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Accounting and Journal Entry for Loan Payment

Ahuja Sahil
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Journal Entry for Loan Payment (Principal & Interest)

Loans are a common means of seeking additional capital by the companies. They can be obtained from banks, NBFCs, private lenders, etc. A loan received becomes due to be paid as per the repayment schedule, it may be paid in instalments or all at once. Below is a compound journal entry for loan payment made including both principal and interest component;

Loan A/C Debit Debit the decrease in liability
Interest on Loan A/C Debit Debit the increase in expense
 To Bank A/C Credit Credit the decrease in Asset

*Assuming that the money was due to be paid to ABC Bank Ltd.

 

Traditional Rules Applied

Loan Account (Personal) – Debit the Receiver

Interest Account (Nominal) – Debit all Expenses & Losses

Bank Account (Personal) – Credit the Giver

The repayment of a secured or an unsecured loan depends on the payment schedule agreed upon between both the parties. A short-term loan is categorized as a current liability whereas the unpaid portion of a long-term loan is shown in the balance sheet as a liability and classified as a long-term liability.

 

Example

The first of two equal instalments are paid from the company’s bank for 1,00,000 against an unsecured loan of 2,00,000 at 10% p.a. Show journal entry for loan payment in Year 1 & Year 2.

In Year 1

Loan A/C 90,000
Interest on Loan A/C 10,000
 To Bank A/C 1,00,000

(The remaining amount of 1,00,000 due to be paid will appear in the balance sheet as a liability)

Related Topic – Journal Entry for Loan Taken from Bank

 

In Year 2

Loan A/C 90,000
Interest on Loan A/C 10,000
 To Bank A/C 1,00,000

(As this would be the last instalment to pay the loan, therefore, this loan will not be shown in the balance sheet after this payment)

 

Impact on Accounting Equation

After the loan is paid off the net effect of these transactions on the accounting equation will be as follows;

The assets of the company decreased by 2,00,000, liabilities reduced by a 1,80,000 and simultaneously owner’s capital went down by the interest amount i.e. 20,000.

Assets = Capital + Liabilities
-2,00,000 = -20,000 + -1,80,000

(The impact has been assessed at the end of all transactions)

 

Short Quiz for Self-Evaluation

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>Read Types of Liabilities

 

Accounting and Journal Entry for Loan Taken From a Bank

Ahuja Sahil
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Journal Entry for Loan Taken From a Bank

Banks and NBFCs are an integral part of an economy as they act as a support for companies by providing them additional cash leverage in the form of loans. Such a loan is shown as a liability in the books of the company. Following is the journal entry for loan taken from a bank;

Bank Account Debit Debit the increase in asset
 To Loan Account Credit Credit the increase in liability

*Assuming that the money was deposited directly in the firm’s bank.

Traditional Rules Applied

Bank Account (Personal) – Debit the Receiver

Loan Account (Personal) – Credit the Giver

Loan received from a bank may be payable in short-term or long-term depending on the terms set by the bank. The repayment of loan depends on the schedule agreed upon between both parties. A short-term loan is categorized as a current liability whereas a long-term loan is capitalized and classified as a long-term liability.

 

Example of Loan Received from a Bank

Loan received via direct credit from ABC Bank for 1,00,000 for new machinery. Show journal entry for this loan taken from a bank.

Bank A/C 1,00,000
 To Loan (Recvd. From ABC Bank) 1,00,000

(Loan received from ABC Bank for new machinery)

 

Impact on Accounting Equation

As per the accounting equation, Total Assets of a company are the sum of its Total Capital and Total Liabilities.

Assets = Capital + Liabilities

In the aforementioned example, total assets of the company increased by a hundred thousand and simultaneously their liabilities grew by the same amount. 

Assets = Capital + Liabilities
1,00,000 = 0 + 1,00,000

The example above doesn’t have any impact on the equity of the company.

Related Topic – Journal Entry for Loan Payment

 

Loans in Financial Statements

Procuring a loan means acquiring a liability, it is an obligation for the business which is supposed to be repaid. Long-Term loans are shown on the liability side of a balance sheet.

Loans shown in the financial statements

 

Short Quiz for Self-Evaluation

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>Read What is a Contra Liability?

 

How to Pursue CPA from the USA?

Ahuja Sahil
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How to Pursue CPA from the USA?

Becoming a CPA from the USA

Becoming a Certified Public Accountant (CPA) in the United States has become more challenging in recent years for several reasons: the type of content tested on the CPA Exam has changed to focus more on the type of real-life tasks CPAs perform; the scope of content on the exam has expanded, and the educational and experience requirements to become certified have increased. This article talks about various aspects of getting a CPA from the USA.

Nevertheless, the CPA credential remains a sought-after goal with proven long-term benefits associated with its achievement. Here is a summary of what you need to know if you want to become a CPA

 

Who oversees the CPA Exam?

The National Association of State Boards of Accountancy (NASBA) and the American Institute of Certified Public Accountants (AICPA) jointly manage the Uniform Certified Public Accountant Examination (the “CPA Exam”).

