functions of accounting include the ascertainment of profit/loss for an accounting period and financial position as at the end of that period. The distinction between capital and revenue items is important both from the Income Statement (Profit and Loss Account) as well as the Position Statement (Balance Sheet) point of view. For example, if a depreciable asset is purchased, the depreciation on that asset is charged to the Profit and Loss Account, and the written down value of the asset (or original cost of the asset less accumulated depreciation) is shown in the Balance Sheet. If the purchase of a depreciable asset, which is a capital expenditure, is treated as revenue expenditure it will understate the profit of the current year and overstate the profits of the subsequent years. Similarly, the Balance Sheet will not give a true and fair view of the assets and equity of the enterprise till the useful life of the asset is over assuming that the asset is not sold earlier. **Capital and revenue item is divided into** I. II. **Capital and Revenue Expenditure** According to Guidance Note on terms used in financial statements issued by ICAI, "Expenditure is incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services". Thus expenditure may or may not involve outflow of cash. It includes the purchase of capital or long-lived asset, goods for the purpose of sale or for getting services. Expenditures are divided into three categories: 1. 2. 3. **Capital Expenditure** Expenditure that acquires a capital asset is capital expenditure. If it acquires stock-in-trade, then it is revenue expenditure. A capital asset is one that is used in or for the purposes of the business and not meant for sale in the ordinary course of business of the enterprise. Purchase of stock-in-trade is not capital expenditure as it is sold in the ordinary course of business. Expenditure on the purchase and installation of machinery is a capital expenditure. Further when an expenditure is made with a view to bringing into existence an asset or advantage for the enduring benefit of trade is a capital expenditure in the absence of special circumstances leading to the opposite conclusion. Asset or advantage of enduring nature means that it must not be fully consumed or used up in the accounting period in which it is incurred. Capital expenditure increases the earning capacity or reduces the operating expenses of a business. According to Kohler the term capital expenditure is "generally restricted to expenditures that add fixed asset units or that have the effect of increasing the capacity, efficiency, life span, or economy of operation of an existing fixed asset." The following are the examples of capital expenditure: a. Expenditure incurred for acquisition of fixed tangible assets such as land, building, machinery, furniture, motor vehicle etc. b. Expenditure incurred for improvement or extension of fixed assets such as increasing the seating capacity of a theatre. c. Expenditure incurred to bring the fixed assets to the place of their use and expenditure incurred on their installation or erection such as freight on fixed assets, wages paid for installation. d. Expenditure incurred for the purchase of intangible assets such as goodwill, patent rights, and trademarks, copyright, etc. e. Expenditure incurred for reconditioning of old fixed assets such as expenditure incurred on repairing or over healing of secondhand machinery. f. Major repairs and replacement of plant which increase the efficiency of the plant. g. The cost of shifting a plant to another place is a capital expenditure. **Treatment of Capital Expenditure**. Capital expenditure is capitalized. It is written off over the estimated useful life of the asset. For example, when machinery is purchased, Machinery Account is debited at the price paid for it and later shown in the Balance Sheet as an asset after deducting depreciation. Similarly, wages paid for the installation of machinery is capitalised by debiting the Machinery Account. **Rules for Determining Capital Expenditure.** The following are the rules for determining capital expenditure: a. An expenditure is capital expenditure, if it is incurred for acquiring a long term asset (having a useful life of more than one year) for use in the business to earn revenue and not meant for sale. b. An expenditure is capital expenditure, if it is incurred to put an asset into working condition. For example, the transportation and installation charges are added to the cost of machine. Similarly, the legal charges like registration and stamp duty is added to the cost of land and building. Again, architect fee paid for supervising construction of building is capitalised. c. An expenditure incurred for putting an old asset into working condition is treated as capital expenditure and added to the cost of the asset. d. An expenditure incurred to increase the earning capacity of a business is treated as capital expenditure. For example, expenditure incurred for shifting the factory to convenient site is a capital expenditure. e. Borrowing costs (e., interest and other costs incurred by an enterprise in connection with the borrowing of