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Balance Sheet is a statement showing the financial position of a business entity on a particular day. It shows the liabilities and assets of the business. It consists of items from the trial balance.

Trial balance is the third step after passing journal entries and posting in ledgers. The trial balance is the summary of all the accounts based on the ledger balance. It is an account prepared to check the athematic accuracy of the debit and credit balances are equal and accurate.

Steps to Prepare Balance Sheet from Trial Balance

All the debit side items related to assets listed in the trial balance shall be posted on the assets side of the balance sheet. All the credit side items related to capital and liabilities listed in the trial balance shall be posted on the liabilities side of the balance sheet.

1. Post the amount of capital on the liabilities side of the balance sheet under the head “capital & reserves”.

2. Then, the net profit or net loss ascertained while preparing the income statement shall be added or reduced respectively from the amount of capital.

3. Now, post all the “non-current liabilities” such as long-term bank loans, long-term debentures issued, etc. on the balance sheet’s liabilities side.

4. Then, post the “current liabilities” such as sundry creditors, bills payable, etc. Incorporate necessary adjustments related to outstanding expenses and pre-received income.

5. Moving to the asset side, start with the head “non-current assets”.

6. First, post the tangible assets under the head “non-current assets” such as plant & machinery, land & building, etc. Calculate depreciation/accumulated depreciation on the tangible assets and deduct the same to arrive at the net value.

7. Second, post the intangible assets under the head “non-current assets” such as software, goodwill, etc. Calculate amortization/accumulated amortization on the intangible assets and deduct the same to arrive at the net value.

8. Now, post all the long-term investments acquired such as bonds and debentures under the head “non-current assets”.

9. After posting all the non-current assets move forward to posting the “current assets” on the asset side of the balance sheet,

10. Post “current assets” such as cash in hand, cash at the bank, sundry debtors, bills receivable, etc. Incorporate necessary adjustments related to provisions for doubtful debts, prepaid expenses, and outstanding income,

11. Post the amount of closing stock given in the adjustments under the head “current assets”.

12. The final step is totaling both the liability and asset sides. Both sides of the balance sheet should be of an equal amount.

These steps complete the preparation of the balance sheet from the trial balance.

Illustration

A snippet of the trial balance and balance sheet has been attached for better understanding.

Adjustments

1. Closing stock as on 31st March yyyy is 2,00,000.
2. The salary outstanding for March yyyy is 60,000.
3. Depreciation @10% to be charged on Plant and machinery.
4. Amortization @10% charged on computer software.

Prepare a Balance Sheet from the above-given trial balance. Net Profit for the year ended 31/03/YYYY is 610,000.

Conclusion

• It is important to record the balances of ledger posts of different accounts in the trial balance since it helps the company know if their postings are right or wrong when there is a match or mismatch in the debit or credit side of the trial balance.
• The trial balance is later used to make the balance sheet, which is the most important financial statement as it determines the business’s financial position.
• All the credit sides of the trial balance are treated as liabilities and posted in the balance sheet based on the headings such as debt and equity, reserves and surplus, long-term borrowings, short-term borrowing, and current liabilities.
• All the debit side of the trial balance is treated as assets and posted on the asset side of the balance sheet based on the heading like tangible, intangible assets, current assets etc.

Every year or after a certain period, the ledger accounts are balanced after posting the transactions. The difference in the totals of the two sides of an account is written on the side with the smaller total. The debit balance of a trading account means the company has incurred a gross loss for that period. Let us break this down for you,

Debit Balance

While preparing an account, if the debit side of an account is greater than the credit side, the difference is called “Debit Balance”. In short, if Dr. Side > Cr. Side, it is said to have a debit balance.

Assets have a debit balance, and Liabilities have a credit balance. Similarly, Expenses have a debit balance, and Revenues have a credit balance.

Due to the fact that they are the balancing figures, a debit balance appears on the credit side while a credit balance appears on the debit side.

Related Topic – Debit Balance and Credit Balance in Accounting (Detailed)

Meaning in Trading Account and What it Indicates

A trading account is a financial statement which records all the trading activity (buying and selling) of the firm’s main products/services during an accounting period. As part of the preparation of final accounts, this is the first financial statement prepared.

