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Meaning of “Income received in advance“

Income received in advance refers to an income that has been received by the entity in the current accounting period but it actually relates to the future accounting period. The entity has just received the income but has not earned it yet. It is also known as Unearned Income.

The entity receiving the income in advance still has an obligation to render the goods or services in the next accounting period, corresponding to the income received. Only after the entity renders the goods or service, the transaction will be considered complete. So, because of this reason, income received in advance is certainly considered to be a liability.

As per the accrual system of accounting and to present the true and fair financial position of the entity, income received is to be recorded in the books of accounts, irrespective of when the actual goods or services are provided. So, income received in advance is recorded as a liability in the current accounting period.

Income received in advance includes

• Rent received in advance
• The commission received in advance
• Professional fees received in advance
• The premium received in advance, etc.

From the meaning of the word “Income received in advance” itself, we can conclude that it is a liability and not an asset.

Treatment in Financial Statements

Income received in advance is shown in both the Balance Sheet and Profit and Loss account.

A snippet of the balance sheet has been attached to show the presentation of income received in advance.

Conclusion

Income received in advance is a liability and not an asset.

>Related Long Quiz for Practice Quiz 31 – Income received in Advance

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Adjustment in final accounts

Adjustment of bad debts is often a tedious task for the students which ultimately leads to an error and false representation of the financial position of the business. They are adjusted in two ways depending on their record in the books of accounts, which is as follows;

1. Treatment of bad debts before preparation of trial balance

As a debtor fails to pay the due amount his account is credited and closed as well as a new account is opened known as the Bad debts account.

In the trial balance:
The net amount of bad debts incurred during the financial period and the Sundry debtors excluding the amount of bad debts appear as a separate item in the Trial balance on the debit side.

In the Income statement or the Profit and loss a/c:

Bad debts being an expense are recorded under operating expenses in the income statement or on the debit side of the Profit and loss a/c.

Journal entries for adjustment of bad debts:

(being bad debts written off)

(being bad debts transferred to p&l a/c)

2. Treatment of bad debts after the preparation of trial balance

Sometimes the amount of bad debts may be mentioned as an adjustment item outside the Trial balance. These types of debts are often referred to as further bad debts and have not yet been written off. To provide a true financial position of the company it is necessary to include these bad debts while preparing the Final accounts.

In the profit and loss a/c:

They are added to the already written off bad debts and appear on the debit side of the profit and loss a/c.

In the balance sheet:

They are deducted from the adjusted sundry debtors on the asset side of the balance sheet.

Journal entry for adjustment of further bad debts:

(being bad debts written off)

Example

The extract of the trial balance of XYZ Ltd. is as follows:

XYZ Ltd. sells goods to a retailer at 50 days credit. However, after 50 days, the company realizes that the retailer has been declared insolvent and only an amount of 4,000 will be received against the total amount of 8,000. The adjustment in the final accounts is as follows;

(being amount irrecoverable from the retailer)

Extract of Profit and loss a/c

Extract of balance sheet

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Opening Balance

The opening balance of an account can be found on the credit or debit side of the ledger account. Opening balance is represented by “Balance b/d”. When the opening balance is shown on the debit side then it is said to have a debit balance and when the opening balance is shown on the credit side then it is said to have a credit balance.

To make this concept clear, we will interpret the opening balances of various types of accounts with the help of their modern rules.

Asset

Asset shows positive (+) balance (or) debit balance. According to modern rules of accounting when there is an increase in the value of the asset the particular asset account gets debited and vice-versa. Cash a/c, Bank a/c, Machinery a/c, Building a/c etc., are a few most common examples of asset accounts.

Assets are shown Left Hand Side on the Ledger account and they are represented with the insertion “To” for recording all the debit side entries in a ledger. Opening balance of an asset is recorded by passing an opening entry i.e., “To Balance b/d”.

Liability

Liability shows negative (-) balance (or) credit balance. According to modern rules of accounting when there is an increase in the value of liability the particular liability account gets credited and vice-versa. Creditors a/c, Bills payable a/c, Bank loan a/c etc., are a few most common examples of liability accounts.

Liabilities are shown Right Hand Side on the Ledger account and they are represented with the insertion “By” for recording all the credit side entries in a ledger. Opening balance of liability is recorded by passing an opening entry i.e., “By Balance b/d”.

Capital

Capital shows a negative (-) balance (or) credit balance. According to modern rules of accounting when there is an increase in the value of capital the particular capital account gets credited and vice-versa. Owner’s capital a/c, Partners capital a/c, Share capital a/c etc., are a few most common examples of capital accounts.

Capital is shown Right Hand Side on the Ledger account and they are represented with the insertion “By” for recording all the credit side entries in a ledger. Opening balance of capital is recorded by passing an opening entry i.e., “By Balance b/d”.

