Introduction to Financial Accounting and Mechanics of Accounting

Financial Accounting: Scope and Purpose

Financial accounting is the systematic process of recording business transactions and summarizing them into financial statements. These statements allow analysts, banks, and other external stakeholders to assess a company’s performance and financial health.

Why It Matters

• Analysts use financial statements to evaluate a company’s profitability, liquidity, and risk – the basis for stock recommendations and investment decisions.
• Banks require financial statements before granting loans; they check whether the borrower can generate enough cash to repay.
• Without accounting, business performance would be guesswork. Financial statements provide a common language for decision-makers.

The Mechanics: A Two‑Step Process

Accountants do not simply “prepare” financial statements from thin air. The work proceeds in two stages:

1. Enter transactions – Every financial event (sale, purchase, payment) is recorded in the accounting book (journal).
2. Summarize transactions – The recorded entries are grouped and condensed to create the financial statements (income statement, balance sheet, cash flow statement).

Exam tip: The twin pillars of accounting mechanics are recording and summarizing. Many exam questions assume you understand that financial statements are the end product of a structured cycle, not a one‑step exercise.

Key Takeaways

• Financial accounting’s purpose: provide reliable information for external decision‑makers.
• Key users include analysts and banks – both rely on financial statements to judge performance.
• The process has two clear phases: (1) record transactions in the accounting book, (2) summarise them into statements.
• Understanding this flow is essential before diving into specific accounts, rules, or ratios.

Scope and Purpose of Financial Accounting

Financial accounting exists because you cannot manage what you do not measure. A small business might have a few hundred financial transactions in a period; a large one runs into thousands. Without systematic recording, it is impossible to answer even basic operational questions: How much do customers owe us? How much do we owe suppliers?

Why record transactions?

• Record today → answer tomorrow. A sale on credit gives the product today but collects cash 30 days later. A notebook suffices for a vegetable vendor with a few customers; for a company like Asian Paints or Tata Motors, a notebook is useless.
• Software helps, but cannot replace understanding. Tools like Tally, Zoho, SAP, and Oracle Financials automate recording and summarisation. A manager must still know how to record a transaction and why the resulting financial statements look the way they do.

What is the scope of accounting?

Accounting covers two linked activities:

1. Recording financial transactions as they occur.
2. Summarising them periodically to prepare financial statements.

What do financial statements tell us?

They answer a set of fundamental business questions:

Exam tip: Do not let software blind you. The exam will test your ability to reason from transactions to statements, not your ability to click buttons. Be able to trace how a credit sale affects receivables and revenue.

Transition: Forms of business organisations

Different forms of business organisation—such as sole proprietorships, partnerships, and companies—prepare financial statements differently.

Key takeaways

• Recording is essential to know receivables, payables, and overall financial position.
• Accounting = recording transactions → summarising → financial statements.
• Financial statements answer six core questions: capital sources, capital use, liabilities, receivables, revenue & expenses, profit/loss.
• Software automates but does not replace conceptual understanding.
• The same accounting logic applies whether the business is a small shop or a multinational.

Different Forms of Business Organisations

While the mechanics of accounting — the double-entry system, journals, ledgers — is mostly the same regardless of business structure, the legal form affects who owns the entity, who bears risk, and how certain transactions (e.g., owner’s personal use of assets) are recorded. Four major forms exist.

Sole Proprietorship

A simple structure suited for small ventures. The business is owned and run by a single individual.

• Owner’s liability is unlimited — the law does not distinguish between the proprietor and the business. If the business cannot repay its debts, lenders can seize the proprietor’s personal assets.
• Profits and losses belong entirely to the owner.
• No separate legal entity; no distinction between personal and business transactions in the eyes of law.

Accounting implication: Any personal withdrawal by the owner is recorded as a drawing against their capital account.

Partnership

When one person lacks sufficient capital or expertise, they may take one or more partners. The arrangement is governed by a partnership deed that specifies profit/loss sharing (equal shares if not stated).

