Control accounts are the summarized form of their related subledgers. They are shown in the general ledger and act as a control to check if the total in the general ledger is in sync with the total of its associated subledgers.
Sales Ledger Control Account (SLCA)
Also known as the “Trade debtors control A/C”, it shows the total trade debtors of a company at a given time. In other words, the sales ledger control account, shows the total of the amount owed to a business by its customers at a particular point of time, i.e. the total of Accounts Receivables.
Sales ledger control account is a part of a balance sheet and a short-term asset.
Example
Let’s assume that on December 31, 2013, the total debtors in the general ledger are valued at 1,00,000.
Also known as the “Trade creditors control A/C”, it shows the total trade creditors of a company at a given time. In other words, it shows how much in total a business owes to its suppliers at a particular point of time, i.e. the total of Accounts Payable.
Purchase ledger control account is a part of a balance sheet and a short-term liability.
Example
Let’s assume that on December 31, 2013, the total creditors in the general ledger are valued at 1,00,000.
Type
Creditors
Amount
Creditor 1
Foxtrot Pvt Ltd.
30,000
Creditor 2
Ingenious Corp.
40,000
Creditor 3
Rent Free Pvt Ltd.
30,000
Total Creditors
Purchase Ledger Control A/C
1,00,000
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The difference between financial accounting and management accounting is very important to understand as both of them serve different purposes and audiences.
A person from the management may not find certain information relevant, and at the same time, a cost accountant can’t work without this information. A creditor and a manager would need different sets of information from the accounting records of a business.
Financial Accounting
It is a branch of accounting, which deals with classifying, measuring and recording a business transaction. Financial accounting is concerned with the preparation of financial statements for the purpose of demonstrating the performance and position of a business. The end products are P&L Account for the period end and Balance Sheet as on the last day of the accounting period.
It is mainly concerned with “External users of information” such as Shareholders, Government, Lenders, Public and other users of accounting information.
It focuses on historical data and helps in reporting done on quarterly, annually, etc. basis.
Example: Suppose a Bank wants to decide whether to extend credit to a firm. It will need to look into the business’ financial accounting data such as financial statements.
It helps in effective performance management, control, planning, decision-making, etc. It generally includes budgeting decisions as well. Since management accounting is not a legal requirement, it is not based on Generally Accepted Accounting Principles and accounting standards.
It is a branch of accounting, which is mainly concerned with “Internal users of information” – commonly, managers. Management accounting provides a basis for internal users to make a logical and informed decision.
It focuses on the present and future and there is no set reporting schedule.
Example: Let’s say that a Sr. Manager wants to make an internal decision on an investment made in a particular business segment. It will need internal management accounting data such as the return on investment, etc.
The above information presents a few key points of difference between financial accounting and management accounting.
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The reason why closing stock is not shown in trial balance takes into consideration whether or not the closing stock has been adjusted with purchases or not. It is important to understand and endure so that a correct trial balance is prepared and the ledger balances are accurately checked.
It is usually shown as additional information or an adjustment outside the trial balance.
Reason
Closing stock is the leftover balance out of goods which were purchased during an accounting period. Total purchases are already included in the trial balance, Hence closing stock should not be included in the trial balance again. If it is included, the effect will be doubled.
Suppose total purchases during an accounting period inside a Trial Balance are: 10,000
Closing Stock: 2,000 (This is included in purchases already)
If both of these figures are shown in trial balance then there will be a mismatch of 2,000 because the effect has now been doubled in the trial balance.
Also, No separate account is opened for closing stock inside the general ledger. Hence, the closing stock is not to be shown in the trial balance.
The only instance when closing stock will appear in trial balance is when the closing stock is adjusted against purchases with the below-mentioned journal entry.
This nullifies the double effect as closing stock & purchases are now adjusted and are treated separately.
A ledger account can have both debit or a credit balance which is determined by which side of the account is greater than the other. Debit balance and credit balance are terms often used in the accounting world hence it is important to understand the distinction and their exact meaning.
Debit Balance
While preparing an account if the debit side is greater than the credit side, the difference is called “Debit Balance”. So, if Debit Side > Credit Side, it is a debit balance.
Cash Account
To ABCD
1000
By ZYX
500
To XYZ
2500
By CBA
2000
By Balance c/d
1000
Total
3,500
Total
3,500
Above example shows the debit balance in the cash account (By Balance c/d) which is shown on the credit side.
When the credit side is greater than the debit side the difference is called “Credit Balance”. So, if Credit Side > Debit Side, it is a credit balance.
Creditor’s Account
To Cash A/C
10,000
By Purchases A/C
25,000
To Balance c/d
15,000
Total
25,000
Total
25,000
Above example shows credit balance in creditor’s account (To Balance c/d) which is shown on the debit side.
A debit note also known as a debit memo is a document sent by the seller to the buyer informing about the current debt obligations or it may be a document sent by the buyer to the seller at the time of returning goods as proof (return outwards).
Depending on the purpose of the debit note, it can provide information regarding a forthcoming invoice or serve as a reminder for payments that are due. It is often used in b2b (business-to-business transactions).