funds) that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset till the asset is ready for its intended use or sale as per AS-16 : Borrowing costs. **Revenue Expenditure:** If an expenditure is made not for the purpose of bringing into existence any capital asset or advantage of enduring nature but for running the business or working it with a view to produce the profits is revenue expenditure. Such expenditure benefits the current period only. It is incurred to maintain the existing earning capacity of the business. For example, the amount spent on purchase of stock-in-trade is of revenue nature. Administrative expenses and selling and distribution expenses are other examples of revenue expenditure. **Rules for Determining Revenue Expenditure**. The following are the rules for determining revenue expenditure: a. An expenditure incurred for the purpose of acquiring goods purchased for resale, consumable items, etc. is a revenue expenditure. For example, purchase of raw material in the case of manufacturing unit and purchase of merchandise meant for the purpose of resale. At the end of the year, closing stock and opening stock of these items adjusted to match cost with revenue for calculating profit. b. Expenditures incurred on other direct expenses, e., expenses on production and purchase of goods such as wages, power, freight etc. are revenue expenditure. c. Expenditure incurred for maintaining fixed assets in working order is revenue expenditure. For example, amount spent on repairs and renewals is revenue expenditure. d. Depreciation on fixed assets is revenue expenditure. e. Expenditures incurred on office and administrative and selling and distribution departments (not covered above) in the normal course of business are revenue expenditures. These include salaries, rent, telephone expenses, electricity, postage, advertisement, travelling expenses, commission to salesmen. f. Expenditures incurred on non-operating expenses and losses are revenue expenditures. For example, interest on loan taken after commencement of commercial production, loss on sale of a long term asset, loss by theft, loss by fire are revenue expenditures. g. Expenditure incurred by an enterprise to discharge itself from recurring liability is of revenue nature. For example, a lump sum amount paid to a pensioner by the employer is revenue expenditure. h. Expenditure incurred for protecting the business is a revenue expenditure. For example, the amount spent on propaganda campaign to oppose the threatened nationalization of industry is of revenue nature. i. Expenditure incurred to maintain the existing efficiency or the earning capacity is of revenue type. **Distinction between Capital Expenditure and Revenue Expenditure:** The following are the points of distinction between capital expenditure and revenue expenditure: a. **Enduring benefit:** Capital expenditure is meant for enduring benefit, e., for more than one accounting period. Revenue expenditure benefits one accounting period only. b. **Nature of asset:** Capital expenditure relates to the acquisition of fixed asset and revenue expenditure relates to the acquisition of stock-in-trade. c. **Effect on net profit**: Capital expenditure is capitalised while revenue expenditure is transferred to the Trading or Profit and Loss Account. Unexpired portion of the capital expenditure is shown as an asset in the Balance Sheet. Revenue expenditure is expired cost. d. **Nature of liability discharged**: Expenditure incurred by an assesse to free himself from a capital liability, for instance, disadvantageous lease is a capital expenditure, while the amount spent in discharging himself from a recurring liability is of revenue nature. e. **Periodicity of occurrence:** Capital expenditure is usually of non-recurring nature while revenue expenditure is usually of recurring nature. f. **Earning capacity:** Capital expenditure helps to increase the earning capacity of the business or to reduce the operating cost. Revenue expenditure is incurred to maintain the existing earning capacity of the business. g. **Matching:** Capital expenditure are not matched against capital receipts. Revenue expenditures are matched against revenue receipts for income determination. h. **Commencement of business:** Capital expenditures may be incurred even before the commencement of business. Revenue expenditures are incurred only after the commencement of business. **Deferred Revenue Expenditure:** Deferred revenue expenditure is a revenue expenditure by nature but it is not treated as revenue expenditure on the ground that its benefit is not fully exhausted in the accounting period in which it is incurred. The Guidance Note on 'Terms used in Financial Statement', issued by the Institute of Chartered Accountant of India, states that "*Deferred revenue expenditure is that expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will benefit over a subsequent period or periods."