The debit side shows “opening stock” + “expenses“, whereas the other side has “closing stock” + “revenues“.

As a result, if the left side (Dr.) is greater than the right side (Cr.), expenses will exceed revenues, resulting in a loss.

Note: Direct expenses are shown in the trading account, whereas indirect expenses are shown in the income statement.

The debit balance of a trading account means gross loss. However, a credit balance of the trading account indicates a gross profit. This signifies that the company lost more money than it made. This number is transferred to the debit side of a profit & loss account to further calculate net profit or a net loss.

Related Topic – What are Sales Returns and Allowances?

Example Showing Gross Loss

Prepare a trading account for the year ending 31 Mar YYYY from the following balances. This example has deliberately been chosen to show the debit balance of the trading account.

Closing stock is valued at 30,000 at the year-end.

Trading Account for the year ending 31 Mar YYYY

Related Topic – Is Purchase Return a Debit or Credit?

Short Quiz for Self-Evaluation

Related Topic – Treatment of Closing Stock in Trading Account

Frequently Asked Questions Related to this Topic

A question that is commonly asked around this topic is,

Question – 1 – Select the most appropriate alternative from those given below:

Debit balance of Trading Account means _____?

1. Gross Loss
2. Net Loss
3. Net Profit
4. Gross Profit

Answer – The answer is A. The reason is clearly explained in the above text in this article.

Question – 2 – What is debit side of trading account?

Answer – The debit side of a trading account shows a combination of Opening Stock, Purchase & Return Outwards, and Direct Expenses.

Question – 3 – Trading Account is a _____ account?

1. Personal
2. Real
3. Nominal
4. Valuation

Answer – The answer is C. It is a nominal account prepared at the end of an accounting period.

Related Topic – Trading Expenses in Final Accounts

Conclusion

A trading account is an important indicator used by various internal and external parties to know the overall business performance and efficiency.

• To summarize, a trading account is a type of financial statement that is utilised by companies in order to keep track of the buying and selling activities that take place during an accounting cycle.
• The reason why it is so crucial is that it helps to determine whether the company made a profit or a loss during the year.
• A debit balance of the trading account represents that it has a greater debit side as compared to the credit. It shows that the company has suffered a loss from trading activities, which is an indication that more money has been lost than earned.
• A gross loss is then transferred to the debit side of the profit and loss account in order to further calculate net profit or a net loss.

The ability of a company or individual to meet its financial goals can be negatively affected by a gross loss. If a company suffers a gross loss, it may have difficulty paying its bills in the future. Therefore, it may need to borrow or dissolve its assets to stay operational.

>Read Accounting Fundamentals Quiz – Level Intermediate (#3)

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Meaning of Bad debts

As we can see, the term ‘Bad Debt’ comprises of the word ‘bad’, which gives us a fair idea that it is something about the debtors who are not good for the business.

So basically, Bad Debt is the amount owed by the customer to the business which is now irrecoverable. It is an expense for the business and it may arise due to reasons such as fraud, insolvency of the debtor, etc. We can also refer to it as Uncollectible Accounts Expense and Irrecoverable Debts.

Yes, bad debts are recorded in the Income statement. The Income statement shows the aggregate financial position of a business during a specified period by displaying the amount of revenue generated and expenses incurred by a business. Bad debts being an expense are recorded under operating expenses in the Income Statement or on the debit side in the Profit & Loss a/c.

Example

ABC Ltd. sells goods to a retailer for 40,000 at 50 days credit. However, after 50 days, the company realizes that the retailer has been declared insolvent and the amount is no longer recoverable. This amount of 40,000 is an expense for ABC Ltd and leads to a fall in the accounts receivable.
The journal entries to be recorded in the books of ABC Ltd are as follows:

(being amounts written off as bad debts transferred to bad debts account)

(being bad debts transferred to profit and loss a/c)

Bad debts as shown in the Income statement

(Extract of Income Statement)

What are Retained Earnings?