NASBA is responsible for administering and scoring the CPA Exam within the 55 separate U.S. licensing jurisdictions—which include the 50 states, the District of Columbia, Puerto Rico, Guam, the U.S. Virgin Islands, and the Commonwealth of Northern Mariana Islands (CNMI).

The AICPA oversees updates to the CPA Exam. The exam is administered at Prometric test centres. There are over 10,000 Prometric test sites in 160 countries.

 

Eligibility Criteria for the CPA Exam

Any candidate wishing to sit for the CPA Exam must meet certain educational requirements, though these do vary by jurisdiction so it’s best to verify with your state board.

Typically candidates must have completed either a bachelor’s degree or 120 college credit hours to be eligible. Most states require a minimum number of credit hours in specific business and accounting subjects.

In addition, nearly all states now require that candidates have 150 credit hours (this is sometimes referred to as the “150-Hour Rule”) to become certified, though most states still only need 120 hours to sit for the CPA Exam. Most states also require verified work experience to become licensed, but not to sit for the exam.

 

CPA Exam structure and scoring

The exam consists of four separate sections;

  1. Auditing and Attestation (AUD)
  2. Financial Accounting and Reporting (FAR)
  3. Regulation (REG)
  4. Business Environment and Concepts (BEC)

Altogether, the exam sections add up to 14 hours of testing. To pass, you must score at least 75 in each of the four sections within an 18-month period.

In recent years, the AICPA has restructured the exam in an attempt to test higher-level skills like evaluation and analysis rather than just testing your ability to memorize. In addition to multiple-choice questions (MCQs), the exam now includes Task-Based Simulations and Document Review Simulations, which are designed to replicate real workplace situations and require that you leverage your knowledge and experience to answer them.

Simulations make up 50% of your total score on the exam, so it’s critical for you to practice them as part of your exam prep.

 

CPA Exam “Testing Windows”

Candidates may take the CPA Exam during the first two months of each calendar quarter. These are often referred to as the four “testing windows”:

  1. January 1 – February 28 (or 29, if it is a leap year)
  2. April 1 – May 31
  3. July 1 – August 31
  4. October 1 – November 30

 

How to Apply for a CPA Exam section?

To start the testing process, you need to schedule your test at least 5 days before you wish to take the test, though NASBA recommends scheduling 45 days in advance to ensure your space (sometimes even farther out, depending on demand).

To register for the exam, contact your State Board of Accountancy. Once your application has been processed, you will receive a Notice to Schedule (NTS), at which point you may contact Prometric to schedule your exam session.

You may take any or all of the sections on your scheduled test day. However, if you do not pass a portion, you have to schedule to retake that exam in the next testing window.

 

How do I take the CPA Exam if I live outside the U.S.?

If you’re a CPA candidate who wishes to take the CPA Exam in an international location, you must:

  • Select a participating jurisdiction (note that Alabama, California, CNMI, Delaware, Idaho, Kentucky, Mississippi, New Jersey, North Carolina, and the Virgin Islands do not currently participate in international CPA Exam administration)
  • Contact the Board of Accountancy in your chosen jurisdiction and ensure you meet its eligibility requirements (some, but not all, states require that candidates be U.S. citizens)
  • Submit a completed application and any required fees
  • To review the requirements to sit for the CPA Exam as an international candidate, click here.

 

How and when will I get my score?

The AICPA grades all exams and sends the results to the State Boards of Accountancy. Your State Board or jurisdiction will send you your results.

Typically, the AICPA will process test results and release the scores within 30 days of the test date, though this can vary, especially soon after the CPA Exam has undergone changes.

 

How difficult is it to pass the CPA Exam?

Due to many of the factors covered in this article, such as the additional type of content and the ever-expanding scope that it covers as legislation change and grow, CPA Exam pass rates have declined in recent years.

National pass rates exceeded 50% for many years, but pass rates for individual sections now average between 45% and 50%, according to AICPA. Students often pass one or two sections but struggle to pass all four sections within the 18-month time frame.

 

How to increase my chances of passing the Exam?

Because it is so challenging to pass all four sections of the CPA Exam, most students seek the help of a prep course. The most popular CPA Review courses are now online and/or self-study based, versus classroom-based.

Most follow a traditional “linear” learning approach, where students are instructed to study every topic in the order in which the course presents it, from the first chapter to the last chapter. Becker is a well-known example of this kind of traditional, linear course.

More modern CPA Review courses, such as Surgent CPA Review, use adaptive learning technology to streamline the study process and personalize studies to each student’s specific weaknesses.

Rather than trying to study every lecture, textbook, and test bank question—which most candidates simply don’t have time to do—students using adaptive learning technology focus their study time on the specific topics they don’t know well, which saves many hours of study time.

In the end, as the low CPA Exam pass rate indicates, the road to becoming a CPA can be long and difficult. But studies have shown that CPAs make, on average, $1 million more over their career than non-CPA accounting professionals, so the effort can certainly pay off.