* Deferred revenue expenditure is, for the time being, deferred from being charged against revenue. The unwritten off portion of the deferred revenue expenditure is shown on the asset side of the Balance Sheet. A portion of the total deferred revenue expenditure is charged as revenue expenditure. Deferred revenue expenditure should be written off over a certain number of years. AS-26 "*Intangible Assets" has diluted the concept of deferred revenue expenditure. According to it, if expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired that can be recognised, then expenditure should be recognised when it is incurred. For example, preliminary expenses in establishing a legal entity, expenditure on training activities and expenditure on relocating or reorganising an enterprise, expenditure on launching of new products, expenditure on advertising and promotional activities should be recognised as expenses in the year in which these are incurred. However, share issue expenses and discount on issue of shares/debentures can be written off over a certain number of years."* Deferred revenue expenditure should be distinguished from prepaid expenses. In case of deferred revenue expenditure the benefits available cannot be precisely estimated but in case of prepaid expenses, like payment of insurance in advance, benefits available can be precisely estimated. In case of prepaid insurance, insurance protection will be available for a definite period after close of the financial year. Illustration 1. Classify the following into capital or revenue expenditure: \(a) Overhaul expenses of 10,000 spent on second hand machinery purchased. \(b) Carriage of 1,000 spent on machinery purchased. \(c) Legal fees of 5,000 paid to acquire property. \(d) 1,500 paid for servicing the company's car including 500 paid for change of oil. \(e) 1,000 paid for replacement of a worn out part of a machine. \(f) 18,000 spent for construction of temporary huts, which were necessary for construction of the cinema house and were demolished when the cinema house was ready. Solution: \(a) Overhaul expenses spent on second hand machinery purchased is a capital expenditure. \(b) Carriage paid on machinery is a capital expenditure. \(c) Legal fees paid to acquire property is a capital expenditure. \(d) Amount spent on servicing entity's car is a revenue expenditure. \(e) Amount spent on replacement of worn part of a machine is a revenue expenditure. \(f) Amount spent on construction of temporary huts is a capital expenditure. **Illustration 2.** Classify the following into capital or revenue expenditure: \(a) 5,000 spent as lawyer's fee to defend a suit claiming that the firm's factory site belonged to the plaintiff's land. \(b) 1,50,000 spent on the repairs and white-washing for the first time on purchase of an old building. \(c) 15,000 spent in connection with obtaining a license for starting a factory. \(d) 6,000 paid as compensation to two employees who were retrenched. \(e) 8,000 custom duty paid on import of machinery for modernisation of factory production. **Solution:** \(a) Lawyer's fee to defend the impugned suit is a revenue expenditure. \(b) Amount spent on repairs and white-washing for the first time on purchase of old building is a capital expenditure. \(c) Amount spent in connection with obtaining license for starting a factory is a capital expenditure. \(d) Amount paid as compensation to the employees is a revenue expenditure. \(e) Custom duty paid on import of machinery for modernisation of factory is a capital expenditure. **Illustration 3.** State with reasons whether the following are capital or revenue expenditure: \(a) Freight and cartage on the new machine 150, and erection charges 500. \(b) Fixtures of the book value of 2,500 sold off at 1,600 and new fixtures of the value of \` 4,000 were acquired, cartage on purchase 500. \(c) A sum of 400 was spent on painting the factory. \(d) 8,200 spent on repairs before using a second hand car purchased recently, to put it in usable condition. **Solution:** \(a) Freight and cartage on the new machine and erection charges \` 500 are capitalised because they will benefit the business for more than one accounting period. \(b) Loss on sale of fixtures 900 (2,500 -- 1,600) is a revenue expenditure although it is of non-operating nature. Amount spent on new fixtures 4,000 and on cartage 500 are capital expenditures as they will benefit future periods also. \(c) 400 spent on painting the factory is a revenue expenditure as it was incurred to maintain the factory building. \(d) Overhaul expenses (or repairs) 8,200 incurred to put a second hand car in working condition is a capital expenditure. It will benefit in future also. **Illustration 4.