Expense

Expense shows positive (+) balance (or) debit balance According to modern rules of accounting when there is an increase in the value of expense the particular expense account gets debited and vice-versa. Salary a/c, Rent a/c, Commission paid a/c etc., are a few most common examples of expense accounts.

Generally, expense accounts get closed by the end of every accounting year and their balances are not carried forward to the next accounting period. Hence there will be no opening balance for the expense account.

Income/Revenue

Income shows the negative (-) balance (or) credit balance. According to modern rules of accounting when there is an increase in the value of income the particular income account gets credited and vice-versa. Discount received a/c, Income received a/c, Rent received a/c etc., are a few most common examples of income accounts.

Generally, income accounts get closed by the end of every accounting year and their balances are not carried forward to the next accounting period. Hence there will be no opening balance for the income account.

Drawings Account

This is considered as an exception to this question. The drawings account is a contra account to the owner’s capital account because the owner’s withdrawal reduces the value of the owner’s equity. Drawings account debit balance is contradictory (opposite) to its anticipated credit balance of the owner’s capital account. Drawings have no opening balance.

Amount (or) goods withdrawn by the proprietor for his personal use is one of the most common examples of drawing.

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The simple meaning of capital, as known by many, is the sum of money invested in the business by the owner/shareholder/partners. It can be in the form of cash or assets. From the accounting perspective, capital is generally of three types, equity capital, debt capital, and working capital.

Capital as a Liability

A very common question that strikes us is that even though capital is invested by the owner in the form of cash or assets, why is it recorded on the liabilities side of the balance sheet? From the accounting perspective, Capital is a liability because the business is obliged to repay its owner.

To make the point clear, I would like to introduce you to the two different accounting perspectives of the same.

Internal Liability

Firstly, in the case of equity capital, it refers to ownership and represents the owner’s fund. The company is obliged to repay the owners as it is an internal liability and interest on capital is also paid during the operations of a company. A company is considered as a separate legal entity from its owner. The proprietor/shareholder/partners have invested the amount with an aim and expectation of profits in return.

However, the owners are repaid only if any amount is left after paying off all the obligations during the winding up of the company. It is not a mandatory liability like in the case of debt capital. It can also be represented as follows:

Assets = Liabilities + Capital

I have used the accounting equation to show the shareholder’s equity/capital as a difference and balancing figure between the company’s liabilities and assets. Since the capital invested is used to pay off all the debts, it has a credit balance and is recorded on the liabilities side of the balance sheet.

External Liability

Secondly, let us assume that company A has borrowed a certain sum of money from company B, and holds onto the amount invested for realizing feasible profits in the future. The company is obliged to repay, irrespective of profits or loss.

In simple words, I can conclude that capital is a liability.

Capital as shown in the balance sheet

Balance Sheet as of 31st March, YYYY

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To begin with, let me explain to you the meaning of a Subsidiary.

Meaning of Subsidiary

A subsidiary is a business entity in which another company termed as the parent/holding company owns & controls more than 50% of the share capital. If 100% share capital of an entity is owned by the parent company then such an entity will be referred to as a wholly-owned subsidiary.

The parent company will report the “investment in subsidiary” as an asset in its balance sheet. Whereas, the subsidiary company will report the same transaction as “equity” in its balance sheet.

Real-world examples of Holding & Subsidiary Company

1. Whatsapp & Instagram are subsidiaries of Facebook Inc.
2. Skype & LinkedIn are subsidiaries of Microsoft Corporation.

Journal Entry for Investment in Subsidiary

Suppose, Book Ltd acquires 60% shares in Paper Ltd in the month of April 20×1 against consideration of 5,000,000. In this case, more than 50% stake has been acquired by Book Ltd in the entity Paper Ltd. Therefore, Paper Ltd will be considered as a Subsidiary of Book Ltd.

Journal entry to be passed in the accounting records of Book Ltd at the time of acquisition;

Presentation in Financial Statements

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As we all know, a payment is made when we purchase a good or service on credit or cash basis. In terms of a business, a vendor (supplier/creditor) is a person who sells goods to the company on a cash or credit basis with an agreement to receive the payment within a specified period.

This in turn affects the accounts payables as the vendors are the creditors of the company as well as considered a short-term liability and are recorded under the head of current liabilities in the balance sheet.

Journal entry for payment to the vendor

1. At the time of purchase of goods

(being goods purchased from the vendor on credit)

2. At the time of payment for purchased goods

(being payment made to the vendor)

Example

XYZ Ltd. purchased goods from a vendor amounting to 60,000 on a credit basis in May and agreed to make the due payment in July. The journal entries in the books of XYZ Ltd. are as follows:

(being goods purchased on credit from the vendor)

(being payment made to the vendor in cash)

Note: In case the company purchases the goods from the vendor directly for cash then only the following entry shall be passed in the books of accounts;

(being goods purchased from the vendor for cash)

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Individuals employed in an organization receive a salary but salaried individuals do not maintain books of accounts. They are not required to pass any journal entry and prepare financial statements.

