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Home » Blog » Introduction to Final Accounts and Accounting Treatment

Introduction to Final Accounts and Accounting Treatment

  • Account & Audit|Blog|
  • 10 Min Read
  • By Taxmann
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  • Last Updated on 4 August, 2022

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Final Accounts

Table of Contents

1. Introduction

2. Basic Principles Governing Final Accounts

3. Trading Account

4. Profit & Loss Account

5. Balance Sheet

After reading this article, you will be able to understand the following:
    • Know the Meaning of Financial Statements
    • Learn the fundamentals of Final Accounts
    • Identify the type of expenditure-Capital and Revenue
    • Prepare Income Statement and Balance Sheet
    • Understand the closing and adjustment entries

1. Introduction to Final Accounts

The primary function of accounting includes computing the net result of operations of the business for the current period. To meet out this purpose, Income statement and Balance sheet are prepared. These two documents are popularly called as Final Accounts. It is the last phase of Accounting Process.

The components of final accounts depend upon the type of entity. In case of non-manufacturing entities, the business operations include purchase and sale of goods. That is why Trading Account is prepared to calculate Gross Profit. But a manufacturing entity is interested in computation of total cost of manufacturing the finished products. For this purpose, separate account is prepared as Manufacturing Account. The following table shows the components of final accounts for manufacturing and non-manufacturing firms:

Manufacturing firm Non-Manufacturing Firm
1 Manufacturing A/c 1 Trading a/c
2 Trading a/c 2 Profit and Loss A/c
3 Profit and Loss A/c 3 Balance Sheet
4 Balance Sheet

The process of final accounts starts after preparation of trial balance. It is mainly divided into following two parts:

1. Income Statement: It is prepared to find out the net result of the operations. It is sub-divided into two parts:

a. Trading Account

b. Profit and Loss Account

2. Position Statement: It includes Balance Sheet showing the status of assets and liabilities as at a particular point of time.

2. Basic Principles Governing Final Accounts

There final account are required to be prepared in such a manner so that the income statement and Balance sheet show true and fair view of profitability and financial position of the business. The following are also considered in this regard:

    1. In the preparation of final accounts, proper distinction is required between capital and revenue items. If a capital expenditure is wrongly charged as revenue, then it will lead to undervaluation of profits.
    2. The profitability of the firm can be known if and only if all personal incomes and expenditure are separately treated from the business income and expenditures.
    3. Any such item or information, disclosure of which is material to judge the profitability, should be disclosed appropriately.
    4. The matching principle should be applied strictly which requires that expenses incurred to earn the revenue should be properly matched. For example if during the year 1,000 units have been purchased but 850 units have been sold, then cost of goods sold should be calculated in respect of 850 units and this cost should be compared with the corresponding sale proceeds.
    5. When revenue nature expenses have been incurred but the amount is heavy and the benefits are expected to be received in future also. Then a portion is charged in current period and remaining should be deferred for to be charged in future periods.
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3. Trading Account

In the process of preparation of final accounts, the first step is to calculate the amount of gross profit earned or gross loss incurred. The gross profit is the excess of sales over cost of goods sold. It is the first stage in the preparation of final accounts of a trading concern and the result of this account is transferred to Profit and Loss Account.

The Trading Account is prepared in T shape format. The items to be debited include the following:

1. Opening Stock:
It refers to the closing inventory of the last year entered in the books through the opening entry. Therefore, it always appears in the trial balance. It is important to note that in the first year of its operations, there will be no opening stock.

2. Purchases and purchases returns:
The Purchases account will have debit balance and it shows the gross amount of purchase of goods and materials for the purpose of resale or to be used in production. It includes both cash and credit purchases. On the other hand, Purchases returns account will have credit balance. The net purchases are debited to Trading Account. Besides purchases returns, following are also deducted from purchases:

(a) Goods given as Charity

(b) Goods given as sample

(c) Goods taken by the proprietor for personal use.

3. Direct Expenses:
These expenses are incurred on goods purchased, till they are brought to the place of business for sale. In addition, expenses incurred on production such as wages, power and fuel, factory rent, etc. are also treated as direct expenses. The following are some of the important direct expenses:

(a) Carriage or freight or cartage inwards:
It refers to the cost of bringing materials to the godown of the firm and making them available for use. It is important to note that if such expenses are in connection with the purchase of fixed asset, then the same are capitalised and not taken to Trading account.