Be sure to research eligibility and experience requirements and be diligent in selecting a CPA Review course that you’re confident will help you pass all four sections the first time.

>Read How to become a Chartered Accountant in India

 

6 Reasons to do Accounting and Finance Courses from Udemy

Ahuja Sahil
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6 Reasons to do Accounting and Finance Courses from Udemy

Accounting and Finance Courses from Udemy

For those of you who are not aware of Udemy, as of today, it is one of the top online education portals and learning platforms in the world. In this article, we will explain why you should consider enrolling in accounting and finance courses from Udemy.

Udemy has plenty of online courses where you can learn almost anything from bread baking to accounting. In today’s fast-paced life, online courses are not just convenient, but they are not affordable to

Udemy

1. Industry Leader in Online Education

Man studying onlineFounded in 2010, Udemy in 2022 has over 200,000 courses and plenty of instructors offering both paid and free courses in the form of video lectures combined with other media. It has some great teachers with heaps of students who have benefited from it.

Udemy has a variety of online courses that can help you learn almost anything. Accounting and finance courses from Udemy cover topics such as Financial Management, Taxes, Trading, Auditing, MS Excel, and many other related areas.

 

2. Free and Paid Courses

Free vs PaidUdemy offers both free and paid courses. You may choose any of them as they both have their own benefits and drawbacks. A free course might be tempting. However, a paid course might end up providing you with more value for money.

It is highly suggested that you do your due diligence before enrolling in a course. Don’t forget to research the course, author, author’s background, reviews, etc.

 

3. Reviews and Ratings

Reviews are availableAll courses have real reviews and ratings provided by actual students who are enrolled in the course. This is also applicable to accounting and finance courses from Udemy and it is always advisable to look out how the course has been rated and reviewed.

The review system on Udemy is really helpful for new users and aspirants looking to enrol in the course. An ethical review system is a good indicator of the overall quality of the course.

 

4. Start Instantly & Learn On-the-Go

learn on the goAll Udemy programs are available for consumption immediately after the purchase. As a student, you can choose when and how to start learning as per your own comfort.

The Udemy platform is built on modern web infrastructure which enables the students to learn anytime, anywhere and on any screen size. This means all accounting and finance courses on Udemy are available and mobile, tablets and PCs.

 

5. Self-paced and No Eligibility Criteria

eligibilitySelf-paced instruction means that the content of the program is based on the learner’s response. In simple words, the content can be paced as per the student’s requirement so it can be paused, replayed, and restarted forever.

Largely there are no prerequisites that prevent you from enlisting in accounting and finance courses from Udemy; however, there are few courses on Udemy which expect you to have some prior knowledge in the concerned area.

 

5. Great Instructors at an Affordable Cost

Some expert instructors on Udemy have a vast array of experience and sophisticated educational backgrounds. If you were to hire a CPA, CMA, etc., their professional services would cost at least 10-100 times as compared to their online courses.

Udemy has made it affordable for candidates to avail of high-quality online education by paying a fraction of the original market cost.

 

6. Certification and 30 Days Money Back Guarantee

Many courses provide a certificate of completion, which can be useful for freshers starting their careers, as this can go on your resume under the head “Trainings & Courses”. It is any day better.

In rare cases when you’re unhappy with the course material, you may request a refund from Udemy, which is usually a smooth process.

 

 

What is Management Accounting?

Ahuja Sahil
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Management Accounting

The word “management accounting” is a combination of two words “Management” & “Accounting”, in layman terms this means accounting for internal management. Also known as managerial accounting, it deals with generating financial information for business managers within the organization.

Its main purpose is planning & decision making. In real-life scenarios, this is achieved with the help of one or multiple ERPs as this is where all the financial data is stored. Some of the top financial ERPs in the world today are Quickbooks, E-Business Suite, PeopleSoft, Hyperion Financial Management, SAP, Tally, etc.

Unlike financial accounting which is regulated and is available to both internal and external users of accounting, management accounting is confined to only internal users of information.

Management Accounting Infographic
Benefits of Managerial Accounting

 

Uses of Management Accounting

Budgeting & Forecasting – This is one of the primary reasons why managerial accounting exists. Budgeting & forecasting is an integral activity of every business and it is entirely supported by management accounting.

Performance Measurement – It helps with various operating activities which focus on the performance of a particular department, business segment, and/or the company as a whole. Performance can not only be measured but also be compared with previous accounting periods.

Cost Accounting – Managerial accounting helps with cost control, cost reduction, product pricing, etc. Example – An estimated cost vs actual cost analysis is performed with the help of management accounting tools to ensure a cost centre is not overspending.

Planning – Planning is a significant part of the decision making process. Planning can be operational, strategic, or financial. Combined with other sources of data, managerial accounting helps to achieve efficient planning.

Solving Problems – Financial accounting is more about recording and reporting what has happened, whereas, management accounting is more about making decisions based on what happened. Facts and figures are gathered to identify problem areas and thereby to implement their respective solutions.

Mgmt. accounting is acting on the basis of existing data to make futuristic decisions. There are more areas where managerial accounting may be utilized.