So, it is assumed that the question asked is “journal entry for salary paid” and not for salary received. An employer paying salary to his employees will be required to pass the journal entry in his books of accounts for salary paid.

Journal Entry for Salary Paid

I will present the journal entry in the books of the employer for salary paid using both the golden rule and the modern rule of accounting.

1. According to the “Golden rules” of accounting

(Being salary paid by cash/cheque)

2. According to the “Modern rules” of accounting

(Being salary paid by cash/cheque)

Example

1. Textile Inc. paid salary amounting to 500,000 to its employees by cheque or through online modes for the month of March 20xx on 31/03/20yy.

Journal entry in the books of Textile Inc. on 31/03/20xx will be as follows

(Being salary paid by cheque or through online modes for the month of March 20yy)

2. Jute Inc. paid a salary amounting to 75,000 to its employees in cash for the month of March 20yy on 31/03/20yy.

Journal entry in the books of Jute Inc. on 31/03/20xx will be as follows

(Being salary paid in cash for the month of March 20yy)

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Outstanding expenses such as outstanding salary, rent, wages, etc. are shown in the trial balance on the credit side as they are a liability for the business. I would like to explain this further with the help of an example which is as follows;

Example

The trial balance of XYZ Ltd. shows the amount of rent as 7,000, however, rent amounting to 4,000 has not been paid yet for March.

This outstanding rent of 4,000 is shown in the Trial balance as follows:

Trial Balance as of 31st March, YYYY

Note

• When the outstanding expenses are already shown in the Trial balance it means that the adjusting entry has already been recorded in the books of accounts.
• It shall be shown in the balance sheet of the company under current liabilities and no adjustment is required in the Profit and loss a/c.
• However, If outstanding expenses are not shown in the Trial balance then these expenses, shall be added to their respective account and recorded on the debit side in the Profit and loss a/c.

>Related Long Quiz for Practice Quiz 34 – Outstanding Expenses

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Another name of Balance Sheet

There are several names given to the balance sheet such as Statement of financial position, Statement of financial affairs, Net worth statement etc., In American history balance sheet was referred by various other names such as- Treasurer Reports, Financial Statements, Statement of Assets and Liabilities, Consolidated Balance Sheet and Condensed Financial Statements.

Apart from all the above-mentioned names, the two most popular names of the Balance Sheet are- Statement of financial position and Statement of Assets and Liabilities.

To make the concept clear, I would like to add logic behind the different names of the balance sheet followed by a snippet of a practical example.

Statement of Financial Position

The balance sheet is called a statement of financial position because it shows financial stability, liquidity and performance of the business. This statement helps the business to define its future financial goals.

Analyzing the statement of financial position would help the users of financial data (both internal and external users) to forecast the period, value and volatility of the organization’s future earnings.

Statement of Assets and Liabilities

The balance sheet is also known as the statement of assets and liabilities because it portraits what entity owns (Assets) and owes (Liabilities) along with the amount invested by the owner (or) shareholders in the form of capital for a specified period.

The logic behind this name states that there should be a balance between total assets and total liabilities along with the owner’s equity. Hence a sound organization’s financial statements must always be balanced.

Assets = Liabilities + Owner’s Equity

Practical Example

The following are the balances of ABC Enterprises. Prepare Balance Sheet.

Balance Sheet of ABC Enterprises

The Balance Sheet has 3 main components– Liabilities, Assets and Net Worth

Liabilities- It refers to the debts owed by the organization which are needed to the paid before the entity is legally wound up. They are classified into two types- Current and Non- Current Liabilities. Bank Loans, Sundry Creditors, Bills Payables are a few examples.

Assets- It refers to the economic resources owned and controlled by the organization for deriving long-term future benefits. They are classified into two types- Fixed and Current Assets. Land & Building, Sundry Debtors, Bills Receivables are a few examples.

Owner’s Equity- It refers to the amount introduced (or) invested by the owner at the time of starting the business. This amount remains in the business until the entity is legally wounded by the law. Owner’s Equity is also known as capital (or) net worth.

Owner’s Equity = Assets – Liabilities

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In accounting, beginning and ending balances are used interchangeably with opening and closing. For the sake of easy understanding, I am assuming the beginning and ending balance of an account to be the opening and closing balance of a ledger account. 