Retained Earnings are the accumulated net income of an entity at the end of an accounting period that is retained by it to meet any future contingencies, invest in expansion activities, pay dividends to its shareholders, share buybacks, or issue bonus shares.

Retained Earnings are a part of “Shareholders Equity” presented on the “Liabilities side” of the balance sheet as it indicates the company’s liability to the owners or shareholders.

The company cannot utilize the retained earnings until its shareholders approve it. Thus, retained earnings are credited to the books of accounts when increased and debited when decreased. If the balance of retained earnings is negative, then it is referred to as accumulated losses/deficit, or retained losses.

As per the Modern Rules of Accounting

Retained Earnings (liability) are Credited (Cr.) when increased & Debited (Dr.) when decreased.

Why is it like this?

According to this rule, an increase in retained earnings is credited and a decrease in retained earnings is debited. This is a rule of accounting that cannot be broken under any circumstances.

How is it done?

1. Retained Earnings are credited with the Net Profit earned during the current period. Crediting the retained earnings will increase its balance.

Example

Samsung Inc. earned a net profit of 500,000 during the accounting period Jan-Dec 20×1. The company decided to retain the profits for that year and invest the retained earnings in expanding the business. This increase in retained earnings is credited to Retained Earnings Account.

Given below is the journal entry to be recorded: (Rule Applied – Cr. the increase in liability)

(Transferring net profit earned to retained earnings.)

2. Some instances which reduce the balance of retained earnings are-

a. Net loss during the current period
b. Dividend payable
c. Bonus Shares issued, etc.

Retained Earnings will be debited with these transactions.

Example

Shareholders of Apple Inc. approve the dividend declared by the board of directors amounting to 100,000. The dividend payable reduces the balance of retained earnings so it is debited in the financial books.

Given below is the journal entry to be recorded: (Rule Applied – Dr. the decrease in liability)

(Dividend to be paid from retained earnings.)

As per the Golden Rules of Accounting

Retained Earnings (Liability) are credited as per the Golden Rules

Since retained earnings are a part of shareholders’ equity, it is an obligation of the company to pay it back to the owners. Thus, it is a liability of the company and it is credited as per the golden rules of accounting for personal accounts.

Example

HP Inc. earned a net profit of 500,000 during the accounting period Jan-Dec 20×1. The company decided to retain the earnings for that year and utilize them for further growth. This is a liability (shareholders’ fund) of the company to pay the earnings back to the shareholders. Thus, the retained earnings are credited to the Retained Earnings Account.

Given below is the journal entry to be recorded: (Rule Applied – Cr. the giver)

(Transferring net profit earned to retained earnings.)

Retained Earnings inside the Balance Sheet

Retained earnings show a credit balance and are recorded on the balance sheet of the company. A balance sheet example showing retained earnings is provided below.

Conclusion

The key takeaways from the above discussion are:

• Retained earnings are the incomes retained by a business for future contingencies, reinvestment, expansion, or any other purpose.
• Retained Earnings are a part of “Shareholders Equity” presented on the “Liabilities side” of the balance sheet.
• If the balance of retained earnings is negative, then it is referred to as accumulated losses/deficit, or retained losses.

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Direct and Indirect expenses-

Direct expenses include all those expenses which have a direct connection with the manufacture of the goods (i.e., conversion of raw materials into finished products). Such expenses are direct expenses and are placed on the debit side of the trading account. These expenses are also called as manufacturing expenses.

Indirect expenses include all those expenses that are incurred to run business activities. These expenses have no direct connection with the manufacturing of goods. Such expenses are indirect expenses and are placed on the debit side of the profit & loss account. These expenses are also known as office expenses.

Difference between Direct Expenses and Indirect Expenses

The following are the differences between Direct Expenses and Indirect Expenses:

1. Direct Expenses:
   • Direct expenses are specifically tied to the production of goods or services.
   • They can be directly allocated to a particular product, service, or department.
   • Examples include raw materials, direct labor, manufacturing supplies, and shipping costs for goods sold.
   • Direct expenses vary with the level of production or output; as production increases, direct expenses also increase.
2. Indirect Expenses:
   • Indirect expenses are not directly associated with the production of goods or services but are necessary for the overall operation of the business.
   • They are often incurred for the benefit of multiple departments or the entire organization.
   • Examples include rent, utilities, administrative salaries, depreciation, and insurance.
   • Indirect expenses typically remain relatively constant regardless of the level of production or output.