• Joint and several liability — all partners are personally liable for the firm’s debts. Lenders can pursue any partner’s personal assets if business assets are insufficient.
• Accountants maintain a partner’s capital account for each partner. Non-business transactions (e.g., a partner taking inventory for personal use) are recorded as recoverable; if unpaid, the amount is deducted from that partner’s capital.

Limited Liability Partnership (LLP)

A variation that limits partners’ liability to their investment. Personal wealth is not at risk if the business fails. Accounting treatment is similar to a regular partnership, but the legal shield changes the risk profile.

Companies (Registered under the Companies Act)

Large entities like Asian Paints, Infosys, TATA Steel typically choose this form. Key advantages attract millions of small investors:

1. Limited liability — shareholders can lose only the amount they invested; personal wealth is protected.
2. Liquidity — shares are traded on stock exchanges, allowing investors to sell anytime.

• Public Limited Company — can offer shares to the general public. Example: TATA Steel had 4.72 million shareholders, Asian Paints 1.12 million.
• Private Limited Company — suitable for smaller ventures that still want limited liability. Shares are not traded on exchanges, so investors lack liquidity.

Exam tip: The crucial difference between a public and private limited company is liquidity of shares, not limited liability (both offer it).

Co-operative Society

Members are directly connected to the business objective. Examples: AMUL (milk producers), IFFCO (fertiliser), Co-optex (silk weavers). Unlike companies, any person with surplus funds cannot join — you must be a producer or user.

• One member, one vote — voting rights are equal regardless of investment. In companies, voting power depends on number of shares held.
• Provides limited liability to its members.

Comparison Table

Key takeaways

• Accounting fundamentals are common; differences arise in capital accounts and treatment of owner transactions.
• Sole proprietorship and partnership expose owners to unlimited personal liability; LLCs and companies shield personal wealth.
• Public companies offer both limited liability and share liquidity — the two main investor attractions.
• Co-operatives restrict membership to those directly involved and use one‑member‑one‑vote rather than proportional voting.
• The form chosen affects how transactions with owners (drawings, capital contributions) are recorded and disclosed.

Users of Accounting Information

Accounting is the language of business; financial statements communicate a company’s performance concisely. Different decision-makers rely on these statements to assess the business’s health, profitability, and risk. Each group has a specific interest:

Primary Users & Their Information Needs

Exam tip: Know the reason each group uses financial information, not just the list. For example, lenders focus on repayment capacity; employees care about job security; customers care about long-term viability.

Key takeaways

• Accounting information serves multiple stakeholders, each with a unique decision.
• Investors (existing and prospective) and lenders are the most direct users.
• Suppliers extend credit (30–60 days) based on the buyer’s financial standing.
• Government uses statements for taxation and economic planning.
• Long-term customers (e.g., defense, IT outsourcing) need assurance of the supplier’s survival.
• Credit rating agencies translate financial health into symbols (e.g., AAA).

Double Entry System of Bookkeeping

Bookkeeping is the chronological recording of financial transactions in books of accounts. Every business transaction has a source document (invoice, voucher, bank receipt) that triggers the record. Modern software automates the process, but the underlying principle remains unchanged: double entry bookkeeping.

What is Double Entry?

Every financial transaction has two effects – a dual aspect. Recording both sides prevents errors and makes financial statement preparation straightforward.

• Credit purchase of raw material: (1) raw material increases, (2) a liability to pay the supplier arises.
• Cash purchase: (1) raw material increases, (2) cash decreases.

If only one side were recorded, finding the amount due to a supplier would require scanning every invoice – error-prone. Double entry avoids this by pairing every debit with a credit.

Types of Accounts

Double entry classifies all accounts into three groups to apply consistent rules.

Exam tip: The term “creditors account” is a representative personal account – it summarises all individual supplier balances in one ledger account. Individual supplier accounts are kept in a sub‑ledger.