 

Short Quiz for Self-Evaluation

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>Read Difference between Finance and Accounting

 

Difference Between Current Assets and Liquid Assets

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What is the Difference Between Current Assets and Liquid Assets?

Current Assets and Liquid Assets are both used to assess a company’s cash position and are also applied in the process of ratio analysis to compare with other related variables. They are similar, however, there is a slight difference between current assets and liquid assets.

Both current assets and liquid assets help determine the overall short-term financial situation and the ability of a company to repay its short-term commitments.

 

Current Assets

These are short-term assets owned and held by a company for 12 months (maybe less) or for a single accounting year. The intentions are to convert current assets into cash within a short period of time or to utilize them to pay off other current liabilities.

Examples of current assets include cash in hand, cash at bank, sundry debtors, short-term investments, bills receivable, inventory, prepaid expenses, etc.

  • Current assets are shown separately as a line item in the financial statements.
  • They include prepaid expenses and inventories.
  • Current assets are used to calculate the current ratio of a business.
  • In theory, they are liquid but practically current assets are not as easily convertible to cash as compared to liquid assets.
  • Current assets are also known as circulating assets, circulating capital and floating assets.

Related Article – What is Super Quick Ratio?

 

Liquid Assets

are short-term assets which are considered highly liquid in nature. They are cash, cash equivalents and any other assets which can practically be turned into cash in just a few days.

Quick assets are calculated as;

Current Assets – (Inventory + Prepaid Expenses)

Inventory and prepaid expenses are excluded from liquid assets as they can not be converted into cash within a few days of time.

  • Liquid assets are not shown separately in the financial statements.
  • They do not include prepaid expenses and inventories.
  • Liquid assets are used to calculate the liquidity or quick ratio of a firm.
  • In theory and practically liquid assets are more liquid and quickly convertible to cash as compared to current assets.
  • Liquid assets are also known as quick assets.

 

>Related Long Quiz for Practice Quiz 20 – Current Assets

>Related Long Quiz for Practice Quiz 27 – Liquid Assets

>Read Difference between fixed assets and current assets

 

Types of Accounting Ratios

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Accounting Ratios

There are mainly 4 different types of accounting ratios to perform a financial statement analysis; Liquidity Ratios, Solvency Ratios, Activity Ratios and Profitability Ratios.

A financial ratio is a mathematical expression demonstrating a relationship between two independent or related accounting figures. Such ratios are calculated on the basis of accounting information gathered from financial statements.

Four different ways to show financial ratios are;

  • Simple or Pure – A simple ratio is shown as a quotient, example – 3:1
  • Percentage – This type of representation is done in form of a percentage, example 30%
  • Turnover Rate or Times – Accounting ratio expressed in form of rate or times, example 3 times.
  • Fraction – It is when a ratio is expressed in a fraction, example 2/3 or 0.67

 

Types of Accounting Ratios

Liquidity Ratios – First among types of financial ratios is liquidity ratio; it used to judge the paying capacity of a business towards its short-term liabilities. It helps with the evaluation of a company’s ability to satisfy its short-term commitments.

Higher the liquidity ratios better the company’s cash position. Main types of liquidity ratios are;

  1. Current ratio
  2. Quick ratio
  3. Net-Working Capital
  4. Super-Quick Ratio
  5. Cash flow from operations ratio

Solvency Ratios – second among types of accounting ratios is solvency ratios; it helps to determine a company’s long-term solvency. It is often used to judge the long-term debt paying capacity of a business.

Solvency ratios look at a firm’s long-term financial strength to meet its obligations including both principal and interest repayments.

Main types of liquidity ratios are;

  1. Debt to Equity Ratio
  2. Debt to Asset Ratio
  3. Proprietary Ratio
  4. Fixed-Assets Ratio
  5. Interest-Coverage Ratio

Activity Ratios – Activity ratios are also known as performance ratios, efficiency ratios & turnover ratios. They are an important subpart of financial ratios as they symbolise the speed at which the sales are being made.

Higher turnover ratio means better utilisation of assets which indicates
improved efficiency and profitability.

Main types of activity ratios are;

  1. Stock or Inventory Turnover Ratio
  2. Trade Receivables or Debtor’s Turnover Ratio
  3. Trade Payables or Creditor’s Turnover Ratio
  4. Working Capital Turnover Ratio

Profitability Ratios – Efficiency leads to profitability and profitability is the ultimate indicator of the overall success of a business. Profitability ratio shows earning capacity of the business with respect to the resources employed.

Main types of profitability ratios are;

  1. Gross Profit Ratio
  2. Net Profit Ratio
  3. Operating Profit Ratio
  4. Operating Ratio
  5. Return on Investment or Return on Capital Employed
  6. Price Earnings Ratio

All these types of accounting ratios are used by internal and external users for various different purposes such as management accounting, credit rating, loans and other credit, etc.

 

Short Quiz for Self-Evaluation

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What are Liquid Assets?