List of Direct & Indirect Expenses

The following are the Direct Expenses and Indirect Expenses:

Conclusion

Direct expenses are directly related to the production process and can be allocated to specific products or services, while indirect expenses are more general and support the overall operation of the business.

>Related Long Quiz for Practice Quiz 23 – Direct and Indirect Expenses

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Yes, the cash book is both a journal and a ledger. 

To make the concept simpler, let us first be familiarized with the meaning of journals and ledgers, which shall help in determining the reasons for a cashbook to be both a journal as well as a ledger.

What is a Cashbook?

A Cashbook is a book of original entries that records all the cash and bank transactions. It may be a single-column, double-column, or triple-column cash book.

• Single-column Cash Book: In a single-column cash book, there is only one column and it records the cash transactions.
• Double-column Cash Book: In a double-column cash book there is one column each for cash and bank transactions.
• Triple-column Cash Book: In a triple-column cash book there are three columns, one each for cash transactions, bank transactions, and discounts allowed and received.

What is a Journal?

A Journal is a descriptive financial record of a business that is used for future reconciling as well as a transfer to other books of accounts such as the ledger. It is a book of original entries.

Cashbook is considered to be a journal because all the cash/bank receipts and payments are recorded in this book in a descriptive form similar to journal posting.

What is a Ledger?

In simple words, a ledger refers to recording individual accounts in a summarized form that are posted from a journal. It is a book of principal entries.

A cashbook is considered to be a ledger because all the cash transactions that are made during a particular financial period are recorded in this book in chronological order.

When a cashbook is prepared there is no need for a cash a/c as the book serves the same purpose and therefore, it can be used as a substitute.

What is the Format of a Cashbook?

The format of a Cash book is given in the image below:

Note: We may observe from the above image that the format and posting of a cashbook are similar to that of journal and ledger accounts. Therefore, it is right to say that a Cash book is both a Journal and a Ledger.

Conclusion

The above article may be summarised as follows:

• A Cashbook is a book of original entries that records all the cash and bank transactions.
• It is both a Ledger and a Journal.
• It may be a single-column, double-column, or triple-column cash book.
• It is a book of original entries, hence, it is considered a Journal.
• All the transactions of a year are recorded in the cash book and therefore, it is also a ledger.

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Every business organization uses inventory to generate sales. Inventory includes the raw material used to produce the goods, the goods which are yet to be completed (work-in-progress), and the finished goods which are ready to be sold.

If an organization manufactures products using raw materials or offers services that may require some raw materials, it must prepare accounting records for inventory.

Inventory can be purchased in two ways- on cash (or) credit.

In this question, we would like to explain both inventories purchased on credit and cash.  Starting with its meaning followed by Journal Entries and simple practical problems.

Purchased Inventory on Credit

When an organization purchases raw materials for manufacturing finished products from another organization on agreed terms that consideration (price or value) of raw materials (Inventory) will be paid on some future date then it is called Credit Purchase of Inventory.

Journal Entry for Inventory purchased on credit

1. Modern Accounting Approach

2. Traditional Accounting Approach

Practical Example

On 1st May Alexa Co., a manufacturer of sofa sets purchased hardwood from Anna Co. for 500,000 on a credit period of 2 months. Journalise the following transaction in the books of Alexa Co.

                                             In the books of Alexa Co.

1. When Inventory is purchased on credit from Anna Co.

(Being Inventory purchased on credit).

2. When the consideration (price or value) of Inventory is duly paid,

(Being consideration duly paid on the due date).

Purchased Inventory on Cash

When an organization purchases raw materials for manufacturing finished products from another organization on payment of cash, it is known as Purchase of Inventory on Cash.