Debit and Credit Rules

Debit (Dr) and Credit (Cr) are technical terms. The rules for each account type are:

• Personal account: Debit the receiver, Credit the giver.
• Real account: Debit what comes in, Credit what goes out.
• Nominal account: Debit expenses and losses, Credit income and gains.

Applying the rules – two base transactions

1. Credit purchase of raw material ₹100 lakhs from Sun Limited

• Accounts: Raw material (Real) – comes in → Debit. Sun Limited (Personal) – giver → Credit.
• Entry: Raw material A/c Dr ₹100L; Sun Limited A/c Cr ₹100L

2. Rent paid ₹3 lakhs to Mr. Vivek by bank transfer

• Accounts: Rent expense (Nominal) – expense → Debit. Cash & Bank (Real) – goes out → Credit.
• Entry: Rent expense A/c Dr ₹3L; Cash & Bank A/c Cr ₹3L

Exam tip: There is no “Mr. Vivek account” because full payment was made; only the cash outflow and expense need recording. Do not create a personal account if no future payment/receipt exists.

Worked Example: Mr. Ram’s Garment Business

Ten transactions show the full debit/credit logic. Assume all amounts in lakhs (₹L).

Key observations:

• The business and owner are separate ( entity concept ) – Mr. Ram’s capital is treated as a liability (personal account credit).
• Sales transaction requires two entries: (a) record the inflow of cash and income, (b) record the outflow of goods and expense (cost of sales).
• Credit purchases (Transaction 6) require a personal account for the supplier; cash purchases (Transaction 5) do not.

Key Takeaways

• Double entry means every transaction affects at least two accounts; one debit and one credit.
• Accounts are classified as Personal (individuals/entities), Real (assets), or Nominal (income/expenses).
• Debit/credit rules: Personal – Dr receiver, Cr giver; Real – Dr what comes in, Cr what goes out; Nominal – Dr expenses/losses, Cr income/gains.
• Always first understand the transaction, then identify accounts and their types, then apply the correct rule.
• The entity concept keeps the business separate from its owner – capital is credited to a personal account.
• Cash vs credit: cash transactions omit the personal account of the other party; credit transactions require it.

Subsidiary Books

Transactions of a similar nature—especially frequent ones—can be recorded in special subsidiary books instead of being entered individually in the journal. This simplifies the recording process and reduces clerical effort.

Why use a subsidiary book? If a business has 10 suppliers and buys from each 100 times a year, there are 1,000 purchase transactions. In every transaction the goods account is debited (the common element). Instead of making 1,000 separate journal entries, a Purchase Book is maintained. Only the supplier’s name and invoice amount are recorded as each purchase occurs. At the end of the month, all purchases are totalled and a single compound entry is made:

$$\text{Goods A/c Dr.} \quad \text{(total purchases)} \\ \qquad \text{To Sundry Creditors A/c} \quad \text{(total amount)}$$

The breakup of the total owed to each supplier is available in the Purchase Book itself – it acts as a detailed supporting record.

Similarly, a Sales Book can be used for credit sales, and any transaction type that is frequent and homogeneous can have its own subsidiary book. For example, Indian Oil Corporation might maintain a Transport Book to record thousands of invoices from transport operators each day.

Key idea: A subsidiary book is a time-saving device that groups similar transactions and summarises them into one entry per period.

Key Takeaways

• Subsidiary books are used for frequent, similar transactions (e.g., purchases, sales).
• The Purchase Book records supplier name and invoice amount; at month-end a single summary entry is posted.
• The detail (individual supplier balances) stays in the subsidiary book; the general ledger only sees the total.
• Any frequent, homogeneous stream of transactions can have its own subsidiary book.

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The Ledger

Even with subsidiary books, preparing financial statements directly from thousands of individual entries is impractical. All transactions must be consolidated by account so that the net balance of each account is known. This consolidation happens in the ledger.

A ledger is a register with a separate page (or section) for each account. In a manual system, each account page is divided into two sides: the left side for debits and the right side for credits.