In some cases, a seller may issue a debit memo when the full amount was not charged, i.e. the invoice amount was incorrect.
In the case of a buyer, it reduces the amount due to be paid back to the seller if the amount due is nil then it allows further purchases on behalf of that. The intent is to notify the seller that they’ve been debited against the goods returned.
A debit note is issued for the value of the goods returned. In some cases, sellers may send debit notes which look like an invoice, however, they are different as debit notes are not required to be paid immediately.
Example of Debit Note
Sent by the seller,
Companies X & Y have a seller and buyer relationship and the seller (X) sent a debit note for 50,000 informing Y about the current obligation due.
Sent by the buyer,
Company-A purchases goods worth 1,00,000 from Amazon in a (business-to-business) transaction, however, 10,000 worth of goods were found damaged due to some reason & this was notified to Amazon at the time of actual delivery.
Company-A (buyer) issues a debit note for 10,000 in the name of Amazon (seller). This reduces the obligation of the buyer by 10,000 and is now only required to pay 90,000.
Few Characteristics of a Debit Note
It is usually a document sent by the seller to the buyer informing about the current debt obligations
2. It may also be sent by a buyer to inform about the debit made on the account of the seller along with the reasons.
Goods returned by the buyer are purchase return, and the impact of returning goods to the seller are;
Current liability decreases as payables against credit purchases reduce.
Expense decreases as credit purchases reduce.
Creditor’s A/C
Debit
To Purchase Return A/C
Credit
In the books of the seller
Goods received (back) by the seller are sales return, the impact of receiving goods by the seller are;
Revenue decreases as credit sales reduce.
Current assets decrease as receivables against credit sales reduce.
Sales Return A/C
Debit
To Debtor’s A/C
Credit
Sample Debit Note Template
Revision and Highlights
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Total cumulative depreciation of a tangible asset up to a specific date is called Accumulated Depreciation. It is the total depreciation already charged as expense in different accounting periods. It is a contra-asset account which, unlike an asset account, has a credit balance.
It is shown on the balance sheet as a deduction from gross fixed assets.
Original Cost of Asset – Accumulated Depreciation = Net Cost (or) Carrying Value (or) Book Value
Example
Let’s assume that a company buys a vehicle for 50,000 with a lifespan of 5 years and no scrap value. According to the straight line method of depreciation, the asset will be depreciating at 10,000/year.
Accumulated Depreciation
Carrying Value
Year 1
10,000
50,000 – 10,000 = 40,000
Year 2
10,000 x 2
40,000 – 10,000 = 30,000
Year 3
10,000 x 3
30,000 – 10,000 = 20,000
Year 4
10,000 x 4
20,000 – 10,000 = 10,000
Year 5
10,000 x 5
10,000 – 10,000 = 0
The purpose of a contra-asset account such as this is to reduce the book value of an asset to show the loss of value due to wear and tear.
Companies buy assets such as buildings, furniture, machinery, etc., all of which lose their value with everyday use. This depreciation loss is to be accounted for in the books of accounts to show the most accurate picture of the financial statements of a business.
Journal Entries related to Accumulated Depreciation
In the above table, the journal entries would be:
Journal entry to be done annually to show the accumulated depreciation.
Depreciation A/C
10,000
To Accumulated Depreciation A/C
10,000
After 5 years the machine’s scrap value is zero. To remove both the vehicle and its related depreciation from the company’s accounting records.
Accumulated Depreciation A/C
50,000
To Vehicle A/C
50,000
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An honorarium is a voluntary payment given to a person for services delivered. These are generally acts or services for which customs and traditions disallow a price to be set. Payments are made just as a gesture to thank or appreciate the person for rendering the services. The honorarium is not legally required.
Example
A person was told to judge a competition for which the sponsors were only willing to offer an honorarium, so, legally there is no payment to be made for this task. There is no salary, it is not a freelance or an hourly contract.
Another example of an honorarium could be a situation where a person gives a speech at a conference, he/she may receive an honorarium for the service.
In accounting, Grouping refers to presenting similar items with similar qualities together. They are shown under a common head inside financial statements. For example, let’s say a company has 200 different creditors that it deals with. All of them will not be shown separately in financial statements, only the net total of all the creditors will be presented.
Another example would be of Stock which shows the net total of (Raw Material + Work In Progress + Finished Stock).
The arrangement of assets and liabilities on the balance sheet in proper order is called Marshalling. The assets, liabilities, and capital on a balance sheet must be properly marshalled and shown in a logical order. There are 2 common ways of Marshalling:
By Liquidity
Assets are arranged in order of liquidity i.e. they can be converted to cash easily. Most liquid assets, such as cash, will come first and least liquid assets, such as building, will come last. Liabilities are arranged in the order they are to be discharged.
