1 Unit 1: Introduction to Accounting

Unit 1: Introduction to Accounting

1.1 Definition of Accounting

Accounting is the art of recording, classifying and summarizing business

transactions.

A business transaction is any event which changes the financial position of the
business.

1.2 Need & Importance of Accounting/Objects of Accounting

1. Accounting is a language, a system that communicates information.

Such information is required:
 To find out where a business stands and what is the worth of
that business.
 To find out how business performs.
2. Accounting is of a great assistance to management for planning,
controlling and decision making process. It is with the help of
accounting information that the performance of an entity can be
appraised.
3. Accounting helps us in prevention of fraud and discovery of frauds as
accounting and accounting information system facilitate keeping
records of all transactions in a systematic manner.
4. Loan from financial institutions cannot be taken unless financial
information of the business is provided in an acceptable manner.
Accounting provides guidance for this.
5. Payment of sales tax and income tax is only possible if books of
accounts are maintained.

1.3 Book-Keeping vs. Accounting

Bookkeeping is the process of recording, in chronological order, the daily

transactions of a business entity. It forms part of the accounting information
system.
On the other hand, accounting is an information system – includes the process
of recording, classifying, summarizing, reporting, analyzing and interpreting the
financial condition and performance of a business – in order to communicate it
to stakeholders for business decision making.

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2 Unit 1: Introduction to Accounting

1.4 Branches of Accounting

There are three branches of accounting:

1. Financial Accounting: Financial accounting involves recording and
classifying business transactions, and preparing and presenting financial
statements to be used by internal (managers) and external users
(customers, suppliers, loan providers, employees, government, etc.).
2. Management Accounting: This branch of accounting provides
information to management for better administration of the business. It
helps in making important decisions and controlling of various activities
of the business. The management is able to take decisions efficiently
with the help of various Management Information Systems such as
Budgets, Projected Cash Flow and Fund Flow Statements, Variance
Analysis reports, Cost-Volume-Profit Analysis reports, Break-Even-Point
calculation, etc.
3. Cost Accounting: Cost accounting deals with evaluating the cost of a
product or service offered. The objective of cost accounting is to help
the management in fixing the prices and controlling the cost of
production.

1.5 Important Accounting Terms, Concepts & Principles

Business An organization or economic system where goods and

services are exchanged for one another or for money to
earn profit.
Going Concern An assumption by accountants that a business will
operate indefinitely unless specific evidence to the
contrary exists.
Assets Any valuable thing controlled by the business to use in
business to generate benefits; for example, building,
machinery, cash, etc. Asset has two types:
Non-Current Asset – which give benefits for more than
one year e.g., building
Current Asset – which give benefits for less than one year
e.g., cash.
Liabilities Debts or obligations of an entity that have arisen from
past transactions. Liability has two types.
Non-Current Liability – which will be settled after more
than one year e.g., loan payable after five years.
Current Liability – which will be settled within one year
e.g., electricity bill payable.
Capital Amount invested by the owner into his business
Inventory/Stock Goods which are ready or will be ready for sale in an
ordinary course of business.

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3 Unit 1: Introduction to Accounting

Purchases Purchase of goods for re-sale purpose to earn profit.

Sales Sales of goods in an ordinary course of business to earn
profit.
Income Income is money that an individual or business receives in
exchange for providing a good or service or through
investing capital.
Expense Cost of doing the business.
Creditor/ Trade A supplier of goods from whom the business purchased
Payable goods on credit.
Debtor/ Trade A customer to whom the business sold goods on credit.
Receivable
Separate Entity’s An accounting concept which treats a business separately
Concept from its owner.
Drawings Goods or cash withdrawn by the owner of the business
for its personal use.
Accrual Concept This accounting concept requires recording income when
they are earned and not when they are received in cash,
and recording expenses when they are incurred and not
when they are paid.
Matching It means that expenses are recorded (matched) with the
Principle income that is generated from those expenses.

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4 Unit 2: Analysis of Transaction & Double Entry System

Unit 2: Analysis of Transaction & Double Entry System

2.1 Analysis of Transaction

Business transaction is any event which changes the financial position of the
business.
Each transaction has two aspects. One aspect is known as ‘Debit’ and the other
aspect is known as ‘Credit’.

Activity 2.1
Identify the two aspects of the following transactions.
First Aspect Second Aspect
1 The business man purchased office ↑ Furniture ↓ Cash
furniture for Rs.300000.

2 The business man purchased goods for

Rs.200000.

3 The business man sold goods for Rs.

300000.

4 The business man took loan from a bank

amounting Rs.800000.

2.2 Single & Double Entry Systems

There are two methods of book keeping.

1. Single Entry System: Only one side of the transaction is recorded.
2. Double Entry System: Both sides of the transaction are recorded. The
recording of one side is known as debit entry while recording of other side is
known as credit entry. Both debit and credit entries are recorded with equal
amount.
Professional accountants used double entry system while recording business
transactions.

2.3 Rules of Double Entry System: Debit & Credit

All the items to be recorded are classified into five heads.

1. Assets: Any valuable thing controlled by the business to use in business to
generate benefits
2. Liabilities: Debts or obligations of an entity that have arisen from past
transactions.
3. Capital: Amount invested by the owner into his business.

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5 Unit 2: Analysis of Transaction & Double Entry System

4. Income: Income is money that an individual or business receives in exchange for

providing a good or service or through investing capital.
5. Expense: Cost of doing the business.