** Classify the following into capital or revenue or deferred revenue expenditure : \(a) Heavy advertising cost of 10,00,000 spent on the launching of a company's new product. \(b) Advertisement expense 50,000 incurred during peak festive season on regular basis. \(c) 2,000 paid for hiring of computer time for the preparation of the accounts of the business. \(d) Interest paid 40,000 on loan taken for construction of building and purchase of plant and machinery before the asset is ready for intended use. **Solution:** \(a) Heavy advertising cost of 10,00,000 spent on the launching of a company's new product is a revenue expenditure as per AS-26. According to AS-26 (Para 56) "Intangible Assets", expenditure incurred on "launching new products or process" and "expenditure on advertising and promotional activities" are recognised as expenses when these are incurred. Earlier, it used to be treated as deferred revenue expenditure. \(b) Advertisement expense 50,000 incurred during peak festive season on regular basis is a revenue expenditure. \(c) 2,000 paid for hiring of computer time for the preparation of the accounts of the business is a revenue expenditure. \(d) Interest paid 40,000 on loan taken for construction of building and purchase of plant and machinery before the asset is ready for intended use is a capital expenditure. **Distinction between Expenses and Expenditure** **Expenditure:** According to the Guidance Note on Terms used in financial statements issued by ICAI, expenditure is incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods or services. It does not necessarily involve actual delivery or parting with money or property. Incurring a liability is also expenditure. Expenditure may be capital expenditure, revenue expenditure or deferred revenue expenditure. **Expense:** According to the Guidance Note on Terms used in financial statements issued by ICAI, expense is a cost relating to the operations of an accounting period or to the revenue earned during the period or the benefits of which do not extend beyond that period. Expense is expired cost. It decreases owners' equity, other than those relating to distribution of dividend to shareholders in case of a company or withdrawal etc. made by the owner (s) in case of non-corporate entities. Expenses give benefit during the accounting period only in which they are incurred. An expense is incurred when goods or services are used in the process of earning revenue. **CAPITAL AND REVENUE RECEIPTS:** The distinction between capital receipt and revenue receipt is important because capital receipt is taken to the Balance Sheet and revenue receipt is taken to the Trading and Profit and Loss Account. Capital receipts are the receipts which are not obtained in course of normal business activities of the enterprise. The examples of capital receipts are: 1. Capital contributed by the owner(s), 2. Secured or unsecured loans taken, 3. Receipts from sale of fixed assets and non-current investments. In case of not for profit organisation, legacy and life membership are capital receipts. Revenue receipts are the receipts which are obtained in course of normal business activities. They include proceeds from sale of goods, fee received from the services rendered in the ordinary course of business, receipts. The nature of receipt is decided from the point of view of the person receiving it. The following broad principles may be laid down as guide for determining whether a particular receipt is of capital nature or of revenue nature: a. A receipt on account of fixed assets is a capital receipt whereas a receipt on account of current assets or circulating capital is a revenue receipt. For example, sale proceeds from sale of fixed assets is a capital receipt while proceeds from sale of stock-in-trade is a revenue receipt. Capital profit from sale of fixed asset is to be shown in Profit and Loss Accounts. b. A receipt in substitution of source of income is a capital receipt whereas a receipt in substitution of income alone is a revenue receipt. For example, compensation for loss of employment or agency is a capital receipt (though taxable) whereas damages for breach of business contract is a revenue receipt. c. An amount received for surrender of certain right under an agreement is a capital receipt whereas amount received by way of compensation of loss of future profits is a revenue receipt. For example, pension is a revenue receipt whereas lump sum received in commutation of pension is a capital receipt (though taxable). d. The nature of a receipt is determined exclusively by its character in the hands of the receiver. e. Where an asset is held as an investment, the sale proceeds of such asset is a capital receipt. But where an asset is held as stock-in-trade, the sale proceeds of such asset is a revenue receipt. For example, profit on sale of shares to a dealer in shares is a revenue receipt. **Distinction between Capital Receipts and Revenue Receipts:** Capital receipts are not obtained in the course of normal business activities of the enterprise whereas revenue receipts are obtained in the course of normal business activities. Capital receipts are usually obtained in case of a company from issue of shares, debentures, borrowings and sale of fixed assets or investments. Revenue receipts are usually obtained from sale of goods, rendering of services or use of enterprise resources yielding interest, royalties and dividend. Capital receipts are usually of non-recurring nature and revenue receipts are usually of recurring nature. Capital receipts from financing activities such as issue of shares, debentures and borrowings are shown on the liabilities side of the balance sheet as these receipts create liabilities payable at a future date whereas interest on borrowings is shown as a charge in the Profit and Loss