Opening Balance

In the ledger, balance b/d means opening (or) the beginning balance of an account. Balance b/d refers to that balance that is brought down (or)  forward to the current accounting period from the previous accounting period. In simple terms, the ending (or) closing balance at the end of the month becomes the opening balance for the next month.

Opening balance can be debit- To (or) credit- By. According to the modern accounting approach, assets, liabilities and owner’s equity (capital) have opening balances.

For Example- On 31st March YYYY, the closing balance of the machinery was 500,000. What will be the opening balance of machinery on 1st April YYYY?

Closing Balance

In the ledger, Balance c/d means closing (or) ending balance of an account. Balance c/d refers to the amount that is carried down (or) forward from the current accounting period to the next accounting period. Balance c/d is the difference between the debit side and credit side of the ledger used for balancing the accounts.

If the debit side exceeds the credit side, then the balancing figure (say balance c/d) appears on the credit side of the ledger and vice-versa. Closing balance can be debit- To (or) credit- By.

Example- Mr X purchased furniture for 200,000. Depreciation is to be charged at 10% as per the Straight Line method. What will be the closing balance as of the year-end?

According to the modern rules, Assets shows opening (or) beginning balance on the debit side whereas, Liabilities and Owner’s equity (capital) shows the opening balance on the credit side. The closing balance (or) ending balance is placed on either side of the opening balance.

For example- If the opening balance of machinery is shown on the debit side of the ledger account then the closing balance of the machinery will be shown on the credit side to balance the ledger account.

To make the above concept easy and understandable, a snippet of the cash account will help you in understanding the opening and closing balance of an account.

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In my opinion, the following are some of the difficult adjustments in the final accounts.

Meaning and Definition

Sales refer to the number of goods or services sold by a business entity.

Sales can be of two types :

• Cash sales
• Credit sales

Sales where the buyer’s payment obligation is settled immediately with the help of currency notes, bank cards, etc. are called cash sales. Cash sales reduce the risk of bad debts and help support routine business operations.

Sales where the buyer’s payment obligation is settled at a later date sometimes after many days, weeks, or months (based on a payment agreement) are called credit sales. It is recorded as “debtors or accounts receivable” in the balance sheet.

Credit sales refer to the total value of sales an organization (or) company makes on credit. If the company offers any discount to its customers on the credit sale of goods (or) if sales returns occur, then such amounts must be deducted from the total value of credit sales to arrive at the Net Credit Sales figure.

In simple terms, net credit sales refer to the total revenue generated by the company when it sells goods and services to its customers on credit, reduced by the amount of sales allowance and sales return from the total credit sales.

Example of Net Credit Sales

Cakes and Bakes made total credit sales of 100,000. A discount of 10,000 was allowed on all the sales made. A customer that had purchased goods from the entity, returned 5,000 worth of goods. Calculate net credit sales.

Net credit Sales = Total credit sales reduced by sales return and discount allowed.

= 100,000 – 10,000 – 5,000

= 85,000

Related Topic – Return Inwards and Return Outwards Deducted From?

Net Credit Sales Formula

From the above explanation, a formula to calculate Net Credit Sales can be derived.

Total Credit Sales – Sales Returns – Discount on Sales

• Total Credit Sales = It is the amount of total sales made by an entity on a credit basis.

Total credit sales are calculated by adding up all the sales for which payment obligation is to be settled on a later date or it can also be calculated by reducing cash sales from the total of all the sales made by an entity in a given period.

Total credit sales = Total sales – Total cash sales

• Sales Returns = It is the amount of goods returned by the customer to the entity.

At times the buyer may return goods due to poor quality, inaccurate quantity, untimely delivery, or other reasons. The value of all the goods returned to the entity is added up to arrive at the figure of sales return for a given period.

• Discount on Sales = It is the reduction in the price of goods or services offered by an entity at the time of sale.

Discount is generally calculated on a percentage basis. For example; A discount of 10% is offered by an entity on the sale of certain products. The total credit sales made by the entity are 4,00,000. Therefore, the discount on the credit sales shall be 10% of 4,00,000 i.e. 40,000.

Related Topic – Types of Accounts for Purchase Returns and Sales Returns?

Example of How to Calculate Net Credit Sales

Apple Inc. furnishes you with the following sales information. Calculate the value of Net credit sales.

Net Credit Sales = Credit Sales – Sales Returns – Discount allowed on Sales

= 3,00,000 – 1,00,000 – 60,000

= 1,40,000

Related Topic – How to Calculate Days Sales Outstanding?

Net Credit Sales in the Balance Sheet

Net credit sales are shown in the Balance Sheet in the “Current Assets” section under the head “Trade Receivables”.

In the case of credit sales, the payment may be received by the entity in some days, weeks, or even months so it is recorded as “debtors/accounts receivable” under the head Trade Receivables.