Journal Entry for Inventory purchased on credit

1. Modern Accounting Approach

2. Traditional Accounting Approach

Practical Example

On 1st June, John and Co., a manufacturer of chairs purchased wood from Tom Co. for 200,000 on a credit period of 2 months. Journalise the following transaction in the books of John and Co.

                                             In the books of John and Co.

(Being Inventory purchased on Cash).

Conclusion

The above discussion may be summarised as follows:

• Inventory includes the raw material used to produce the goods, the goods which are yet to be completed (work-in-progress), and the finished goods which are ready to be sold.
• It is a current asset used in the production of goods.
• Inventory may be purchased either on Cash or on credit.

>Related Long Quiz for Practice Quiz 21 – Inventory

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Examples of Bank Reconciliation Statement

Illustration 1,

From the following particulars prepare a Bank Reconciliation Statement on 31^st January XXXX

1. Debit Balance as per Cash Book 48,000.
2. A cheque of 37,000 was deposited and collected by the bank but not recorded in Cash Book.
3. Purchased Furniture and payment by the debit card 25,000, was not recorded in Cash Book.
4. A cash deposit of 26,000 was recorded in the cash column of Cash Book.

Solution:

Illustration 2

From the following particulars prepare a Bank Reconciliation Statement on 31^st October XXXX

1. Pass Book of Ms Jane shows an overdraft of 50,000.
2. Cheques issued but not presented for payment to bank 40,000.
3. Payment side, bank column of Cash Book was undercast by 500.
4. Interest on overdraft charged by the bank was 1,500.

Solution:

Examples of Cash Book

Illustration 1,

Solution:

Illustration 2,

Prepare a 2 column cash book

Solution:

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Zero Working Capital

Before diving into the concept of Zero Working Capital, let me help you understand the meaning of Working Capital.

Working Capital is the term used to demonstrate whether the company possesses adequate current assets to discharge off its current liabilities. It is calculated as follows:

Working Capital = Total Current Assets – Total Current Liabilities

Now, taking this forward let us interpret the theory of Zero Working Capital.

The Working Capital of a company can be positive or negative, i.e. the total current assets may exceed the total current liabilities or vice-versa. However, there can be a situation when the total current assets are equivalent to the total current liabilities of the company. Such a situation is referred to as Zero Working Capital. Zero Working Capital is when,

Total Current Assets = Total Current Liabilities, or

Total Current Assets – Total Current Liabilities = Zero

Example

Using the data given in the balance sheet above, let us calculate the zero working capital.

1. Total Current Assets = Cash in hand/bank + Sundry Debtors + Bills Receivable + Inventory
= 15,000 + 1,80,000 + 1,00,000 + 55,000
= 3,50,000

2. Total Current Liabilities = Sundry Creditors + Bills Payable + Outstanding Expenses
= 1,95,000 + 85,000 + 70,000
= 3,50,000

As there is no excess of Total Current Assets over the Total Current Liabilities, this situation is referred to as Zero Working Capital.

Benefits and Approach of Zero Working Capital

Zero Working Capital is one of the latest techniques in working capital management. Let us now understand the benefits and approach of zero working capital in a real-life scenario.

1. Reduction in the level of investments in working capital

Zero Working Capital is a strategy to reduce the level of investment in the working capital and thereby increase the investments in the long term assets. Following this strategy, companies avoid excess investments in current assets and prefer paying off their current liabilities using the existing current assets only.

2. Savings in Opportunity Cost of Funds

Working Capital earns a very low rate of return as compared to long term investments. Also, maintaining zero working capital will help save the opportunity cost of funds as the company can now use the excess funds to exploit various other opportunities.  So, owing to its benefits, the management would certainly prefer zero working capital.

3. Just-in-Time Methodology

Zero Working Capital approach will be possible only if the Just-in-Time methodology is adopted by the company. Following the demand-based production and distribution system is advised. Very low or zero inventory is emphasized. Everything should be produced and supplied as and when the demand for the same arises.

To keep in pace with the Just-in-Time practice, the receivable and payable terms should also be modified. Payable time granted by the supplier should be extended and the credit terms granted to the debtors should be cut back. This will ensure that you have the cash required to fund the supplier’s payment.