Sample Format of a Balance Sheet in Order of Liquidity
Liabilities
Amt
Assets
Amt
Bills Payable
xxxx
Cash
xxxx
Creditors
xxxx
Bank
xxxx
Loans
xxxx
Govt. Securities
xxxx
Outstanding Expenses
xxxx
Other Investments
xxxx
Reserves & Surplus
xxxx
Bills Receivable
xxxx
Capital
xxxx
Debtors
xxxx
Stock
xxxx
Furniture
xxxx
Plant & Machinery
xxxx
Building
xxxx
By Permanence
Assets are arranged in order of permanency i.e. with the most permanent on the top and the most liquid on the bottom. Liabilities which have to be discharged last are shown first and those which have to be discharged first are shown last.
Sample Format of a Balance Sheet in Order of Permanence
Liabilities
Amt
Assets
Amt
Capital
xxxx
Building
xxxx
Reserves & Surplus
xxxx
Plant & Machinery
xxxx
Outstanding Expenses
xxxx
Furniture
xxxx
Loans
xxxx
Stock
xxxx
Creditors
xxxx
Debtors
xxxx
Bills Payable
xxxx
Bills Receivable
xxxx
Other Investments
xxxx
Govt. Securities
xxxx
Bank
xxxx
Cash
xxxx
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As the name suggests, accounting techniques that are used during the times of high inflation are called Inflation Accounting. It is widely used to counter the effect of historical cost accounting at the times of high inflation. It is also called price Level Accounting.
Inflation has an effect on prices, but corporate finances also become vulnerable due to the rise in prices and financial statements may not show the true value. Adjustments are made to rectify this so the financial statements show a true picture of business.
In developed nations, the inflation rate is generally stabilized. Developing and under-developed nations would generally have a high rate of inflation. Therefore, in the 2nd case, examining the books of accounts is difficult, because historical information is less convincing and relevant as prices increase rapidly.
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The Cost of Goods, also known as COGS or Cost of Sales, is the actual cost of the commodities sold to customers. It involves both costs of the material used for production and direct labour cost. The cost of goods sold (COGS) is shown in the income statement. Sales are either recorded in a company’s cash book or the sales book.
It includes;
Raw material, Storage, Freight or Shipping Charges
Factory Overheads
Direct Labor Cost
How to Calculate the Cost of Goods Sold (COGS)?
COGS = Opening Stock + Purchases – Closing Stock
Also, COGS = Net Sales – Gross Profit
Example 1
Opening Stock of a business is valued at = 2,500,000
Purchases = 1,000,000, Closing Stock valued at = 1,500,000
COGS = OS + P – CS
= 2,500,000 + 1,000,000 – 1,500,000
= 2,000,0000
Example 2
Net Sales = 2,000,000, Gross Profit = 1,000,000
COGS = Net Sales – GP
= 2,000,000 – 1,000,000
= 1,000,000
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To understand Accruals we need to understand the meaning of the word accrual, which is “The act of accumulating something”. Accruals are mainly related to prepayments and arrears.
In accrual-based accounting, accruals refer to expenses and revenues that have been incurred or earned but have not been recorded in the books of accounts. Adjustment entries are incorporated in the financial statements to report these at the end of an accounting period.
In other words, they consist of balance sheet accounts that are a liability or non-cash based assets. A few examples of accruals may include accounts receivables, accounts payable, accrued rent, etc.
Accrued Expense is an expense which has been incurred, but has not been recorded in the books of accounts presently. It will require an adjustment entry in the books of accounts to reflect this in the financial statements.
Accrued Income is an income which has been earned, but has not been recorded in the books of accounts presently. Similar to accrued expenses, an adjustment entry will be required in this case too.
Money owed by a business in the current accounting period is to be accrued and should be added to the expenses in the profit and loss account.
Money that is owed to a business in the current accounting period is to be accrued and should be added to the income in the profit and loss account.
Examples of Accruals
Illustration 1
A company pays 25,000 to rent every month. On January, 1 it decides to pay 1,00,000 advance towards rent.
Accruals related treatment – The company will not record the payment as an expense immediately because the building has not been used yet. So when they report their quarterly results after March, 31, they will report expenses for 3 months i.e. 25,000 x 3 months = 75,000 because the building will only be used for 3 months till that time.
Illustration 2
Another example is when a company is supposed to receive 25,000 per month as rent but the tenant pays 1,00,000 on January, 1 in advance.
Accruals related treatment – The company will not record the received amount as income till the building has been used. So, again during the quarterly results after March, 31, they will report income for 3 months i.e. 25,000 x 3 months = 75,000 because the building will only be used for 3 months until that time.
Where Should Accruals be Recorded?
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Contra account is an account which is used to reduce or offset the value of an associated account. It holds opposite sign for a particular type of account.
If an account has debit balance (e.g for an Asset a/c), then there will be a credit balance in its contra account. The opposite is true for a liability account.
It is shown on a company’s balance sheet. It can be used for any type of account such as asset, liability, capital, revenue.
Examples of Contra Account
Drawings Account
Account
Balance
Capital Account
Credit
Drawings Account (Contra)
Debit
An example where drawings account is a contra a/c linked to company’s capital account.