(b) Manufacturing Wages:
Wages paid to workers in the godown/stores, should be debited to the trading account. If any amount is outstanding, it must be brought into books so that full wages for the period concerned are charged to the trading account. However, if wages are paid for installation of an asset, it should be added to the cost of the asset.

3.1 The Trading Account is credited with the following:

1. Sale and sales returns:
It reflects the total sale of goods by the firm during the period. It includes both cash as well as credit sales. The amount does not include sales tax or Value Added Tax. There may be sales returns also. So, net sales are to be disclosed to the credit of Trading Account.

2. Closing Stock:
It refers to the unsold goods lying in the godown of the firm at the end of the period. As per the convention of conservatism, this stock is always valued at lower of cost and net realizable value. It is usually given outside the trial balance as an adjustment and is recorded in the books through the following adjustment entry:

Closing Stock Account Dr. XXX
To Trading A/c XXX

3.2 Balancing of Trading Account

After having entered, the items to the relevant sides of Trading Account, the totals of debit side and credit side are compared. If the total of the credit side is more than that of the debit side, the excess is Gross Profit.

3.3 Closing entries in respect of Trading Account

The following are the relevant closing entries:

1. For items on the debit of Trading Account:
Trading Account Dr. XXX
To Opening Stock Account XXX
To Purchases Account XXX
To Wages Account XXX
To Power and Fuel Account XXX
2. For items on the Credit of Trading Account:
Sales Account Dr. XXX
Closing Stock Account Dr. XXX
To Trading Account XXX
3. For Gross Profit:
Trading Account Dr. XXX
To Profit and Loss Account XXX
In case of loss, following entry would be passed:
Profit & Loss Account Dr. XXX
To Trading Account XXX

3.4 Format of Trading Account

The format of Trading Account is as follows:

Particulars Amount Particulars Amount
To Opening Stock XXX By Sales XXX
To Purchases XXX Less: Returns (XXX) XXX
Less: Returns (XXX) XXX By Closing Stock XXX
To Wages XXX By Gross Loss transferred to Profit and Loss A/c XXX
To Direct Expenses XXX
To Carriage Inwards XXX
To Freight, Octroi and Cartage XXX
To Gross Profit transferred to
Profit and Loss A/c XXX
XXX XXX

Illustration 1

Manu Enterprises has provided you the following information for the year ending 31st March, 2019. Prepare Trading Account.

`
Stock as on 1st April, 2018 50,000
Octroi 18,000
Freight 11,000
Carriage Inwards 7,000
Wages 40,000
Sales (Gross) 11,13,000
Sales Returns 19,000
Purchases of Stock 9,00,000
Returns Outwards 30,000
Closing Stock as on 31-3-2019 42,000

Solution

In the books of Manu Enterprises

Trading account

For the year ended 31st March, 2019

Particulars Amount Particulars Amount
To Opening Stock 50,000 By Sales 11,13,000
To Purchases 9,00,000 Less: Returns (19,000) 10,94,000
Less: Returns (30,000) 8,70,000 By Closing Stock 42,000
To Wages 40,000
To Octroi 18,000
To Carriage Inwards 7,000
To Freight 11,000
To Gross Profit transferred to Profit and Loss A/c 1,40,000
11,36,000 11,36,000

4. Profit & Loss Account

It is prepared to calculate the net profit earned or net loss incurred by the firm in a particular accounting period. This account starts with the amount of gross profit (or loss) reflected by Trading Account. The gross profit appears to the credit side and gross loss to the debit side. All indirect expenses are transferred to the debit side of Profit and Loss Account. The administrative expenses include salaries, printing and stationery, postage, audit fees, rent and rates, etc. The expenses are also debited to Profit and Loss Account. These expenses are salesmen’s salaries, packing charges, advertisement expenses, export duties, bad debts, commission to agents, etc. There are some indirect incomes also like dividend received, profit on sale of investments or machinery, interest received, etc. These are credited to P & L A/c.