Account and dividends to shareholders are shown as appropriation of profit in the appropriation section of Profit and Loss Account. Interest accrued/outstanding will also be shown as a liability. Illustration 5. State with reasons whether the following are capital or revenue receipts: \(a) Introduction of capital by the owner 10, 00, 000. \(b) Amount realised from sale of old machinery 50,000 (book value 48,000). \(c) Sale of goods for cash 10,000. \(d) Cash received from debtors 20,000. \(e) Sale of investments for 40,000 (book value 44,000). \(f) Interest received on investments 3,000. **Solution:** \(a) Introduction of capital by the owner 10, 00,000 is a capital receipt as it creates a claim on the business to repay it. \(b) Amount realised from sale of old machinery: 50,000 is a capital receipt. Capital profit on sale of 2,000 is to be shown in Profit and Loss Account. \(c) Sale proceeds from sale of goods 10,000 is a revenue receipt as it is a receipt in the course of normal business activities of the enterprise. \(d) Cash received from debtors 20,000 is a revenue receipt as this is in the course of normal business activities of the enterprise. \(e) Sale proceeds from investments 40,000 is a capital receipt and capital loss of 4,000 is to charge in the Profit and Loss Account. \(f) Interest on investments 3,000 is a revenue receipt as use of enterprise resources yielding interest is revenue. **ACCOUNTING EQUATION:** The accounting equation represents the relationship between the assets, liabilities and capital of a business and it is fundamental to the application of double entry bookkeeping where every transaction has a dual effect on the financial statements. In its simplest form, the accounting equation can be shown as follows: **Capital = Assets -- Liabilities** Capital can be defined as being the residual interest in the assets of a business after deducting all of its liabilities (i.e. what would be left if the business sold all of its assets and settled all of its liabilities). In the case of a limited liability company, capital would be referred to as 'Equity'. Capital essentially represents how much the owners have invested into the business along with any accumulated retained profits or losses. For example, if you were to start a sole trade business with a ₨.1,000 investment then on the first day of trading the accounts of the business would show that it has ₨.1,000 of cash available and that this came from an investment made by you. The capital would ultimately belong to you as the business owner. **Capital** **=** **Assets** **-** **Liabilities** ------------- ------- ------------- ------- ----------------- **₨.1,000** **=** **₨.1,000** **-** **Nil** The accounting equation can also be rearranged in several ways, including: **Assets = Capital + Liabilities** In this format, the formula more clearly shows how the assets controlled by the business have been funded. That is, through investment from the owners (capital) or by amounts owed to creditors (liabilities). You may also notice two other interesting points regarding the formula being laid out in this way: It reflects the format of the statement of financial position (i.e. assets are presented first and the total assets figure balances with the total amount of equity and liabilities); and It more clearly reflects the fact that total debits will always equal total credits (i.e. Assets (Dr) = Capital (Cr.) + Liabilities (Cr.)) **Drawings, income and expenses:** Drawings are amounts taken out of the business by the business owner. They will therefore result in a reduction in capital. Income and expenses relate to the entity's financial performance. Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business. Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities. The accounting equation can be expanded to incorporate the impact of drawings and profit (ie income less expenses): **Assets = Capital introduced + (Income -- Expenses) -- Drawings + Liabilities** **Practical example** We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation. **Example** Anushka began a sole trade business on 1 January 2024. During the first month of trading, the following transactions took place: a. b. c. d. e. f. g. h. Explain how each of the above transactions impact the accounting equation and illustrate the cumulative effect that they have. **Solution** The impact of each of the above transactions has been outlined below, followed by a summary of the cumulative effect of these transactions on the accounting equation: 1. The cash (asset) of the business will increase by ₹ 5,000 as will the amount representing the investment from Anushka as the owner of the business (capital). 2. ₹ 10,000 of cash (asset) will be received from the bank but the business must also record an equal amount representing the fact that the loan (liability) will eventually need to be repaid. 3. The assets of the business will increase by ₹ 12,000 as a result of acquiring the van (asset) but will also decrease by an equal amount due to the payment of cash (asset). 