Conclusion

Zero Working Capital eventually helps in better management of the current assets and current liabilities but is still considered to be a difficult scenario to be implemented in practical business life.

>Related Long Quiz for Practice Quiz 33 – Working Capital

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What is a Suspense Account?

A Suspense account is maintained by a business to record transactions that are doubtful and unidentifiable for the time being. It is a temporary account that records certain transactions that have occurred, but there is uncertainty as to which ledger such entries may be posted.

Accounting Process of Suspense Account

If the suspense account is shown in the trial balance then it will be directly shown in the statement of financial position (say- Balance Sheet).

If the suspense account appears on the debit side of the trial balance, it will be shown on the Asset side of the balance sheet. If the suspense account appears on the credit side of the trial balance, it will be shown on the Liabilities side of the balance sheet.

A suspense account appears in the trial balance if either side of the trial balance doesn’t agree (or) if any error occurs during the trial balance preparation. A suspense account is a temporary account and it gets closed once the particular error is found and rectified.

A Suspense account never appears in the Income Statement because income statements are prepared to ascertain gross profit (or) net profit. If the income side exceeds the expenses side then it is gross profit or vice-versa.

A practical example and a snippet of the balance sheet are added below for a better explanation and a clear understanding.

Example

ABC Enterprises furnishes you with the following information. They have maintained a Suspense Account and the balance is given here. Prepare the financial statements with the Trial Balance of ABC given below:

Trial Balance of ABC Enterprises

From the above Trial Balance of ABC Enterprises, we may observe a Suspense Account with a Debit Balance of 20,000. This is shown on the Assets Side of the Balance Sheet under the head Current Assets.

The Balance Sheet of ABC showing the presentation of the Suspense Account is given below:

Extract of Balance Sheet of ABC Enterprises

Conclusion

The above discussion may be summarised as follows:

• A suspense account makes the trial balance agree and facilitates the further preparation of financial statements.
• A suspense account can be placed on either side of the balance sheet depending on the placement of the Trial Balance.
• A Suspense account never appears in the Income Statement because income statements are prepared to ascertain gross profit (or) net profit.
• A suspense account is a temporary account and it gets closed once the particular error is found and rectified.

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What is a Debit balance?

While preparing a ledger account (T-account), if the sum of the debit side is greater than the sum of the credit side, then we say that the account has a “debit balance“.

Debit side > Credit side

Assets have a debit balance

Let us understand this concept by correlating it with the golden and modern rules of accounting and with an example.

1. The golden rule of accounting for a real account (i.e. assets like plant & machinery, furniture & fixtures, etc) is

                             Debit what comes in, Credit what goes out

2. On the other hand, the Modern rule of accounting states-

                    Debit the increase in asset, Credit the decrease in asset

Keeping this in mind, we will move forward to an example.

Example for Asset A/c

Samsung Inc. acquired 2 plants & machinery for 2,50,000. Out of the 2, it sold 1 for 1,00,000. Also, 20,000 depreciation was charged. So, the ledger account for plant & machinery will be presented as follows in the books of Samsung Inc.,

With the purchase of 2 plants & machinery, there will be an increase in the overall assets of Samsung Inc. So, we will have to debit the purchase/increase in the asset. And on the sale of any asset purchased before, you need to credit the asset account.

Therefore, in general, the debit side of an asset account will be > than the credit side, resulting in a debit balance.

In this example, the above ledger shows the debit balance (debit side > credit side) in plant & machinery A/c (By Balance c/d – 1,30,000).

What is a Credit balance?

While preparing a ledger account (T-account), if the sum of the credit side is greater than the sum of the debit balance, then we say that the account has a “credit balance“.

Credit side > Debit side

Liabilities have credit balance

Again, let’s just interpret this concept by correlating it with the rules along with an example.

1. The golden rule of accounting for personal accounts (eg. creditors) is;

                  Debit the receiver, Credit the giver

2. Modern rule of accounting states-

                 Credit the increase in liability, Debit the decrease in liability

Keeping these rules in mind, let us now understand why liabilities have a credit balance with an example.