4.1 Items Debited to Profit & Loss A/c

1. Administrative Expenses:

(a) Office Salaries

(b) Office Rent and Rates

(c) Lighting

(d) Audit Fees

(e) General Expenses

(f) Printing and Stationery

2. Selling and Distribution Expenses:

(a) Salesmen’s Salaries

(b) Godown Rent

(c) Advertising

(d) Delivery Van Expenses

(e) Freight and Carriage on sales

(f) Packing expenses

3. Finance Charges:

(a) Interest on Loan

(b) Interest on bank overdraft

(c) Interest element in Finance Lease

4. Abnormal Items:

(a) Loss by theft

(b) Loss on sale of fixed assets

(c) Loss by fire to the extent not covered by insurance

4.2 Items Credited to Profit & Loss A/c

    1. Gross Profit as per Trading account
    2. Interest received
    3. Rent received
    4. Discount received
    5. Profit on sale of fixed assets
    6. Extraordinary gain

NOTE: The following items are shown separately in P & L A/c, one to the debit side and other to the credit side:

    1. Interest expense and interest received
    2. Discount allowed and discount received
    3. Bad debts and bad debt recovered

4.3 Closing entries in respect of Profit and Loss Account

The following are the relevant closing entries:

1. For items on the debit of P & L A/c:
Profit & Loss Account Dr. XXX
To Salaries Account XXX
To Advertising Account XXX
To Interest Account XXX
To Rent Account XXX
2. For items on the Credit of P & L A/c:
Interest Received Account Dr. XXX
Bad Debt recovered Account Dr. XXX
To Profit & Loss Account XXX
3. For Net Profit:
Profit & Loss Account Dr. XXX
To Capital Account XXX
In case of loss, following entry would be passed:
Capital Account Dr. XXX
To Profit & Loss Account XXX

4.4 Format of P & L Account

The format of Profit & Loss Account is as follows:

Particulars Amount Particulars Amount
To Depreciation XXX By Gross Profit XXX
To Legal Expenses XXX By Rent Received XXX
To Loss by Fire XXX By Commission Received XXX
To Salaries paid XXX Less: Advance (XXX) XXX
ADD: Outstanding XXX XXX By Bad Debt Recovered XXX
To Interest Expense XXX By Miscellaneous Income XXX
To Carriage Outwards XXX By Net Loss transferred to XXX
To Discount Allowed XXX Capital Account
To Net Profit transferred to  Capital A/c XXX
XXX XXX

Illustration 2

Consider the following information in relation with Sunrise Traders:

Gross profit ` 4,36,000, Discount Received ` 19,200, Salaries ` 99,840, Interest Received ` 8,800, Miscellaneous Income ` 13,920, Bank Charges ` 3,200, Consultancy fees ` 16,800, Loss by Fire ` 4,800, Depreciation ` 43,440, Audit fees ` 1,920, Electricity charges ` 17,840, Stationery ` 5,600, Legal charges ` 25,920, Discount allowed ` 21,600, Telephone, postage & Telegrams ` 11,200, Bad debts ` 8,560, Interest ` 40,800.

Prepare profit and loss account of Sunrise traders for the year ended on 31st march, 2019.

Solution

In the books of Sunrise traders

Profit & Loss Account

For the year ended 31st March, 2019

Particulars Amount Particulars Amount
To Salaries 99,840 By Gross Profit 4,36,000
To Bank Charges 3,200 By Interest Received 8,800
To Consultancy fees 16,800 By Miscellaneous Income 13,920
To Loss by Fire 4,800 By Discount Received 19,200
To Depreciation 43,440
To Audit fees 1,920
To Electricity charges 17,840
To Stationery 5,600
To Legal charges 25,920
To Discount allowed 21,600
To Telephone, postage & Telegrams 11,200
To Bad debts 8,560
To Interest 40,800
To Net profit 1,76,400
4,77,920 4,77,920

5. Balance Sheet

Balance Sheet is a statement showing the total assets and liabilities of an entity as at a particular date. It is important to note that Trading A/c and Profit & Loss A/c are prepared for a particular period as periodical statements. But Balance Sheet is a positional statement. It shows the financial position of the business on a particular date. Usually in case of non-corporate entities, Balance Sheet is prepared in horizontal format i.e. T shape format. In this case, the right and left hand sides of the balance sheets are called as Assets and Liabilities. Balance sheet is not an account rather it is simply a statement showing closing balances of real and personal accounts.

5.1 Arrangement of Assets and Liabilities

As such there is no prescribed format of balance sheet for non-corporate business entities. Here two terms “Grouping” and “Marshalling” are important. Grouping means putting together items of similar nature under a common heading like current assets, fixed assets, etc. Marshalling means the order in which the various items are shown in the Balance Sheet. This order may be liquidity or permanence.