4. The inventory (asset) of the business will increase by the ₹ 2,500 cost of the inventory and a trade payable (liability) will be recorded to represent the amount now owed to the supplier. (Note that in the accounting records, the purchase of inventory may be recorded as an expense initially and then an adjustment made for closing inventory at the year-end. Any inventory not sold will ultimately be recorded as an asset though). 5. Anushka will record revenue (income) of ₹ 400 for the sale made. A trade receivable (asset) will be recorded to represent Anushka's right to receive ₹400 of cash from the customer in the future. As inventory (asset) has now been sold, it must be removed from the accounting records and a cost of sales (expense) figure recorded. The cost of this sale will be the cost of the 10 units of inventory sold which is ₹ 250 (10 units x ₹ 25). The difference between the ₹ 400 income and ₹ 250 cost of sales represents a profit of ₹ 150. The inventory (asset) will decrease by ₹ 250 and a cost of sale (expense) will be recorded. (Note that, as above, the adjustment to the inventory and cost of sales figures may be made at the year-end through an adjustment to the closing stock but has been illustrated below for completeness). 6. Interest (i.e. finance costs) are an expense to the business. Therefore cash (asset) will reduce by ₹ 60 to pay the interest (expense) of ₹ 60. 7. The business has paid ₹ 250 cash (asset) to repay some of the loan (liability) resulting in both the cash and loan liability reducing by ₹ 250. 8. Cash (asset) will reduce by ₹ 10 due to Anushka using the cash belonging to the business to pay for her own personal expense. As this is not really an expense of the business, Anushka is effectively being paid amounts owed to her as the owner of the business (drawings). Journal Entry Questions and Solutions Example 1 Pass the necessary journal entries related to the 'Opening Entry'. a. On 1st April 2023, Ram started a business with cash ₹5,00,000. Lightbox b. On 1st April 2023, Vinod started business with cash ₹1,00,000, furniture ₹2,00,000, and Building ₹10,00,000.  c. On 1st April 2023, Mohan's Books of Account shows Cash ₹16,000, Stock ₹54,000, Debtors ₹47,000, Furniture ₹42,000, Creditors ₹37,000, and Capital ₹1,22,000. Lightbox \(d) On 1st April 2023, Amit's Books of Account shows Cash ₹4,000, Bank ₹10,000, Stock ₹27,000, Debtors ₹23,500, Land and building ₹30,000, Creditors ₹10,000, and Capital ₹1,00,000.  d. On 1st April 2023, Vikas's Books of Account show, Cash ₹30,000, Bank ₹10,000, Stock ₹80,000, Debtors ₹48,000, Furniture ₹7,200, Creditors ₹25,000, and Bank Loan ₹20,000. Lightbox Example 2 Pass the necessary journal entries in the books of Reshi Raj, \(a) On 1 April 2023, Cash Purchases ₹20,000. \(b) On 9 April 2023, Sold goods to Rama at the list price of ₹60,000 at a trade discount of 10%. \(c) On 11 April 2023, Vinod sold goods to us worth ₹30,000 at a 10% trade discount. \(d) On 18 April 2023, Returned goods to Vinod at the list price of ₹2,000. \(e) On 22 April 2023, Paid cash to Vinod ₹24,000 in full settlement. \(f) On 25 April 2023, Rama returned goods of list price ₹10,000. \(g) On 28 April 2023, Rama paid ₹43,000 in full settlement of his account. Solution: Example 3 Pass the necessary journal entries in the book of Raghav from the following transactions: \(a) On 1 April 2023, Opened a Bank Account by depositing ₹50,000. \(b) On 7 April 2023, Goods were brought for ₹10,000, and payment was made by cheque. \(c) On 9 April 2023, Ravi (the debtor) directly deposited an amount of ₹40,000 in Raghav's account. \(d) On 15 April 2023, cash withdrawn ₹5,000 for personal use. \(e) On 21 April 2023, Sold goods to Ankit for ₹30,000 at a cash discount of 10% and received a cheque for the full amount deposited into the bank the same day. \(f) On 26 April 2023, The cheque received from Ankit was dishonored. \(g) On 29 April 2023, the Bank charged interest for ₹500. Solution: Lightbox Example 4 Pass the necessary journal entries related to the following transactions in the book of R.K. Pvt Ltd. \(a) On 1 April 2023, Purchased goods for cash ₹40,000 and paid ₹2,000 for their carriage. \(b) On 11 April 2023, Amar who owned ₹20,000 declared insolvent. \(c) On 16 April 2023, Machinery bought for ₹5,00,000 and paid ₹25,000 for its installation. \(d) On 19 April 2023, Further paid ₹5,000 on the carriage of the machine bought. \(e) On 24 April 2023, Purchased bricks and timber for ₹10,00,000 for construction of the building and made payment through cheque. \(f) On 29 April 2023, Amar who was earlier declared insolvent paid 30 paise in Rupee. Solution:  Example 5 Pass Journal Entries in book Susmita Ltd.: \(a) On 1 April 2023, Susmita got 10% interest on the capital of ₹5,00,000. \(b) On 9 April 2023, Susmita paid 15% interest on drawings of ₹8,000. \(c) On 11 April 2023, the Salary of an employee is due for ₹5,000. \(d) On 13 April 2023, Provide 10% depreciation on machinery costing ₹10,00,000. \(e) On 19 April 2023, Goods for ₹4,000 were distributed as free samples. \(f) On 24 April 2023, Goods worth ₹25,000 were stolen by an employee. \(g) On 27 April 2023, Goods worth ₹3,00,000 were destroyed by fire, and the insurance company paid a claim for 60% amount. Solution: Lightbox