Account
Balance
Capital Account
2,00,000
Drawings Account
(50,000)
Net Capital
2,00,000 + (50,000) = 1,50,000
Plant and Machinery Account
Account
Balance
Asset Account
Debit
Accumulated Depreciation Account (Contra)
Credit
An example where accumulated depreciation account of plant and machinery is a contra a/c account linked to company’s plant and machinery.
Account
Balance
Plant and Machinery Account
5,00,000
Accumulated Depreciation Account
(60,000)
Book Value of Plant and Machinery
5,00,000 + (60,000) = 4,40,000
Uses of Contra Account
It is used to offset another account, for instance, debtors have a debit balance of 50,000 however the associated contra account i.e. “provision for doubtful debts” has a credit balance of 10,000. The net numbers for debtors would be (50k-10k) = 40,000.
It is also used to correct errors made with an account.
It helps to make financial records transparent. Simply looking at the accounting records of a given business, one can reach back to the history related to certain debits and credits.
Also known as COA, chart of accounts is a list of all accounts in a company’s general ledger. They are the identified accounts which are available for a company to record transactions.
ERPs such as Oracle, SAP, etc., can allow each account a unique number as defined. With this, it can be identified and modified according to the business’ needs.
Think of chart of accounts as a Tree!
“Assets” will be branches of the tree.
“Current assets, fixed assets, other assets” are its sub-branches.
Finally, accounts such as Cash, Bank, Debtor, Prepaid Insurance are like leaves of the sub-branches.
Keeping the same fundamentals, chart of accounts tree can be differently designed for separate businesses depending on need, size and divisions inside a company.
Below is a sample listing of the order where accounts appear inside chart of accounts.
Type of Accounts
Sub Classification Examples
Balance Sheet Accounts
Assets
E.g. Current Assets, Fixed Assets, Other Assets
Liabilities
E.g. Current Liabilities, Long-Term Liabilities
Capital
E.g. Equity
Profit & Loss Accounts
Operating Revenues & Gains
E.g. Sales
Non-Operating Revenues & Gains
E.g. Profit on sale of assets
Operating Expenses
E.g. Cost of goods sold
Non-Operating Expenses & Losses
E.g. Loss on sale of assets
Few reasons for using the chart of accounts
Chart of accounts helps in differentiating and properly recording different types of transactions such as Assets, Liabilities, Capital, Revenue, Expenditure, etc.
Chart of accounts also helps in efficiently organizing and managing the financial data.
Just like the above accounts, chart of accounts will have different groups such as capital, revenue and expenditure with their subtypes, accounts and individual account numbers to record transactions.
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The word reconcile means “making one thing consistent with another”.In case of business, a Bank Reconciliation Statement or BRS refers to a statement which is made to reconcile bank balance shown on the bank statement or passbook with the bank balance shown in the cash book.This helps a business to keep control of cash and get satisfactory explanations regarding differences between both balances.
These days cash book balances are generally extracted from the company’s accounting ERP and the bank statements are obtained from daily bankfeeds. The reconciliation is either done manually with the help of MS-Excel or is partly automated with help of a few additional software packages.
Both the internal source (cash book) and the external source (a bank statement or a passbook) are reconciled with each other, then all the mismatches are identified and properly recorded.
Two Things to Remember are
Bank Reconciliation Statement should be prepared when a bank statement is received or a passbook is updated.
BRS is made and shown for a specific date.
Why Do We Prepare a Bank Reconciliation Statement (BRS)?
The differences in the two balances arise due to 3 main reasons: Timing, Errors, and Transactions only known to the bank. Overall, the main reason for preparing BRS is to have a strict internal control over company’s cash inflows and outflows. To be more precise, these are a few reasons why we prepare BRS.
S.No.
Scope
Comments
1.
Mistakes and Errors
Bank reconciliation statement helps to detect any errors and mistakes in cash or a passbook.
2.
Explains Delay
Any delay in clearance or collection of checks can be identified.
3.
Fraud Detection
Timely reconciliations help prevent and find any frauds related to cash.
4.
Actual Bank Balance
It helps to identify the actual bank balance of a business.
5.
Valid Transactions
It helps in separating valid and invalid transactions such as a wrongly charged fee by the bank.
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Expenses are costs incurred for a consideration. An expense may be capital or revenue in nature and usually incurred by disbursal of money. Capex and Opex refer to capital expenditure and operating expenditure respectively.
They can also be recognized by agreeing to pay off an obligation e.g. paying rent, buying machinery, paying taxes, etc.
Capital Expenditure (Capex)
Also known as Capex it is an expenditure incurred by a business to acquire fixed assets or add value to them in view of creating future benefits. The benefits derived from capital expenditure extend beyond the accounting period of the actual spend. The assets acquired in question might be tangible or intangible.
This will include everything from costs incurred for installation of a fixed asset, legal costs to acquire it, extension or improvement of fixed assets.
This type of expenditure is shown in the balance sheet on the asset side.
All these are examples of Capex (Capital Expenses) incurred by a business. Even the upgrading and installation cost will qualify as a capital expenditure.
Also known as operational expenditure and operating expense, it is an ongoing cost that a business has to spend to run its day-to-day operations. The benefits derived from such expenses are exhausted within the same accounting period and don’t carry forward. It is the opposite of capital expenditure.