5.2 Format of Balance Sheet (In order of Liquidity)

Liquidity means the most liquid asset like cash is shown first and least liquid assets like Goodwill is disclosed in last.

Assets Amount Liabilities Amount
Bills Payable XXX Cash in hand and at Bank XXX
Sundry Creditors XXX Short term Investments XXX
Outstanding Expenses XXX Bills Receivable XXX
Short term Loans XXX Sundry Debtors XXX
Long term loans XXX Closing Inventory XXX
Reserve and Surplus XXX Long Term Investments XXX
Capital XXX Furniture XXX
Plant and Machinery XXX
Goodwill XXX
XXX XXX

5.3 Format of Balance Sheet (In order of Permanence)

Permanence means the permanent i.e. least liquid item is shown first and most liquid item is shown in last.

Assets Amount Liabilities Amount
Capital XXX Goodwill XXX
Reserve and Surplus XXX Plant and Machinery XXX
Long term loans XXX Furniture XXX
Short term Loans XXX Long Term Investments XXX
Outstanding Expenses XXX Closing Inventory XXX
Sundry Creditors XXX Sundry Debtors XXX
Bills Payable XXX Bills Receivable XXX
Short term Investments XXX
Cash in hand and at Bank XXX
XXX XXX

Illustration 3

After having prepared the Trading and Profit and Loss Accounts, Vipul Enterprises provides the following information:

Cash at Bank 32,000
Cash in hand 10,500
Goodwill 25,000
Capital 7,00,000
Plant and Machinery (Cost ` 2,45,000) 1,96,000
Land and Building (Cost ` 4,75,000) 3,80,000
Furniture (Cost ` 80,000) 60,000
Long Term Investments 40,000
Closing Inventory 28,500
Debtors (Less: Provision for bad debts 4,000) 76,000
Bills Receivable 18,000
Short term Loans 12,800
Bills Payable 12,600
Net Profit 99,600
Sundry Creditors 45,000
Drawings 15,000
Outstanding Salaries 11,000

Solution

In the books of Vipul Enterprises

Balance Sheet

As on 31st March, 2019

Assets Amount Liabilities Amount
Capital 7,00,000 Goodwill 25,000
Add: Net Profit 99,600 Plant and Machinery 2,45,000
Less: Drawings (15,000) 7,84,600 LESS: P. Depreciation (49,000) 1,96,000
Short term Loans 12,800 Land and Building 4,75,000
Sundry Creditors 45,000 LESS: P. Depreciation (95,000) 3,80,000
Outstanding Salaries 11,000 Furniture 80,000
Bills Payable 12,600 LESS: P. Depreciation (20,000) 60,000
Long Term Investments 40,000
Closing Inventory 28,500
Debtors 80,000
LESS: P. Bad Debts (4,000) 76,000
Bills Receivable 18,000
Cash at Bank 32,000
Cash in hand 10,500
8,66,000 8,66,000

Also Read:
Golden Rules of Accounting
Method of Accounting
Indian Accounting Standards

Tags:accounting Accounting Treatment Final Accounts

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Author: Taxmann

Taxmann Publications has a dedicated in-house Research & Editorial Team. This team consists of a team of Chartered Accountants, Company Secretaries, and Lawyers. This team works under the guidance and supervision of editor-in-chief Mr Rakesh Bhargava.

The Research and Editorial Team is responsible for developing reliable and accurate content for the readers. The team follows the six-sigma approach to achieve the benchmark of zero error in its publications and research platforms. The team ensures that the following publication guidelines are thoroughly followed while developing the content:

  • The statutory material is obtained only from the authorized and reliable sources
  • All the latest developments in the judicial and legislative fields are covered
  • Prepare the analytical write-ups on current, controversial, and important issues to help the readers to understand the concept and its implications
  • Every content published by Taxmann is complete, accurate and lucid
  • All evidence-based statements are supported with proper reference to Section, Circular No., Notification No. or citations
  • The golden rules of grammar, style and consistency are thoroughly followed
  • Font and size that's easy to read and remain consistent across all imprint and digital publications are applied
View all posts by Taxmann

Author TaxmannPosted on July 25, 2022August 4, 2022Categories Account & Audit, BlogTags accounting, Accounting Treatment, Final Accounts

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