Posting example – Grasim Limited

• Transaction 1: Purchased goods on credit for ₹30 lakhs. Journal entry: Goods A/c Dr. → Grasim A/c Cr.
• Transaction 2: Paid the ₹30 lakhs owed to Grasim. Journal entry: Grasim A/c Dr. → Cash/Bank A/c Cr.

The postings in the Grasim account (ledger):

Both sides total ₹30,00,000 → net balance = 0 (the account is settled).

Rules of posting (derived from the rules of debit and credit)

• Goods A/c (assets/expenses): Debit what comes in → goods arriving → debited.
• Cash/Bank A/c (assets): Credit what goes out → cash paid → credited.
• Grasim A/c (liability/payable): Credit the giver (supplier of goods) → credited when liability arises; Debit the receiver (payment to supplier) → debited when liability is settled.

Balance of an account

• If total debits > total credits → debit balance.
• If total credits > total debits → credit balance.

Trial Balance

After all postings, the debit and credit balances of every account are listed in a statement called the trial balance. The trial balance is the direct source for preparing the Profit and Loss Account and Balance Sheet.

Key Takeaways

• The ledger summarises all entries by account and gives the net balance of each.
• The left side is always debit, right side credit.
• Posting follows: debit what comes in, credit what goes out; debit the receiver, credit the giver.
• A trial balance lists all account balances; it is the stepping stone to financial statements.

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Subsidiary Ledgers

Just as subsidiary books simplify recording, subsidiary ledgers simplify summarisation by separating detailed account information from the main ledger. In practice, it is common to maintain:

• Sundry Creditors Ledger (or Accounts Payable Ledger) – contains individual accounts of all suppliers.
• Sundry Debtors Ledger (or Accounts Receivable Ledger) – contains individual accounts of all customers.

The main ledger, called the General Ledger (GL) , holds only one control account for each group:

• Sundry Creditors A/c (in GL) – shows the total amount owed to all suppliers.
• Sundry Debtors A/c (in GL) – shows the total amount owed by all customers.

All purchase/sales entries and payment/receipt transactions are summarised and posted to these GL control accounts. The net balance of Sundry Creditors A/c tells the business how much it must pay to its suppliers in aggregate; the balance of Sundry Debtors A/c tells how much it must collect from customers.

The breakup (individual amounts due to each supplier or from each customer) is maintained in the respective subsidiary ledger. The total of all individual balances in the subsidiary ledger must equal the balance of the GL control account.

Exam tip: The GL control account and the subsidiary ledger must always reconcile. If they differ, a posting error has occurred – a classic exam question.

Key Takeaways

• Subsidiary ledgers hold detailed accounts (e.g., each supplier, each customer).
• The General Ledger contains only control accounts (Sundry Creditors, Sundry Debtors) with summary totals.
• The net balance of the control account equals the sum of individual balances in the subsidiary ledger.
• This two‑tier system keeps the GL clean while preserving detail for day‑to‑day management.

Accounting Equation and Financial Statements

The accounting equation is the foundation of double-entry bookkeeping:

$$\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$$

• Assets (left side): resources the business owns – uses of capital.
• Liabilities + Owner's Equity (right side): sources of capital – where the money came from.

Intuitively: every rupee a business holds has a source (owners or creditors) and a use (cash, building, inventory).

Expanded Accounting Equation

Revenue and expenses are temporary components of owner's equity because profit (or loss) belongs to the owners. The expanded equation is:

$$\text{Assets} = \text{Liabilities} + \text{Equity Share Capital} + (\text{Revenue} - \text{Expenses})$$

• Equity Share Capital: amount directly invested by owners.
• Revenue − Expenses = net profit (or loss) retained in the business. If owners withdraw dividends, that amount is subtracted from profit, and the remainder adds to equity.

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Recording Ten Transactions Using the Expanded Equation

Each transaction is recorded as equal entries on the left (assets) and right (liabilities + equity) – or as offsetting entries on the same side. The equation always balances.