This type of expenditure is shown in the income statement on the debit side.
Examples of Operating Expenditure (Opex)
Telephone, Electricity, Maintenance and Repairs, Carriage are few examples of Opex (Operating Expenses)
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Accounting involves the creation, management, summation & communication of day-to-day transactions of a business ultimately leading to the preparation of financial statements.
On the other hand, finance has a wider scope and is mainly responsible to support in decision-making such as investment, divestment, cash management, Working capital management etc.
Difference between finance and accounting (table format)
Finance
Accounting
1. Finance is a branch of economics which deals with the efficient management of assets and liabilities.
1. Accounting is the occupation of summarizing financial transactions which were classified in the ledger account as a part of book-keeping.
2. It is a pre-mortem study of the organization’s funds or asset requirements.
2. It is a postmortem task of the recording of what has actually happened.
3. The aim of finance includes decision-making, strategy, managing & controlling.
3. The aim of accounting is to collect and present financial information for both internal and external purposes.
4. Determination of funds is based on a cash flow system, actual receipts and payments are recognized for revenue and payments.
4. Determination of funds is based on the accrual system, i.e. revenue is acknowledged at the point of sale and not when it is collected. Expenses are also recognized when they are incurred.
5. Few tools of finance include Ratio analysis, Risk management, Returns on investment, etc.
5. Few tools of accounting include Trading account, P&L account, Balance sheet, Cash flow statement, etc.
Finance and Accounting are both distinct, but complementary to each other.
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In the dual entry accounting system, a contra entry is an entry which is recorded to reverse or offset an entry on the other side of an account. If a debit entry is recorded in an account, it will be recorded on the credit side and vice-versa.
Debit and credit aspects of a single transaction are entered in the same account but in different columns. Each entry, in this case, is viewed as a contra entry of the other. Remember the word contra as “Against” or “Opposite”.
Examples of Contra Entry
1. Cash 50,000 withdrawn for an official purpose from the bank. Journal entry for this transaction will be
Cash A/C
50,000
To Bank A/C
50,000
In the above example, both entries, debit, and credit, are a contra entry of each other, they both offset each other. The narration is not required for such an entry and only a “C” is written in the left column which depicts that it is a contra entry.
2. Cash 10,000 received from a debtor is deposited into the bank
Bank A/C
10,000
To Cash A/C
10,000
The above amount is recorded in the bank column (debit) side of the double column cash book.
A contra entry is also used in the Intercompany netting to offset receivables and payables between 2 different legal entities/subsidiaries of a company so that one final (net) amount remains.
It will be easier to understand the meaning of deferred revenue expenditure if you know the word deferred, which means “Holding something back for a later time”, or “postpone”.
Deferred Revenue Expenditure is an expenditure that is revenue in nature and incurred during an accounting period, however, related benefits are to be derived in multiple future accounting periods.
These expenses are unusually large in amount and, essentially, the benefits are not consumed within the same accounting period.
Part of the amount which is charged to the profit and loss account in the current accounting period is reduced from total expenditure and the rest is shown in the balance sheet as an asset (fictitious asset, i.e. it is not really an asset).
Suppose that a company is introducing a new product to the market and decides to spend a large amount on its advertising in the current accounting period. This marketing spend is supposed to draw benefits beyond the current accounting period.
It is a better idea not to charge the entire amount in the current year’s P&L Account and amortize it over multiple periods.
The image shows a company spending 150K on advertising, which is unusually large as compared to the size of their business.
The company decides to divide the expense over 3 yearly payments of 50K each as the benefits from the spending are expected to be derived for 3 years.
50K will be shown in the current P&L and the remaining Amt. in BS
*Large losses originating from unforeseen circumstances, such as a natural disaster or fire, etc., may also be treated as deferred revenue expenditure.
Reasons
The benefits of such an expense are to be received in the future financial years. Therefore, it is logically incorrect to record 100% of such expenses as revenue expenditures and write them off in the current accounting period.
In most cases, these expenses are so large that they may consume all the profits of the company if written off in the current accounting year. As a result, the users of accounting information will get a false impression.
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The word contingent or contingency means “possible, but not certain to occur”. So, according to the definition, contingent liabilities are those liabilities that may or may not be incurred by a business depending on the outcome of a future event. The existence of this kind of liability is completely dependent on the occurrence of a probable event in future.
An example of such liability is a court case, only if the company loses the court case, contingent liability will actually be realized. In another example of contingent liabilities acting as a surety/guarantor on a loan and assuming the responsibility of paying it back in case of default may also be a case of contingent liability since if the principal debtor fails to pay you will be required to reimburse.
Unlike contingent assets, contingent liabilities are required to be disclosed as soon as they can be estimated, usually as a footnote to the balance sheet. If the possibility of the outflow of money or assets is remote then the disclosure may not be necessary.
There are two questions that need to be answered if a contingent liability is to be recorded with a journal entry:
Is the contingent liability probable?
Can the amount of obligation be estimated?