Ahuja Sahil
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Liquid Assets

The term is usually encountered when dealing with assets which are highly liquid in nature. Liquid assets are either cash, cash equivalents or they can be converted into cash at very short notice. They are also referred to as Quick Assets.

Quick assets can be calculated as [Current Assets – Inventory – Prepaid Expenses]. Inventory and prepaid expenses cannot be converted to cash within a very short period of time.

How to calculate Liquid Assets or Quick Assets

Examples of liquid assets are;

 

Uses and Applications of Liquid Assets

Such resources are used to identify the liquidity of a company with the help of Liquid Ratio/Quick Ratio. This ratio helps to compare a firm’s liquid assets with its current liabilities and assess its short-term solvency.

They are considered a more accurate indicator of the company’s short-term debt paying capability as compared to the current ratio. In other words, the ratio is very important for banks and other financial institutions to understand the actual liquidity of the company.

A comparison between the current ratio and liquid ratio may reveal the extent of stock held up in the business.

 

Short Quiz for Self-Evaluation

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>Related Long Quiz for Practice Quiz 27 – Liquid Assets

>Read Accounting Ratios

 

What is Operating Profit Ratio?

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Operating Profit Ratio

Operating profit ratio establishes a relationship between operating Profit earned and net revenue generated from operations (net sales). operating profit ratio is a type of profitability ratio which is expressed as a percentage.

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

 

Formula to Calculate Operating Profit Ratio

Formula for Operating Profit Ratio

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

Operating Profit = Net profit before taxes + Non-operating expenses – Non-operating incomes

or

Operating Profit = Gross profit + Other Operating Income – Other operating expenses

Revenue From Operations (Net Sales) = (Cash sales + Credit sales) – Sales returns

 

Example

Ques. Calculate Operating profit ratio from the below information

Sales 6,00,000
Sales Returns 1,00,000
Operating Profit 1,00,000

 

Net Sales = Sales – Returns

6,00,000 – 1,00,000

= 5,00,000

Operating Profit = 1,00,000

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

(1,00,000/5,00,000)*100

= 20%

This means that for every 1 unit of net sales the company earns 20% as operating profit.

Alternatively, the company has an Operating profit margin of 20%, i.e. 0.20 unit of operating profit for every 1 unit of revenue generated from operations.

 

High and Low Operating Profit Ratio

This ratio helps to analyze a firm’s operational efficiency, a trend analysis is usually done between two different accounting periods to assess improvement or deterioration of operational capability.

High – A high ratio may indicate better management of resources i.e. a higher operational efficiency leading to higher operating profits in the company.

Low – A low ratio may indicate operational flaws and improper management of resources, it is an indicator that the profit generated from operations are not enough as compared to the total revenue generated from sales.

 

Short Quiz for Self-Evaluation

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>Read Working Capital Turnover Ratio

 

What is Unexpired Cost?

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Unexpired Cost

Every asset in a company is expected to fetch at least 100% returns on its cost, however, the returns obtained may not be in a single accounting period and may spread to multiple future accounting years. This is why unexpired cost exists in a business.

At the time of preparing financial statements, an asset may have costs that are yet to be utilized. Such a cost that is expected to reap benefits in multiple future accounting periods and has not been written off yet is called an unexpired cost. (The benefits are yet to be derived for this portion of the cost)

Example – Deferred Revenue Expenditure, the Net Book Value of an asset on the balance sheet is its unexpired cost.

It is shown as an asset in the company’s final accounts. All assets are capitalized, however, the cost is eventually matched with its future revenue till then it is only a deferred expense waiting to be expensed.

Unexpired Cost  = Cost of Asset – Revenue Generated from Asset to date

Technically, it is the balance of an expense item that has not been written off to the income statement because it still has some remaining value. It is applicable to all costs including the cost of inventory, deferred costs, and prepaid costs.

 

Example – Unexpired Cost

Suppose there is a fixed asset for 1,000,000 which depreciates at 10% straight-line method.

Depreciation charged in current year = 10% x 1,000,000 = 1,00,000

This 1,00,000 is said to be utilized, written off, or expired cost of the asset and is shown in the profit and loss account.

*Assumption – Depreciation shown is only related to the machine.

Expired cost shown in Income Statement

The remaining balance of the asset (book value) is termed as its unexpired cost as the benefits are yet to be derived in future accounting periods.

After the completion of an asset’s useful life, it may still fetch some money which can be determined using the method to calculate the scrap value of an asset.

Unexpired Cost shown in Financial Statements

Related Topic – Difference Between Loss and Expense

 

Example – II

Suppose a company, Unreal Corp. introduces a new product into the market and decides to spend 6,00,000 (50,000 x 12 months) on advertising in the current accounting period.

It decides to pay the entire cost in the first month of the accounting year itself. After 6 months the balance cost (not used yet) can be seen as the unexpired cost of advertisement as the related work has not happened yet.

 

Short Quiz for Self-Evaluation

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>Read Accounting Treatment of Prepaid Expenses in Financial Statements

 

What is Capitalized Expenditure?