Exam tip: A credit purchase (transaction 6) creates a liability – it is not an expense until the goods are sold. Inventory remains an asset until sold, then becomes Cost of Sales.

Verification: The Equation Holds

Total all asset changes: +100 +50 –20 –5 –20 +15 +30 –30 –20 +15 –10 –30 –2 –3? Let's sum systematically.

Summing the final balances gives Assets = 150, Liabilities = 50, Equity Share Capital = 100, Revenue = 15, and Expenses = 15. Net profit is therefore 0, so $150 = 50 + 100 + (15 - 15)$.

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Deriving Financial Statements from Transaction Balances

After all ten transactions, compute each account balance:

Income Statement (Profit & Loss)

Reports performance over the period:

No profit or loss – all revenue offset by expenses.

Balance Sheet

Shows financial position at a point in time:

The left side lists sources of capital; the right side lists uses. The two sides always equal.

Exam tip: The income statement explains why owner's equity changed (profit or loss). The balance sheet shows the result of all transactions – assets funded by liabilities and equity. Memorise the expanded equation – it directly links the two statements.

Key Takeaways

• Accounting equation: Assets = Liabilities + Owner's Equity. Expanded: includes Revenue – Expenses under equity.
• Every transaction affects at least two accounts; the equation always balances.
• Purchasing inventory (goods) is an asset exchange, not an expense – expense only when sold.
• The income statement summarises revenues and expenses over a period; balance sheet summarises assets, liabilities, and equity at a point in time.
• The final balances from the equation directly populate both financial statements.
• In this case, revenue (15) = total expenses (15), so net profit = zero – but inventory of 40 remains to be sold for future profit.

Double Entry System – Worked Example with 10 Transactions

The double entry system records every financial transaction in at least two accounts, ensuring that the basic accounting equation stays balanced. Each transaction has a debit entry and an equal credit entry. This worked example follows a single business (Mr. Ram’s garments shop) through 10 transactions – from initial investment to final financial statements – using both the manual double‑entry process and a faster accounting‑equation approach.

Transaction Recording – Identifying Accounts and Applying Rules

For each transaction, two accounts are identified. The rules for debiting and crediting depend on the account type:

The 10 transactions are recorded as follows (amounts in ₹ lakhs):

Exam tip: For sales, remember to record both the revenue entry (increase cash, credit sales) and the cost‑of‑goods‑sold entry (debit cost of sales, decrease goods). Omitting the cost entry would misstate inventory and profit.

Ledger Posting – T‑Accounts

Each account is opened as a T‑account with a debit side and a credit side. Transactions are posted by writing the amount on the appropriate side and the name of the other account as a cross‑reference.

Example: Cash & Bank Account

(Balance b/d on debit side: ₹85)

The same process is repeated for all accounts. Accounts with only one transaction (e.g., Capital, Building, Furniture, SBI Loan, Sales, Cost of Sales, Salary, Maintenance) need no further calculation – their balance equals that single amount. Accounts with multiple entries (Cash, Goods) require balancing.

Summary of Ledger Balances

Trial Balance – Verifying Arithmetic Accuracy

The balances from all accounts are transferred to a trial balance, listing debit and credit totals. Equality of the two totals indicates that no recording or arithmetic error has occurred (though it does not catch every type of mistake).

Financial Statements

Profit & Loss Account (Income Statement)

Balance Sheet

The balance sheet can also be presented in a vertical format (assets = equity + liabilities).

Accounting Equation Approach – A Faster Alternative

Instead of posting to T‑accounts manually, the same result appears by directly applying the accounting equation:

$\text{Assets} = \text{Liabilities} + \text{Equity}$

Each transaction is recorded in a spreadsheet as a change (positive or negative) to the relevant account. For example:

Summing each column gives the same ledger balances as before. From these balances the trial balance and financial statements are prepared identically.