Example
Patent wars that usually happen between Top brands give a clear-cut explanation. Let’s suppose that Apple files a case of a patent violation on Samsung and Samsung not only realizes that it may have to pay for violations but also estimates how much in total. In this case, Samsung will record the estimated amount in their books of accounts as a Contingent Liability.
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Reserves and provisions are somewhat alike but are created for different reasons and under distinct circumstances. Both are important for a business and one can’t reduce the importance of the other. This article covers major points of difference between reserves and provisions.
Reserves are what a business would put away from its profits for future contingencies and strengthening of the business, whereas, provisions are aimed to satisfy an anticipated known expenditure.
Reserves
Provisions
1. Reserves are made to strengthen the financial position of a business and meet unknown liabilities & losses.
1. Provisions are made to meet specific liability or contingency, e.g. a provision for doubtful debts.
2. Reserves are only made when the business is profitable.
2. Provisions are made irrespective of profits earned or losses incurred by a business.
3. They can be used to distribute dividends to shareholders.
3. They cannot be used to distribute dividends as they are made for a specific liability.
4. They are made by debiting P&L Appropriation Account.
4. They are made by debiting the P&L Account.
5. It is not mandatory to create reserves for the business, it is mainly done for prudence.
5. It is mandatory to create provisions as per various laws.
6. Reserves are shown on the liability side of a balance sheet.
6. Provisions are either shown on the liability side of a balance sheet or as a deduction from the concerned asset.
7. It may be used for investment outside the business.
7. It can not be used for investment purposes.
Reserves
They are the portion of profits set aside to strengthen the financial position of a business. Generally, reserves are created to meet unknown future obligations which may arise due to miscellaneous business reasons.
For example – General reserve, reserve for expansion, dividend equalisation reserve, debenture redemption reserve, capital redemption reserve, increased replacement cost reserve, etc.
Specific reserves, as the name suggests are made for specific reasons and may only be used for that specific purpose. One major difference between reserves and provisions is that a provision is always specific, however, reserves may be generic.
They are shown in the balance sheet along with share capital.
Provisions
They are the portion of profits set aside to meet known losses/expenses in the future. The main purpose to create provisions is to meet recognized future obligations which may arise due to a specific business reason.
Reserve means the amount set aside out of profits or other surpluses that are not meant to cover any liability, contingency, commitment, or legal requirement. Thus, the reserve covers the case of an amount that is neither a liability nor a provision. The following are the important types of reserves:
Capital Reserve- It is an accounting mechanism for conserving profits. It imparts an element of stability to the overall finances of a business enterprise. Capital reserve arises either as a gain on the sale of long-term assets or a settlement of liabilities. It does not include any free balance that might be used for the distribution of profits. Examples of the capital reserve are:
Profits emerging from the revaluation of fixed assets
Profits accruing on the sale of fixed assets
Profits from the re-issue of shares
Profits prior to incorporation of a company
Revenue Reserves – Revenue reserves are created out of revenue profit that is usually distributable profits. All distributable profits are not always available for paying dividends since a certain amount may be required to be kept aside either by law (minimum) or as a managerial decision (higher amount) for business needs. It is only after this that the profits will be available for distribution. A few examples are:
General Reserve
Dividend Equalization Reserve
Debenture Redemption Reserve
General Reserve – General reserve is a retention of a portion of revenue profits for the improvement of the overall financial status of an enterprise and to improve its health in general. It is a salient feature of corporate finance. The creation and maintenance of a general reserve helps in-
Conserving resources
Saving for unforeseen losses
Scope of business expansion
Specific Reserves – A business undertaking in contemporary times is involved in a range of business activities in pursuance of its goal of creating value in the organization. Some of the contingency situations can be looked after and financially managed by the creation of provisions for known events. Management may like to provide a second line of defence against some of these. A specific reserve is created for such a given purpose. A few examples are:
Contingency reserve
Capital Redemption reserve
Workmen Compensation reserve
Types of Provisions
The provision means an amount that is written off or retained, kept aside by way of providing for depreciation; or retained by way of providing for any unknown future liability of which the amount can not be ascertained with reasonable accuracy. Important types of Provision are-
Provision for Doubtful Debts – When it is certain that a debt will not be recovered, the amount is written off as bad debt. But, it is also likely that some of the remaining debts may not be recovered in full. This will be a loss to the business.
Hence, it is a common practice to make a suitable provision for doubtful debt at the time of ascertaining profit and loss. Such a provision is made by debiting the number of doubtful debts to the profit and loss account and crediting the account of provision for doubtful debts.
Provision for Discount on Debtors – In practice, business enterprises allow cash discounts to their customers. The tenure of that discount may spill over into the following accounting year for the sales made during the current year.
This requires a provision to be made on debtors and is treated as a loss for the current year. Provision for discount on debtors is created by debiting the profit and loss account and crediting the amount for provisions for a discount on debtors.
Provision for Taxation – A provision for taxation is created and maintained to meet the income tax payable which is a liability for the business, in the current year. Such provision is created by debiting the Income-tax amount of the profit and loss account for that year and crediting the amount for provision for taxation.