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Capitalized Expenditure or Capitalized Expense

Capitalized expenditure is nothing but a revenue expenditure which is essential to acquire and function a new asset or improve an existing asset’s earning capacity. All such expenses are treated as if it were for the purchase of the fixed asset itself and are termed as a capitalized expenditure.

All such expenses are either shown as fixed assets or added to the cost of a related fixed asset and shown in the balance sheet, whereas all revenue expenses are shown in the profit and loss account (income statement).

An expense is said to be capitalized when its benefits do not expire in the same accounting period or in other words, same accounting year.

Example of expenses which are capitalized – Purchase of a fixed asset, the installation cost of a fixed asset, upgrading a fixed asset, the legal cost incurred to acquire the fixed asset, etc.

Related Topic – What is Capex and Opex?

 

Treatment in Financial Statements

Reason – If a revenue expenditure extends its benefits for more than one accounting year such an expense is capitalized and shown inside the balance sheet, furthermore, any expense which expires within the same accounting year is treated as revenue in nature.

All capitalized expenses are written off in future accounting periods with the help of depreciation of fixed assets.

Detailed Example of Capitalized Expenditure

Furniture – 50,000, Machine – 1,000,000

Installation of Furniture – 10,000, Upgrading Machine – 50,000

All these items are examples of capital expenses incurred by a business. Installation and upgrading cost incurred are treated as capital expenses and added to the book value of machine and furniture respectively.

Example - Capitalized Expenditure

 

Short Quiz for Self-Evaluation

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>Related Long Quiz for Practice Quiz 16 – Capital Expense

>Read Sundry Expenses

 

What is the Difference Between Ledger and Trial Balance?

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Difference Between Ledger and Trial Balance

Although ledger and trial balance are both integral parts of the same accounting cycle, there is still a considerable difference between ledger and trial balance. They both have their respective relevance and timing in the business cycle. In short, a ledger is an account wise summary of all monetary transactions, whereas a trial balance is the debit and credit balance of such ledger accounts.

Traditionally a ledger was prepared in a physical book with a separate page for each account and a trial balance was derived from these accounts. In modern days, all the data is stored in ERPs with the help of computers.

 

Ledger Vs Trial Balance in Table Format

Ledger Trial Balance
A ledger is an account wise summary of all monetary transactions maintained in a classified form. It is a statement of debit and credit balances that are extracted from ledger accounts at a specified time.
It is also known as the principal book of accounts and book of final entry. There is no formal synonym of a trial balance, however, it is informally referred to as TB.
Ledger acts as a foundation to create a trial balance for the business. Trial balance acts as a foundation to create financial statements for the business.
It is essentially a summarized form of all journal entries. It is essentially a summarized form of all ledger accounts.
Details of what is a ledger and a sample format are also provided here. Details of what is a trial balance and a sample format are also provided here.
There are different types of ledgers such as Debtor’s ledger, Creditor’s ledger, General ledger, etc. There are no subtypes of a trial balance. An adjusted trial balance is made to fix partial & improper transactions.

 

Stage Within an Accounting Cycle

Ledger – It is prepared after recording journal entries, consequently, it acts as a support to prepare the trial balance.

Trial Balance – It is the next step after adjusting and closing the ledger accounts, therefore acting as the groundwork for the preparation of financial statements.

Difference between a Ledger and Trial Balance in the Accounting Cycle

 

>Read Difference Between Journal Entry and Journal Posting

 

What is the Difference Between Carriage Inwards and Carriage Outwards?

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Carriage Inwards Vs Carriage Outwards

Carriage inwards and carriage outwards are two different types of expenses incurred by a company while buying and selling goods. They may be treated alike inside a trial balance, however, there is a clear difference between carriage inwards and carriage outwards.

One is charged when the goods are being procured from the supplier, whereas, the other one is incurred while the goods are being sold to a customer. Here is a summarized table covering all major points of difference between carriage inwards and carriage outwards.

 

Carriage Inwards Carriage Outwards
1. Charges incurred for freight and transportation while purchasing goods are known as carriage inwards. 1. Charges incurred for freight and transportation by a business while selling goods is termed as carriage outwards.
2. It is shown on the debit side of a trading account. 2. It is shown on the debit side of a profit and loss account (income statement).
3. It is treated as any other direct expense. 3. It is treated as any other indirect expense.
4. It is also known as freight-inwards or transportation-inwards. 4. It is also known as freight-outwards or transportation-outwards.
5. It may or may not be capitalized depending on the asset being purchased. 5. Carriage outwards is never capitalized.
6. Mostly the buyer is responsible to pay for carriage inwards, however, not always. 6. Mostly the seller is responsible to pay for carriage outwards, however, not always.

 

>Read Accounting for Bills of Exchange

 

Carriage Outwards & Carriage Inwards in Trial Balance

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Treatment of Carriage Outwards and Carriage Inwards in Trial Balance

The trial balance is a statement of Dr. & Cr. balances which are extracted from ledger accounts after balancing them. It is prepared to prove that the total of accounts with a debit balance is equal to the total of accounts with a credit balance in the company. Carriage inwards in trial balance and Carriage outwards in trial balance are both treated as just another expense.