The Complete Accounting Cycle

Key takeaways

• Every transaction is recorded in at least two accounts – one debit, one credit – of equal value.
• The rules for debiting/crediting depend on the account type (real, personal, nominal).
• Ledger accounts are balanced to obtain individual account balances.
• A trial balance sums all debit and credit balances; equality suggests arithmetic correctness.
• The profit & loss account matches revenues against expenses to find profit (here, zero).
• The balance sheet lists assets, liabilities, and equity, and must balance.
• The accounting‑equation approach (spreadsheet) achieves the same result more quickly by tracking changes directly.

Purpose of Financial Accounting

Financial accounting is the systematic recording of financial transactions followed by summarisation into three core statements: income statement, balance sheet, and cash flow statement.

• Income Statement (Profit & Loss Account): Shows revenue earned and expenses incurred to earn that revenue. The difference is profit or loss.
• Balance Sheet: Shows where capital was raised (liabilities + equity) and where it is deployed (assets).
• Cash Flow Statement: Summarises all cash transactions (covered in a later session).

Intuition: Think of the balance sheet as a snapshot of financial position at a point in time, the income statement as a video of performance over a period, and the cash flow statement as the actual cash movements behind that video.

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Forms of Business Organization

Accounting principles apply to all forms, but the legal structure affects owner liability and capital sourcing.

Exam tip: The distinction between unlimited and limited liability is the most tested concept from this section. Unlimited means creditors can go after personal assets of owners; limited means owners lose only their investment.

Key takeaways

• Sole proprietorships and partnerships have unlimited liability; companies (private/public) have limited liability.
• Cooperative societies are member-owned and often formed by small producers.
• The form of organisation does not change accounting rules, but it changes how equity and capital are recorded.

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Users of Financial Accounting Information

Accounting serves a wide range of stakeholders. Each user focuses on different aspects.

Intuition: Profitability tells “is the business making money?”; solvency tells “will it survive long enough to pay what it owes?”

Key takeaways

• Different users need different slices of the same data.
• Profitability drives dividend decisions and wage talks; solvency drives credit decisions and long‑term contracts.

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Bookkeeping and the Accounting Process

Double-Entry Bookkeeping

Bookkeeping is the first step: every financial transaction is recorded as it occurs. The double-entry system records two effects of every transaction – one increase/decrease in an asset, and a corresponding increase/decrease in a liability or equity.

• Example: Taking a loan → Cash (asset) increases AND Loan (liability) increases.
• Recording initially used rules of debit and credit (manual bookkeeping).

From Transactions to Financial Statements

The process flows:

• Ledger: A book containing all accounts; each account accumulates multiple entries. Periodically the net balance of each account is found.
• Trial Balance: A table that summarises net balances of all accounts – used as a check and a bridge to financial statements.

The Accounting Equation

The traditional equation is $\text{Assets} = \text{Liabilities} + \text{Equity}$. The expanded accounting equation is:

$\text{Assets} = \text{Liabilities} + \text{Equity Share Capital} + \text{Revenue} - \text{Expenses}$

This expanded form shows that revenue increases equity, expenses decrease equity, and the equation always stays in balance.

By entering transactions into the expanded equation, net balances can be extracted to prepare a trial balance, then the income statement and balance sheet.

Key takeaways

• Double-entry ensures the accounting equation remains balanced.
• The manual sequence: Journal → Ledger → Trial Balance → Financial Statements.
• The accounting equation can be used directly to record transactions and derive statements.

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Closing Note

Practice bookkeeping and statement preparation with a comprehensive exercise.

Overall Key Takeaways (for this summary)

• Financial accounting transforms raw transactions into three statements (Income, Balance, Cash Flow).
• Business form determines liability – unlimited for proprietorships/partnerships, limited for companies.
• Users include internal and external parties with different needs (profitability vs. solvency).
• Bookkeeping uses double-entry; the expanded accounting equation is a modern tool to record and summarise transactions.
• Trial balance is the precursor to the income statement and balance sheet.