Example for Liabilities A/c

ABC Ltd purchased raw materials from its supplier XYZ Ltd for 5,00,000. During the month it could only make payments of 25,000 and 40,000 to the supplier. The remaining amount is still outstanding. So, the ledger account for XYZ Ltd (Creditors A/c) in the books of ABC Ltd will be presented as follows;

XYZ Ltd has been credited with 5,00,000 because he is the supplier of raw materials (credit the giver). Also, ABC Ltd is now liable to pay 5,00,000 (credit the increase in liability). Then as and when we pay XYZ Ltd, there will be a decrease in the liability, therefore debit. The liability account will show a credit balance until we discharge the dues completely.

So, in general, you will always see the credit side of the liability account to be > than the debit side.

In this example, the above ledger shows the credit balance (credit side > debit side) in XYZ Ltd A/c (To Balance c/d – 4,35,000).

Conclusion

The key points from the above discussion are given below:

• If the sum of the debit side is greater than the sum of the credit side in a ledger, then we say that the account has a “debit balance.
• If the sum of the credit side is greater than the sum of the debit balance in a ledger, then we say that the account has a “credit balance“.

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The differences between cost centre and cost unit are as follows:

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Every year or after a certain period, the ledger accounts are balanced after posting the transactions. The difference in the totals of the two sides of an account is written on the side with the smaller total. The credit balance of a trading account means the company has earned a gross profit for that period. Let us break this down for you,

Credit Balance

While preparing an account, if the credit side of an account exceeds the debit side of an account then the difference is called a “credit balance”. In short, if Cr. Side > Dr. Side, it is said to have a Credit Balance.

Assets have a debit balance, and Liabilities have a credit balance. Similarly, Expenses have a debit balance, and Revenues and Capital have a credit balance.

Due to the fact that they are the balancing figures, a debit balance appears on the credit side while a credit balance appears on the debit side.

Related Topic – Debit Balance and Credit Balance in Accounting (Detailed)

Meaning in Trading Account and What it Indicates

A trading account records all the trading activity (buying and selling) of the firm’s main products/services during an accounting period. It is the first stage in the preparation of financial statements.

The debit side shows “opening stock” + “expenses“, whereas the credit side has “closing stock” + “revenues“.

As a result, if the right side (Cr.) is greater than the left side (Dr.), revenues will exceed expenses, resulting in a profit.

Note: Direct expenses are shown in the trading account, whereas indirect expenses are shown in the income statement.

The credit balance of a trading account means gross profit. However, a debit balance of the trading account indicates a gross loss.

This signifies that the company earned more money than the expenses incurred by it. This number is transferred to the credit side of a profit & loss account to further calculate net profit or a net loss.

Gross Profit = Net sales proceeds > (Cost of Goods sold + All Direct Expenses)

Example Showing Gross Profit

Prepare a trading account for the year ending 31 Mar YYYY from the following balances.

Closing stock is valued at 30,000 at the year-end.

Trading Account for the year ending 31 Mar YYYY

Frequently Asked Questions Related to this Topic

A question that is commonly asked around this topic is,

Question – 1 – Select the most appropriate alternative from those given below:

The credit balance of the Trading Account means _____?

1. Gross Loss
2. Net Loss
3. Net Profit
4. Gross Profit

Answer – The answer is D. The reason is clearly explained in the above text in this article.

Question – 2 – What is the credit side of a trading account?

Answer – The credit side of a trading account shows a combination of Closing Stock and  Sales less Return Inwards.

Question – 3 – Trading Account is a _____ account?

1. Personal
2. Real
3. Nominal
4. Valuation

Answer – The answer is C. It is a nominal account prepared at the end of an accounting period.

Related Topic – Trading Expenses in Final Accounts

Conclusion

A trading account is an important indicator used by various internal and external parties to know the overall business performance and efficiency.