Net credit sales are used to calculate the Debtor’s turnover ratio, Working capital turnover ratio, and Accounts Receivable turnover ratio.

>Read Is a Purchase Order Legally Binding?

Meaning of Service Center

A service centre is a small unit or a department of an organization that provides services to other departments or units within the organization. The cost incurred by the service centre for providing services is charged to the department using such service.

Examples of Service Center

Case 1

ABC Ltd has departments such as Manufacturing unit, Information Technology unit, Repairs and Maintenance, Accounting and Finance unit. ABC Ltd. primarily is engaged in manufacturing printers and heavy industrial machinery.

When the customer has any issues the repairs and maintenance wing resolves the issue. Its manufacturing unit uses complex machines and in case of any technical fault or breakdown, it uses the services of repairs and maintenance department. And thus the repairs dept. in such a case can be called as a service centre.

Taking the same case the manufacturing unit as well as the accounting and finance unit uses the laptops and printers. When the personnel of these department faces any difficulties with their laptops and printers the I.T Team guides them to resolve the same hence, the I.T dept. is also qualified to be termed as a service centre.

These departments may charge the service cost. The managers of the manufacturing and accounting unit have the authority to decide if they are willing to utilize their services or avail the services from outside.

This was a hypothetical example.

Now let’s analyse a real-life corporate example;

Case 2

ITC Ltd is engaged in various businesses. Some of them are Hotel business, FMCG business, Printing and Paper, a Packaging business, Agri products, Information Technology etc.

Its Packaging Division supplies value-added packaging to ITC’s various FMCG businesses.

Its client list includes several well-known national and international companies like Nokia, Colgate Palmolive, Pernod Ricard, Diageo, British American Tobacco, Philip Morris International, Agio Cigars, UB Group, Tata Tetley, Tata Tea, Reckitt Benckiser, Radico Khaitan, Akbar Brothers, Surya Nepal, VST Industries, etc.

Thus, it can be said that the packaging division is a service centre for ITC’s FMCG unit. The packaging division will charge an amount from FMCG division such an amount can be the actual cost incurred or cost plus a certain % of the profit.

The managers or executives of the FMCG division may decide to outsource its product packaging function if the price charged by the packaging unit does not fit into its budget.

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Meaning of a Deferred Revenue

Deferred revenue is an amount received by an entity in advance before delivering the goods or transferring the title to goods or before rendering the services.

The concept of deferred revenue applies only if an entity follows the Accrual System of Accounting. If the entity follows the cash system of accounting it’s of no relevance as the entire amount received becomes income in the year of receipt.

Whether the Deferred Revenue is a Liability?

The answer to this question is  “Yes” it is a liability. Even though you got the answer that it is a liability but I believe a part of the question remains unanswered i.e why is it a liability?

The logic for the same is: Since the entity has already received the amount even before rendering services or delivering goods the entity or a company has a sort of an obligation to deliver the goods or render such services at the predetermined future date. Failing which it may be liable to face legal proceedings or legal actions. Hence, it becomes a liability on a part of the entity to honour such a transaction.

When the entity receives the amount before delivering goods or rendering services that amount is recorded as a “Liability” and once the goods are delivered or services are rendered the liability is reduced and the entity records it as a “Revenue”.

For Example,

In the case of Educational Institutes like Universities, Coaching Institutes etc. it charges fees even before the term commences. In such a case the entity has not yet rendered service of imparting education hence, the tuition fees so received shall become a deferred revenue and shall be recorded as a liability at the time of the receipt and at as and when it’s accrued it shall be recorded as revenue.

Journal Entry for the same shall be;

At the time of receipt of Tuition Fees-

And at the time of recording revenue on monthly basis every month;

Deferred Revenue is Presented in the Balance Sheet as;

Conclusion

Deferred revenue at the time of early receipt of the amount is recorded as a liability and at the time of actual income recorded as revenue in the income statement.

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Working capital = Current Assets – Current Liabilities

I believe if you want to understand how the above formula works you will need to understand each part of this formula i.e you will first need to have a clear understanding of the concept of current assets and current liabilities.

Current assets

It refers to all the assets including cash and cash equivalents which are expected to be converted within a year or within the operating cycle of an entity if such entity has an operating cycle longer than a year.

Current liabilities

It refers to all the payables or debts which an entity expects to discharge within a year or the operating cycle of such entity provided such an entity has an operating cycle longer than a year.

I understand that even though you got a rough idea of this concept you may not be confident while applying this concept hence, to relate to this concept a numerical example would be of great help.

So, I believe once you have a look at the below-mentioned example you will be in a better position to comfortably apply this formula:

Here, Working Capital = Current Assets – Current Liabilities

= Cash in Hand + Cash at Bank + Trade Receivables + Prepaid Rent –Trade Payables  –                  Outstanding Salaries

= 5,000 + 56,000 + 64,000 + 3,000 – 20,000 – 20,000

= 128,000 – 40,000

= 88,000.