Comprehensive Accounting Exercise: Pharma Asia Limited

This exercise walks through the complete accounting cycle for a new company: recording transactions in the accounting equation, preparing a trial balance, making adjusting entries, and finally producing the Profit & Loss Account and Balance Sheet.

The Accounting Equation

For every transaction, Assets = Liabilities + Equity. Equity consists of contributed capital plus retained earnings (revenues – expenses). Expenses reduce equity; revenues increase it.

Step 1: Recording Transactions

All transactions are recorded in a spreadsheet with columns: Date, Details, Asset accounts (name + change), Liability accounts, Equity share capital, Revenue accounts, Expense accounts.

Capital & Loans (Initial)

Interest is recorded only when paid or accrued – no entry at loan receipt.

Asset Purchases & Payments

Revenue & Operating Expenses

Step 2: Trial Balance

After sorting the spreadsheet, all accounts with balances are summarised. Key balances (in lakhs of ₹):

Total assets = 3726, total liabilities = 2138, total revenue = 2790, total expenses = 2002 (before adjustments). The accounting equation balances: 3726 = 2138 + 800 + 2790 – 2002 = 3726.

Step 3: Adjusting Entries

Adjustments ensure revenues and expenses are recognised in the correct period. They affect both the income statement and balance sheet.

Closing Stock of Raw Material

Raw material purchased total = 150+50+300+200+500+300+700 = 2200 lakh. Physical count shows 1200 lakh on hand. Therefore consumption = 2200 – 1200 = 1000 lakh. Entry: reduce Raw Material (asset) by 1000, increase Raw Material Consumption (expense) by 1000.

Depreciation

Compute using straight-line for the months the asset was in use.

Each is recorded as expense and accumulated depreciation (contra-asset). Net book values: Building 114, Machinery 550, Furniture 55.5.

Prepaid Rent

Rent of 30 lakh (15+15) was paid for the full year. The accounting period ends 30 Sep, so only 9 months should be expensed (30 × 9/12 = 22.5). The remaining 7.5 lakh for Oct–Dec is prepaid rent (asset). Entry: increase Prepaid Rent 7.5, reduce Rent Expense 7.5.

Prepaid Insurance

Annual insurance premium 12 lakh paid 1 Sep. Only one month (Sep) is expense – 1 lakh. The rest 11 lakh is prepaid insurance (asset). Entry: increase Prepaid Insurance 11, reduce Insurance Expense 11.

Accrued Interest

Interest on loans is paid semi-annually (June and December). For the period Jul–Sep (3 months), interest has accrued but not paid.

• Term loan: $800 \times 12\% \times \frac{3}{12} = 24$ lakh
• Working capital loan: $400 \times 14\% \times \frac{3}{12} = 14$ lakh
• Total accrued interest = 38 lakh.

Entry: Increase Interest Expense 38, increase Interest Payable (liability) 38.

Income Tax

After all adjustments, total revenue is ₹2,790 lakh and total expenses are ₹2,002 lakh:

$\text{Profit before tax}=2{,}790-2{,}002=\text{Rs. }788\text{ lakh}$

Tax at 30% is ₹236.4 lakh. The adjusting entry increases both Income Tax Expense and Income Tax Payable by ₹236.4 lakh.

Step 4: Profit & Loss Account (for period ending 30 Sep)

Step 5: Balance Sheet (as at 30 Sep)

Assets (₹ Lakh)

Equity & Liabilities

Exam tip: The profit after tax from the P&L account is added to equity (retained earnings) – this is the connection between the two statements. Always check that total assets = total equity + total liabilities.

The Accounting Cycle – Flowchart

Key Takeaways

• Each transaction must keep Assets = Liabilities + Equity.
• Revenues increase equity; expenses decrease equity.
• Adjusting entries (depreciation, prepaids, accruals, closing stock, tax) are necessary to match revenues and expenses to the correct period.
• The trial balance lists all accounts with balances – the starting point for financial statements.
• Profit after tax flows to the balance sheet as retained earnings (part of equity).
• Working capital = current assets – current liabilities; a positive value indicates liquidity.