Provision for Depreciation – Provision for depreciation is the specific portion of depreciation for that accounting year. Depreciation is by principle charged at the end of the accounting year, and this leads to a lowering of the book value of the asset. However, this reduction isn’t accounted for by crediting the asset account in question, because the assets are going to be continued to be shown on the balance sheet at their original price.
Instead, these depreciation amounts are attributable to a specific account named ‘Accumulated Depreciation‘ which records the collective provisions for depreciation. Such provision is created by debiting the depreciation account and crediting the amount of provision for depreciation.
Reserves Vs Surplus
Following are the differentiating factors between Reserves and Surplus:
Meaning – Reserve is the amount set aside out of undivided profits and other surpluses in order to strengthen the financial position of the business, but not designed to meet any liability or contingency known to exist on the date of the Balance Sheet. The surplus is the credit balance of the profit and loss account after providing for dividends, bonuses, provision for taxation and general reserves, and all other external payments.
Creation – Reserves are an appropriation out of profits and are created only if profit has been earned. It is a matter of financial prudence. What remains after reserves have been created, of the profit earned in that year, is termed as surplus for that accounting period.
Purpose – General Reserves can be used by the company to meet any obligation unknown at that point in time. This includes issuing bonus shares, and dividend equalization, among others. The surplus is the “extra” funds available to the business and shows the operational stability of the company. It is usually transferred to the next year as retained earnings.
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An asset is a useful/valuable thing or person. Assets are divided in various ways depending on their physical existence, life expectancy, nature, etc. The difference between tangible assets and intangible assets is purely based on their physical existence in a business.
In simpler words, an asset is a piece ofproperty owned by an individual or organization which is recognized as having value and is available to meet obligations.
Tangible Assets
The best way to remember tangible assets is to remember the meaning of the word “Tangible” which means something that can be felt with the sense of touch.Assets which have a physical existence and can be touched and felt are called Tangible Assets. The main difference between tangible and intangible assets is where one can be touched and felt the other only exists on paper.
Tangible assets can include both fixed and current assets. A few examples of such assets include furniture, stock, computers, buildings, machines, etc.
Intangible Assets
The opposite of tangible assets, Intangible assets don’t have a physical existence and cannot be touched or felt.Intangible assets can either be definite or indefinite, depending on the kind of asset in question.
A few examples of such assets include goodwill, patent, copyright, trademark, company’s brand name, etc.
A patent is a definite intangible asset as it will expire after the patent is over, however, a company’s brand name will remain over the course of the company’s existence.
Difference between Tangible and Intangible Assets (table format)
Tangible Assets
Intangible Asset
1. They have a physical existence.
1. They don’t have a physical existence.
2. Tangible assets are depreciated
2. Intangible assets are amortized.
3. Are generally much easier to liquidate due to their physical presence.
3. Are not that easy to liquidate and sell in the market.
4. The cost can be easily determined or evaluated.
4. The cost is much harder to determine for Intangible assets.
5. They have a scrap value.
5. They do not have a scrap value.
6. May be accepted by financial institutions as collateral.
6. They are not accepted by financial institutions as collateral.
7. Such assets are held both on paper and by possession.
7. Such assets are held just on paper.
8. Examples: Vehicles, Plant & Machinery, etc.
8. Examples: Software, Logo, Patents, etc.
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Current assets are assets which are held by a business for a short period, mainly a year, or within an accounting cycle of a business. These are balance sheet accounts which can either be converted to cash or used to pay current liabilities within the same time frame.
These are typically seen as those assets which can easily be converted to cash to pay off current liabilities and outstanding debt payments.
Greater the number higher the liquidity of a company which leads to more working capital. It is important because it is used day in and day out to pay off a firm’s usual expenditure which is important for its operations. Such expenses include utility bills, short-term debts, overheads etc.
Examples of Current Assets
The list of current assets includes Cash, Bank, Debtors, Stock, Prepaid Expenses, etc. They are shown on the Assets side of the balance sheet.
Such short-term assets are also called circulating assets, circulating capital, or floating assets.
They are shown in the assets section of the balance sheet.
The current ratio which can be calculated as CA/CL also highlights the importance of having enough short-term assets vs. short-term liabilities.
It is used to determine the current assets turnover ratio for a company enabling evaluation of how well the company is using them to generate revenue. It can be calculated as (Total Net Sales/Average Current Assets).
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Depreciation is a reduction in the value of a tangible fixed asset due to normal usage, wear and tear, new technology, or unfavourable market conditions. Unlike amortization, which is applied to intangible assets, depreciation is applicable to tangible assets.
In Simple Terms – Depreciation is when an asset loses value over time. This can be due to normal wear & tear, outdated technology, etc. Imagine you have a mobile phone that costs 5,000 & has a life of two years. It means 2,500 worth of value will disappear per year due to day-to-day usage (50%). This is the depreciation percentage & 2,500 is the depreciation amount.
Assets such as plant and machinery, furniture, building, vehicle, etc. which are expected to last more than one year, but not for infinity, are subject to such reduction. It is an allocation of the cost of a fixed asset in each accounting period during its expected time of use.