It will add more value to your understanding if you also interpret the concept of Gross Working Capital and Net Working Capital.

Gross Working Capital

Gross working capital is the sum total of current assets of an entity. It includes

• Cash and Cash Equivalents
• Trade Receivables
• Inventory
• Short term Investments
• Other Marketable Securities.

Net Working Capital

Now, the net working capital of an entity is nothing but the working capital of an entity. In simple terms, it is a difference between the current assets and current liabilities of an entity.

>Related Long Quiz for Practice Quiz 33 – Working Capital

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Meaning of Non-Current Liabilities

Non-current liabilities are obligations of an entity that becomes due at a future date and such future date falls beyond 12 months. Whereas current liabilities are those obligations wherein an entity is liable to honour such obligations within 12 months.

Meaning of Debt

Debt is any sum of money borrowed by an entity or a person from another entity or a person. Debt is borrowed generally when such an entity has a cash crunch or liquidity crunch or if it has an urgency of making a payment or any other purpose. It can be a long term or a short term debt.

The amount borrowed can be said to be a debt only if such a contract specifies the intention to repay at a future date the amount so borrowed. The borrower might have to pay interest if it’s agreed earlier in the agreement.

Is Non-Current Liability a Debt?

The answer to the above question is that it depends. When we take a bank loan it’s a debt but in case of a deferred tax liability or a long term provision even though it’s a part of non-current liability but it can not be called a debt.

I will give you an example of when it shall be called a debt

You have a business of manufacturing bottles and there been a huge demand for such bottles in the market recently so you decide to increase the production but your plant has a limited capacity hence you decide to purchase a new plant with higher capacity but your entity is facing a shortage of funds hence you apply to the bank for a loan of such amount.

The bank sanctions such loans and transfers the amount so required. Now, The agreement states that the amount borrowed is repayable by you after 5 years.

The loan mentioned in the above case qualifies to be a non-current liability since the obligation to repay arises after 5 years i.e > 12 months. And it’s also an amount borrowed by a person or an entity from another person or an entity. Hence, it’s a perfect example of debt.

You will be able to understand from the below balance sheet that even though deferred tax liability is included under the head of non-current liabilities it does not signify to be a debt. And a bank loan having obligation to pay after a year is covered under long term debt.

Conclusion

All the non-current liabilities are not long term debts but all the long term debts are non-current liabilities.

>Related Long Quiz for Practice Quiz 22 – Current Liabilities

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Importance of Financial Reporting

The importance of financial reporting cannot be exaggerated. It is considered a primary requirement of all the stakeholders for many reasons and purposes. Financial reporting discloses the position, liquidity and performance of the company. The following key points highlight why is financial reporting framework important,

Statutory – Financial Reporting is required by the law for performing statutory audits on the company’s financial statements and reports. These statements help the auditors to express their opinions on the fairness of the financial statements.

Internal Decisions – Financial Reporting is considered the best tool for formulating the internal decision of an organization by providing accurate and updated information on financial statements.

For example, Lenovo Inc’s profit and loss account registered a sharp decrease in net profit due to the use of obsolete technology and poor battery life. Hence the company management should focus on improving overall performance and formulating new strategies to regain customer trust and improve business performance.

External Users – Financial Reporting discloses financial statements that give an idea to the external users (say- creditors, third parties, banks and investors) on the financial creditworthiness, soundness, integrity and liquidity position of the company.

For Example, Apple Inc registers a sharp increase in profit every year and has a strong brand name, credibility and customer base across the world. Due to these reasons, the company has the capacity to procure funds from the banks and NBFCs. This helps the company to grow, prosper and generate huge loans.

Vital Information – Financial Reporting software provides vital information which can be used by the company for making quick and informed business decisions. Such as opening a new business branch across the country.

Planning and Analysis – Financial Reporting acts as a backbone to financial planning, decision and policymaking, financial analysis and is responsible for maintaining company standards.

Investment Decisions – Financial Reporting helps companies and organizations to raise share capital by attracting domestic and foreign investments through marketing, promotions and providing high returns on investments in the form of share dividends.

For Example- HSBC Bank pays off a higher percentage of dividends to its shareholder than compared to other banks. This helps to bank to attract new domestic and foreign investments thereby issuing shares to new shareholders. Financial reporting helps the bank in attracting shareholders by publishing financial statements in newspapers, magazines and prospectus.

Employees and Workers – Financial Reporting helps the employees and workers to understand and analyze the position and performance of the ownership as well as management of a company or an organization based on the audited financial statements.