Here is a list of all major type of accounts in a business and their usual ledger balances.

Account Type Ledger Balance
Asset Debit
Liability Credit
Equity/Capital Credit
Revenue Credit
Expense Debit
Drawings Debit

All expense line items such as carriage inwards and carriage outwards would present a debit balance in the trial balance.

 

Related Topic – How to prepare trial balance from ledger balances?

 

Treatment of Carriage Outwards and Carriage Inwards in Trial Balance
Trial balance showing a debit balance for both carriage inwards and carriage outwards

 

>Read Journal Entry for Carriage Inwards

 

What is the Journal Entry for Carriage Outwards?

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Journal Entry for Carriage Outwards

Carriage outwards is essentially the delivery expense related to selling of goods. Usually it is an expense for the seller and is charged as a revenue expenditure with the help of a journal entry for carriage outwards.

The product may or may not be for resale, the word “Outwards” shows that the cost is incurred while the goods are being sold by the business i.e. they are going out of the business. It is also called freight-outwards or transporation-outwards.

Carriage Outwards Debit
   To Bank Credit

(Paying carriage outwards from bank account)

 

Profit and Loss Account Debit
   To Carriage Outwards Credit

(Carriage outwards being transferred to the profit and loss account)

 

Example

A company pays 5,000 for carriage outwards via cheque along with total sales of 1,00,000. Show the journal entry for carriage outwards.

Carriage Outwards 5,000
   To Bank 5,000

(Paying 5000 as carriage outwards from bank account)

 

Profit and Loss Account 5,000
   To Carriage Outwards 5,000

(Carriage outwards of 5000 being transferred to the profit and loss account)

 

Carriage Outwards Shown in Financial Statements

Unlike carriage inwards which is a direct expense and shown in the trading account, carriage outwards is an indirect expense and shown as an operating item in the income statement.

In line with the accrual method of accounting the amount of carriage outwards shown in the income statement should be related to the sales made within the same accounting period.

Carriage outwards shown in financial statements

 

Short Quiz for Self-Evaluation

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>Read Journal Entry for Carriage Inwards

 

How to Pay Your Credit Card Bill From Another Bank?

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How to Pay Your Credit Card Bill From Another Bank?

Pay Your Credit Card Bill From Another Bank

Are you still old-fashioned when it comes to paying your credit card bills? Visiting the bank and waiting in queues? Well, you’re due for an upgrade and this article explains how you can pay your credit card bill from another bank using net banking.

It is advisable to use this payment option if there are at least a few working days left before the due date. In case of an immediate payment requirement, you may want to check with the receiving bank before making a payment.

 

Step 1 – Go to Credit Card Issuer’s Bill Desk

Almost every major bank has an online portal to make a credit card bill payment from another bank’s savings account. Search online for receiving bank’s “bill desk”.

  • Google receiving bank’s “payment bill desk”.
  • Type > Receiving credit card’s bank name + Bill Desk
  • Most often this search query would bring the required bill desk to the top.
Search bill desk on google to pay your credit card bill with a different bank
Assuming that the Credit Card to be Paid is Issued by Standard Chartered Bank

Out of the search results, choose the relevant link & move to Step 2.

Here is the link we used in this example

 

Step 2 – Fill in all Required Details

After choosing the appropriate search result you should be able to see a window as shown below. Fill in all necessary information along with some personal details such as your mobile number and email id.

*These payments are usually safe and secured by a 128 or 256-bit SSL encryption.

Pay Your Credit Card Bill Online using a Different Bank Account

 

Step 3 – Your Credit Card is Almost Paid!

After step 2 you will be redirected to your bank’s net banking interface. It is all self-explanatory from there, just like you would make any other payment using your bank’s net banking gateway.

Fast forward, once the payment is made you will see a “Success” message along with a payment reference number. It is advisable to save this reference number till the payment confirmation is not received or the payment is reflected in your records.

Payment confirmation screen when credit card bill is paid from another bank

Note – Usually when you pay a credit card bill from another bank using net banking the payment is credited to your bank within 3 working days, therefore it is always advisable to pay in advance.

 

Billdesk of Top 5 Banks in India

State Bank of India BillDesk
HDFC Bank BillDesk
ICICI Bank BillDesk
Axis Bank BillDesk
Kotak Bank BillDesk

 

>Read Why ICICI Bank is the Best Choice for Paying Your Airtel Postpaid Bill?

 

What is the Journal Entry for Carriage Inwards?

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Journal Entry for Carriage Inwards

Carriage inwards is the freight and carrying cost incurred by a business while acquiring a new product. Journal entry for carriage inwards depends on the item and the intent behind its usage.

The product may or may not be for resale, the word “Inwards” shows that the cost is incurred while the goods are being brought into the business.

 

Case I – Journal Entry When Purchasing Inventory

In this case, carriage inwards is treated as a direct operating expense as the intent is to use the product for operations. It is shown on the debit side of trading account.