• To summarize, a trading account is a type of financial statement that is utilised by companies in order to keep track of the buying and selling activities that take place during an accounting cycle.
• The reason why it is so crucial is that it helps to determine whether the company made a gross profit or a gross loss during the year.
• A credit balance of the trading account represents that it has a greater credit side as compared to the debit. It shows that the company has earned a profit from trading activities, which is an indication that more money has been earned than expensed.
• A gross profit is then transferred to the credit side of the profit and loss account in order to further calculate net profit or a net loss.

Gross profit indicates the ability of a company or individual to meet its financial goals. If a company suffers a gross loss, it may have difficulty paying its bills in the future.

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

The following image shows the Balance Sheet Equation:

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

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

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

The Income Statement Equation is given below:

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

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

Debit Balance

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

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

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

Credit Balance

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

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

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

Conclusion

The following are the key takeaways from the article:

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

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List of Current Assets and Current Liabilities

Placement in the Balance Sheet

>Related Long Quiz for Practice Quiz 20 – Current Assets

>Related Long Quiz for Practice Quiz 22 – Current Liabilities

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No, Prepaid Expense is Not a Fictitious Asset.

Meaning of Prepaid Expense

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

Meaning of Fictitious Asset

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

Prepaid assets aren’t fictitious assets

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

For Example,

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

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

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

Journal Entry

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

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

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

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

At the time such expense becomes due

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

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

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

>Related Long Quiz for Practice Quiz 30 – Fictitious Assets

>Related Long Quiz for Practice Quiz 36 – Prepaid Expenses

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Charging Depreciation in the Year of the Sale

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

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

First of all, what does depreciation mean?

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

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

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

Example

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

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

The accounting treatment for the same shall be:

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

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

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

>Related Long Quiz for Practice Quiz 39 – Depreciation

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

Assets that have a credit balance

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

Contra Asset

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

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

Assets with a negative balance

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

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

Calculation

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

= (4,00,000 – 30,000)/10  => 37,000

Net Asset value = Total asset value – Accumulated Depreciation

= 4,00,000 – 1,48,000  => 2,52,000

Placement in the Balance Sheet

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

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Why is Debit written as Dr?

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

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

These are;

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

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

Why is Credit Written as Cr?

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

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

These are;

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

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

Conclusion

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

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

What is Depreciation?

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

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

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

What is Accumulated Depreciation?

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

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

Accumulated Depreciation in the Trial Balance

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

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

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

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

Illustrative Example

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

Solution :

The Trial Balance of Mr. Allen is given below:

Accumulated Depreciation always has a credit balance.

Conclusion

The above discussion is summarised below:

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

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Purpose of subsidiary books

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

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

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

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

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

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

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

Uses of Subsidiary Books

The following are the uses of maintaining a subsidiary book-

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

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

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

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

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

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Return Inwards

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

Journal entry for Return Inwards 

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

(Goods returned by the customer)

As per Modern rules of Accounting,

As per Traditional rules of Accounting,

For example, 

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

Return Outwards

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

Journal entry for Return Outwards

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

(Goods returned to the seller)

As per Modern rules of Accounting,

As per Traditional rules of Accounting,

For Example,

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

Accounting Treatment of Return Inwards and Return Outwards

1. Return Inwards

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

2. Return Outwards

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

Conclusion

The key takeaways from the above discussion are:

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

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Introduction

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

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

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

Meaning of Provision for Doubtful Debts

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

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

Reason for creating Provision for Doubtful Debts

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

Example

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

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

Calculation of Provision for Doubtful Debts-

Step 1– Calculate the Net value of sundry debtors

Net Sundry Debtors = Sundry Debtors – Bad Debts

= 4,00,000 – 40,000 => 3,60,000

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

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

= 18,000

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

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The normal balance of dividends is “Debit”.

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

What is the normal balance of dividends?

Normal Balances in Accounting

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

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

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

Why do dividends have a debit balance?

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

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

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

Conclusion

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

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

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Meaning of Provision for Discount on Debtors

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

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

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

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

Journal Entry for Provision for Discount on Debtors

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

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

Example of the Journal entry

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

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

Treatment of Provision for Discount on Debtors in Final Accounts

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

Conclusion

The following may be concluded from the above article:

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