For Example, Amazon has recorded a sharp spike in profits after deducting corporate taxes and other duties. The company management has decided to pay bonuses and incentives over and above its basic pay to all its prospective employees. This motivates the employees to work even harder and deliver better services to their clients

Financial Information – Financial Reporting furnishes financial information which helps the organization in bidding and negotiating a better business contract. It helps the government in framing suitable economic plans and policies by assessing financial statements and business performance.

Conclusion

We can conclude that financial reporting plays an important role in not only helping the organization to derive long-term profits but also creating an opportunity to expand and diversify the business by setting up long-term goals and better business strategies.

Difference between Assets and Inventory

>Related Long Quiz for Practice Quiz 21 – Inventory

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To begin with, financial reporting is mainly of two types: External and Internal. Reports are prepared for stakeholders (external) as well as the managers (internal) of the organization.
The different components of financial reporting are as follows:

1. The financial statements of a company- the income statement, balance sheet, cash flow statements, and the statement of shareholders equity.

2. The notes to financial statements

3. The quarterly and annual reports of a company

4. Prospectus

5. Management discussion & analysis

1. The financial statements

Income statement – The income statement of a company shows the revenues, expenses, net income, and earnings per share. It is the most important financial statement because it depicts the overall performance of a company.

Statement of financial position – It comprises a companies assets, liabilities, and equity.

Cash flow statement – A cash flow statement shows the monetary position of a company with the help of cash inflows and outflows during a particular financial period.

Statement of equity – This financial statement shows the changes in owners’ equity over a financial period.

2. Notes to financial statement

While recording and classifying the above mentioned financial statements in the books of accounts, the accountants have to maintain various notes to separately show the working. These notes comprise adjustments such as depreciation, interest, dividends, prepaid expenses, accrued income, etc.

3. The quarterly and annual reports of a company

These types of reports are usually prepared in the case of listed companies. These reports comprise the financial statements and their notes to accounts.

4. Prospectus

In terms of finance, a prospectus is a document that portrays the financial security of potential buyers. It is usually recorded in the financial reports of those companies that are going for IPOs.

5. Management discussion and analysis

The preparation of a financial report involves approval at all managerial levels and close analysis to avoid any kind of mistakes. However, this usually takes place in the case of public companies.

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Equity is the capital raised by a company for the purpose of purchase of assets or for making an investment in a specific project or for the smooth functioning of operations. It’s important as it represents the value of an investor’s stake in a company.

It can also be aid that its the sum of money that the company is required to pay at the time of its liquidation to its shareholders after realising all of its assets and paying off all of its debts. Equity is presented in the financial statement as a component of a Balance Sheet.

The formula for calculating the company’s equity

Shareholder’s Equity = Total Assets – Total Liabilities

Inclusive list of items under the head” Equity”

It is generally presented under two subheads – Equity and Other Equity.

The extract shown below indicates the position of Equity in a Balance Sheet;

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Depreciation as an Operating Expense

Yes, depreciation is an operating expense.

To understand this you might want to check the illustrative case given below;

You have an entity providing financial services to your clients. You had commenced it 4 years ago. At the time of the commencement of the operations you had 25 employees and laptops being the core assets of your business, were purchased by you for your team initially.

After 4 years do you still believe that if you dispose of these laptops or you decide to replace them you will get the same amount you had spent initially for purchasing them or could they have the same features and technology that a newly launched laptop currently has or uses?

The answer to this is Obviously Not. The new laptop available in the market will have better features and might be faster. Also, these used laptops shall not possess the same value at the time of their replacement.

I will have a quick run over the concept of “What is Depreciation?”

Depreciation is nothing but a diminution in the value of an asset, due to natural wear and tear, exhaustion of subject matter, effluxion of time accident, obsolescence or similar causes.

Assuming you have received an answer but you still don’t get the logic for treating it as an operating expense the below-given para may be of some help.

An operating expense is an expense that a business incurs for carrying on its normal operations. Hence, since depreciation is charged on an asset that’s used for day-to-day business operations it is covered under operating expense even though it’s a non-cash expense.

Based on the above para you would agree that all the operating expenses are presented on the debit side of profit and loss or an income statement. And since depreciation is related to an asset used for manufacturing or providing service or aiding business for that matter it is an operating expense and so it shall also be presented on the debit side of an income statement.

You can check the profit and loss statement added below for a better understanding of the treatment of depreciation in the income statement.

The depreciation can be treated as a non-operating expense only in specific circumstances where the assets are not used for the main operations of the business. When such an asset is used for an incidental operation then we treat depreciation as a non-operating expense.

>Related Long Quiz for Practice Quiz 28 – Operating Expense

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Meaning of Days Payable Outstanding

Days Payable Outstanding (DPO) refers to the average number of days taken by an organization (or) company to pay to its outstanding suppliers/vendors. It is calculated on the credit purchases made by an organization. It is computed on a monthly, quarterly (or) annual basis. This portraits how well can a company manage its cash outflows.