Purchase Account Debit
Carriage Inwards Debit
   To Bank Account Credit

(Journal entry for carriage inwards paid while purchasing inventory)

 

Trading Account Debit
   To Carriage Inwards Credit

(Transferring carriage inwards to Trading account, it may be added to the cost of goods sold)

 

Carriage Inwards Shown in Trading Account

Carriage Inwards shown in Trading Account

 

Case II – Journal Entry When Purchasing a Fixed Asset

Carriage inwards is treated as a capital expense when incurred while purchasing fixed assets for self-use.

In this case, carriage inwards is added to the cost of the asset and not journalized separately.

Fixed Assets Debit
   To Bank Account Credit

(The amount debited and credited will include the amount paid for carriage inwards)

 

Carriage Inwards Included in the Cost of Fixed Asset

Carriage Inwards added to cost of fixed asset

 

Short Quiz for Self-Evaluation

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>Read Carriage Inwards and Carriage Outwards

 

What is Carriage Inwards and Carriage Outwards?

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Carriage Inwards and Carriage Outwards

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

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

Carriage Inwards and Carriage Outwards Summary

 

When Goods are Brought In

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

Mostly the buyer is responsible for carriage inwards.

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

Related Topic – Journal Entry for Carriage Inwards

 

When Goods are Sent Out

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

Mostly the seller is responsible for carriage outwards.

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

 

Short Quiz for Self-Evaluation

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>Read Journal Entry for Carriage Outwards

 

What are Notes to Accounts?

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Notes to Accounts

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

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

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

 

Example – Notes to Accounts

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

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

Notes to Accounts - Example

 

Most Common Notes to Accounts

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

 

 

Short Quiz for Self-Evaluation

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>Read Off-Balance Sheet Items

 

Treatment of Prepaid Expenses in Final Accounts

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Prepaid Expenses

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

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

Journal Entry for Prepaid Expense

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

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

 

Treatment of Prepaid Expenses in Final Accounts

Explanation with Example

Company – Unreal Corporation

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

Premium prepaid – 600

Accounting Cycle Ends – 31 Dec YYYY

 

Journal Entry on 30th June YYYY

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

(Payment made for insurance premium from the bank)


Adjustment entry

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

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

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

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

Treatment of Prepaid Expenses in Ledger Accounts

Related Topic – More Accounting Questions Related to Revenue & Income

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

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

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

Treatment of Prepaid Expenses in Final Accounts

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

Related Topic – What is Unexpired Cost?

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

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

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

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

 

Short Quiz for Self-Evaluation

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>Related Long Quiz for Practice Quiz 36 – Prepaid Expenses

>Read Journal Entry for Outstanding Expenses

 

What is Overcapitalization?

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Overcapitalization

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

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

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

 

Causes and Effects of Overcapitalization

Causes

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

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

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

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

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

6. Underutilization of funds and poor management

 

Effects

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

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

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

Overcapitalization

Possible Solutions to Overcapitalization

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

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

3. Reduction in face value & buyback of shares.

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

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

 

Short Quiz for Self-Evaluation

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>Read Undercapitalization

 

What is Undercapitalization?

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Undercapitalization

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

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

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

 

Causes and Effects of Undercapitalization

Causes

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

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

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

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

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

4. Purchase of assets at a very low price.

Effects

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

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

Undercapitalization

Possible Solutions of Undercapitalization

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

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

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

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

 

Short Quiz for Self-Evaluation

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>Read Overcapitalization

 

What are Off-Balance Sheet (OBS) Items?

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Off-Balance Sheet (OBS)

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

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

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

 

Examples and Reasons for Off-Balance Sheet Items

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

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

Examples of Off-Balance Sheet Items

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

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

 

Short Quiz for Self-Evaluation

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>Read Contra Liability

 

What is Net Profit Ratio?

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Net Profit Ratio

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

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

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

 

Formula to Calculate Net Profit Ratio

Formula Net Profit Ratio

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

 

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

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

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

 

Example

Ques. Calculate NP Ratio from the below information

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

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

Net Sales = Sales – Returns

7,00,000 – 1,00,000

= 6,00,000

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

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

6,00,000 – (2,00,000 + 1,50,000)

= 3,00,000

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

= 50%

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

 

High and Low Net Profit Ratio

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

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

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

 

Short Quiz for Self-Evaluation

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What is Gross Profit Ratio?

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Gross Profit Ratio

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

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

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

 

Formula to Calculate Gross Profit Ratio

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

 

Gross Profit = Net Sales – COGS

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

*Only used if they are specifically provided

Net Sales  = Cash Sales + Credit Sales – Sales Returns

 

Example

Ques. Calculate the GP ratio from the below information

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

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

Net Sales = Sales – Returns

7,00,000 – 1,00,000

= 6,00,000

Gross Profit = Net Sales – COGS

6,00,000 – 3,00,000

= 3,00,000

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

= 50%

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

 

High and Low Gross Profit Ratio

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

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

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

 

>Read Net Profit Ratio

 

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