First, among types of depreciation methods is the straight-line method, also known as the Original cost method, Fixed instalment method, and Fixed percentage method.
The simplest & most used method of charging such a reduction is the straight-line method. An equal amount is allocated in each accounting period.
The rate of reduction is the reciprocal of the estimated useful life of an asset, so, for example, if the useful life of an asset is 5 years, the percentage charged will be 1/5 = 20%.
According to the Straight Line Method,
Depreciation Amt = (Cost of an asset − Salvage Value) / Useful life of the asset in years
Example – Straight Line Method
Asset cost = 1,000,000
Depreciation Rate = 20%
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*1,00,000
=>2,00,000
Advantages of Straight Line Method are;
Simple and easy to understand.
The book value of an asset can be reduced to Zero.
A fair evaluation of an asset each year on the balance sheet.
Second, among the types of depreciation methods is the diminishing value method which is also known as the Written down value method, Reducing instalment method and Fixed percentage on diminishing balance.
According to the diminishing value method, it is charged on reducing balance & at a fixed rate. In this case, the written down value is spread between the useful life of the asset.
The percentage, at which the shrink happens, remains fixed, however, the amount of depreciation diminishing year after year.
According to the Diminishing Value Method,
R = Rate of Depreciation in %
n = Useful life of the asset in years
S = Residual/Scrap value of the asset
c = Cost of asset
Example – Diminishing Value Method
Asset cost = 1,000,000
Rate of reduction = 20% (DVM)
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*(1,000,000-2,00,000)
=>1,60,000
Advantages of Diminishing Value Method are;
More practical and easy to apply.
The decreasing charge for depreciation cancels out increasing charges for repairs.
This method is applicable for income tax purposes.
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All expenses incurred before a company is formed i.e. cost incurred before the start of business operations is termed as preliminary expenses. They are a common example of fictitious assets and are written off every year from the profits earned by the business.
Examples of such expenses suffered before the incorporation of business are;
Legal cost (Govt. & Court related fees)
Professional fees (Lawyers, Chartered Accountants, etc.)
Stamp duty
Printing fees
Shown in Financial Statements
Also known as pre-operative expenses, preliminary expenses are shown on the asset side of a balance sheet.
The portion which is written off from the gross profit in the current year is shown on the income statement and the remaining balance is placed in the balance sheet. They are preferably written off within the same year (depending on amount & local accounting standards).
Accounting & Journal Entry for Preliminary Expenses
Stage – I – At the time of payment (Opening Entry)
Suppose company-A incurs a total of 100,000 as expenses before the start of business operations, the below entry will be used to show this.
Preliminary Expenses A/C
1,00,000
Debit the increase in expenses
To Bank
1,00,000
Credit the decrease in assets
(Paid via bank)
Stage – II – Preliminary Expenses Written Off (Indirect Expense)
Then company-A decides to write off the total amount of 100k in 5 years therefore only 1/5th (20,000) will be charged in this year’s income statement and remaining (80,000) will be shown in the balance sheet under the head Miscellaneous Expenditure.
Preliminary Exp. Written Off A/C
20,000
To Preliminary Expenses A/C
20,000
Stage III – Charging to Income Statement (Closing Entry)
Company-A then posts the related expense in the current period’s Profit and Loss Account.
The same entry is repeated for the next 4 years to fully amortize the charge in forthcoming accounting periods.
Profit and Loss A/C
20,000
To Preliminary Expenses A/C
20,000
They are not be confused with pre-commencement costs which are incurred immediately before the commencement of business, however, in this case, the business incorporation is already complete. Pre-commencement expenses are directly charged to the current period’s income statement. Example – Employee recruitment expenses, etc.
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Reduction in the value of an intangible asset by prorating its cost over a period of time (generally in multiple accounting periods) is called Amortization. Point worth remembering is that it can only be done for intangible assets such as copyrights, patents, trademarks, goodwill, etc. It is used for writing-off intangible assets whereas depreciation is used for tangible assets.
If related to obligations, it can also mean payment of any debt in regular instalments over a period of time. Home and other loans often talk about such amortization schedules.
If an intangible asset has an unlimited life then a yearly impairment test is done, which may result in a reduction of its book value.
Suppose a company Unreal Pvt Ltd. develops new software, gets copyright for 10,000, and it is expected to last for 5 years.
Now, if the company shows the entire 10,000 as an expense, it will not show the true and fair picture for that accounting period and the profits for that year will show deflated numbers. Hence, every year the company shall record 2,000 for 5 years to write off the copyright’s entire cost,2,000 X 5 Years
This will be seen as amortization of the copyright with the straight-line method. Writing off the entire copyright’s amount in 5 years over 5 equal instalments.
Accounting & Journal Entry for Amortization
Assuming that no contra account was prepared and the reduction was done directly from the intangible asset, the journal entry would be as follows;
Amortization Expense A/C
Debit
To Intangible Asset A/C
Credit
Only to the extent related to the current financial year, the remaining amount is shown in the balance sheet as an asset.
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