If the company takes less time to make payment to its outstanding suppliers then it states that an organization has a strong financial position. but if the company takes a more (or) longer time to pay its outstanding supplier then it could either be an action plan or else the company’s financial position is weak.

Formula

The following formula is used for calculating the Days Payable Outstanding (DPO) of an organization.

Where Cost of Goods Sold (COGS) = Opening Inventory + Purchases – Closing Inventory.

Example

ABC Ltd has furnished you with the following information. Compute Days Payable Outstanding.

Calculation

Days Payable Outstanding = Average Accounts Payable * No. of days/Cost of Goods Sold

= 45,000 * 30/2,25,000

= 6 Days

In my perspective, 6 days is a low average period for an organization for making the payments to all the outstanding suppliers. Therefore it represents a fairly good DPO. Although it depends on the organization about their understandability of high or low DPO.

What is a Purchase Requisition?

In the case of larger organisations, it may so happen that the procurement department places an order of purchase only once such requirement is approved by another department.

When the procurement department intends to procure goods it will have to issue a purchase requisition to its financial wing. Thus the document sent to such another department for approval is called a purchase requisition.

I am inserting the specimen of a purchase requisition you can have a glance;

For Example

ABC Ltd is engaged in manufacturing packed food products, It procures raw materials from various vendors and the company has a policy that before placing any order the department needs to seek the approval of the company’s finance wing. Hence, the procurement department for seeking such approval shall issue a Purchase requisition document.

It includes the following:

• Vendor Information
• Quantity or Units
• Description of Goods
• Location of the Purchaser
• Amount or Price

What is a Purchase Order?

After receipt of the Purchase Requisition from the procurement department, the financial department of an organization shall issue a purchase order to the Vendor.

Continuing the purchase requisition example-

When the finance department of ABC Ltd receives the purchase requisition from the Procurement department for the purchase of raw materials the finance department will analyse the document and once satisfied with the content shall issue a purchase order in favour of the external vendor. And thus the order is said to be placed successfully.

I am inserting the specimen of purchase order you can have a glance;

It includes the following:

• Purchase Order Number
• Purchaser and Vendor Information
• Quantity or Units of Goods
• Price or  Amount
• Invoice Number and Invoice Related Information
• Description of goods
• Payment Terms

Difference between Purchase Requisition and Purchase Order

Purchase Requisition is used to simply seek permission from another department within the entity whereas other department uses a purchase order to actually place an order i.e make a purchase of specific goods required.

Where Purchase requisition is a document generally used internally within an organisation whereas the purchase order is generally issued to the external vendor. The purchase order is issued after purchase requisition.

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“Accumulated Depreciation” is the contra account used to record depreciation.

Let me help you understand the meaning of accumulated depreciation.

Meaning of Accumulated Depreciation

Accumulated Depreciation is the total cumulative depreciation of tangible fixed assets up to a particular date. It is associated with assets such as plant & machinery, furniture & fixtures, equipment, building, vehicles, etc. It is the total depreciation already charged as an expense over the estimated useful life of the assets. It is a contra asset account & has a credit balance.

Accumulated depreciation is presented in the balance sheet and reduced from the gross amount of fixed tangible assets to derive the net value of the asset.

Example of Accumulated Depreciation

Suppose Chocolate Ltd bought a chocolate manufacturing machine worth 500,000 in the month of January 20×1. The estimated useful life of the machine is 5 years with no scrap value.

Following the straight-line method of depreciation, the machine will be depreciated with an amount of 100,000 at the end of every year for 5 consecutive years.

Journal Entry at the end of each year for 5 consecutive years will be;

The depreciation charged every year will be added to the balance of accumulated depreciation. Then, the entire amount of accumulated depreciation is reduced from the gross amount (cost) of the machine in the balance sheet to arrive at the net value.

Journal Entry at the end of 5th year ie. on 31/12/20×5 to remove the machine and accumulated depreciation from the entity’s accounting records will be;

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In simple words, a petty cash book which is usually prepared by the ordinary or imprest system is a book of accounting prepared for the purpose of recording expenses of small value. For example stamps, wages, postage, carriage, stationery, etc.

The two types of petty cashbook are:

1. Simple petty cashbook – In this type of book, receipt of any amount is recorded on the debit side cash column and the payments on the credit side cash column. It is similar to a cashbook.
2. Analytical petty cashbook – In this type of book, a separate column is maintained for each commonly occurring expense. For miscellaneous payments, a column of sundries is added.

The pdf containing a format for both types of petty cashbooks is attached as follows.

petty cashbook formats