The rules of debit & credit related to these items are given below:

Increase is Decrease is
Item
Recorded by Recorded by
Asset Debit Credit
Liabilities Credit Debit
Capital Credit Debit
Income Credit Debit
Expense Debit Credit
.
Activity 2.2
Complete the following table by applying the rules mentioned above.
Transaction Relevant Items Increased/Decreased Accounting Entry
The business man Furniture (Asset) ↑ Furniture (Asset) Dr. Furniture $3000
purchased office furniture Cash (Asset) ↓ Cash (Asset) Cr. Cash $3000
for $3000.
The business man Purchase (Expense)
purchased goods Cash (Asset)
amounting $2000.
The business man sold Cash (Asset)
goods for $3000. Sales (Income)
The business man took Cash (Asset)
loan from a bank Loan (Liability)
amounting $80000.
The business man paid Salary (Expense)
salary to employees Cash (Asset)
amounting $5000.
The business man received Cash (Asset)
rent amounting $2500. Rent received (Income)
The business man invested Cash (Asset)
$70000 into his business Investment (Capital)
The business man repaid Loan (Liability)
loan amounting $80000 Cash (Asset)
The business man Purchase (Expense)
purchased goods on credit Creditors (Liability)
amounting $7000.
The business man sold Debtors (Asset)
goods on credit amounting Sales (Income)
$10000
The business man Drawings (↓ in Capital)
withdraws $2000 for his Cash (Asset)
personal use.

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6 Unit 2: Analysis of Transaction & Double Entry System

2.4 Advantages of Double Entry System

1. Complete record is maintained as both aspects of the transactions are

recorded.
2. Complete record, maintained under double entry system, assists
management in taking business decisions on time.
3. Verification of arithmetic accuracy is easy as the amount of total debits is
equal to the amount of total credits.
4. Financial statements can be prepared easily.
5. Comparison of business performance and position over the years becomes
easy as records of every asset, liability, income and expense are properly
maintained.

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7 Assignment 1

Assignment 1

Name: Roll #:

Complete the following table

Transaction Increased/Decreased Rule of Debit & Credit Accounting Entry

Business purchased office ↑ Furniture (Asset)  Increase in asset is Dr. Furniture $3000
furniture for $3000. ↓ Cash (Asset) recorded as debit. Cr. Cash $3000
 Decrease in asset is
recorded as credit.
Business took loan from ↑ Cash (Asset)  Increase in asset is
bank amounting $35000. ↑ Loan (Liability) recorded as debit.
 Increase in liability
is recorded as
credit.
Business purchased goods
from Mr. Khan on credit
amounting $17000

Business sold goods for

$4000.

Business paid shop rent

amounting $1000.

Business paid $17000 to its

creditor Mr. Khan.

Business sold goods on

credit to Mr. Ali amounting
$10000.

Business received cash

from its Debtor Mr. Ali
amounting $10000.

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8 Assignment 1

Transaction Increased/Decreased Rule of Debit & Credit Accounting Entry

Business paid electricity
expenses amounting $500.

Business paid interest

expense amounting $500.

Business man invested

$50000 into his business.

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9 Unit 3: Accounting Equation

Unit 3: Accounting Equation

Accounting equation is the foundation of double entry accounting. It displays that all the
assets of a company are always equal to the sum of its capital and liabilities at any point
of time.
Assets = Capital + Liabilities
Or in other words:
Assets - Liabilities = Capital

The following table explains the concept of accounting equation.

Accounting Equation
Transactions Effect Assets = Capital + Liabilities
$ $ $
Mr. Khan started his Asset (Cash) ↑ by $10000 10000 = 10000 + 0
business by investing Capital ↑ by $10000
$10000 No effect on Liabilities
Mr. Khan took loan Asset (Cash) ↑ by $5000 15000 = 10000 + 5000
from bank for business Liability (Loan) ↑ by $5000
purpose amounting No effect on Capital
$5000
Mr. Khan purchased Asset (Furniture) ↑ by $1000 15000 = 10000 + 5000
furniture for office use Asset (Cash) ↓by $1000
for $1000 Net effect on assets is zero as one
asset is increased and the other
asset is decreased by the same
amount.
No effect on Capital
No effect on Liabilities
Mr. Khan purchased Asset (Inventory) ↑ by $2000 17000 = 10000 + 7000
goods from Mr. Ali for Liability (Creditor) ↑ by $2000
resale purpose No effect on Capital
amounting $2000 on
credit.
Mr. Khan sold all the Asset (Cash) ↑ by $3000 18000 = 11000 + 7000
goods for $3000. Asset (Inventory) ↓by $2000
Net effect on asset is an increase
of $1000
Capital (Profit) ↑by $1000
No effect on liabilities s
Mr. Khan paid $2000 to Asset (Cash) ↓by $2000 16000 = 11000 + 5000
Mr. Ali. Liability (Creditor) ↓by $2000
No effect on Capital
Mr. Khan withdrew Asset (Cash) ↓by $1000 15000 = 10000 + 5000
$1000 for personal use. Capital (Drawing) ↓by $1000
No effect on Liability

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10 Unit 3: Accounting Equation

Key Point
When goods are purchased for resale purpose, they are treated as expense by
debiting ‘Purchase Account’ and crediting ‘Cash or Creditors Account’ as
appropriate. However, when financial position of the business is ascertained,
all the unsold goods are considered inventory/stock which is treated as asset.
This concept will be further explained in Unit 7: Accounting for Inventory.

Key Point
Capital is the internal obligation of the business as business has to retune it
to the businessman at the dissolution of the business. This is the application
of separate entity concept discussed in Unit 1: Introduction to Accounting.
Similarly, profit earned by the business is the internal obligation of the
business which is payable to the businessman as it is the return on his
investment. So profit is added in capital. Moreover, when business man
withdraws money from business for his personal use, he is actually taking
part of that profit he is entitled to receive; and that profit is included in
capital. So drawing decreases capital.

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11 Unit 4: Accounting Cycle: From Journal to Trial Balance

Unit 4: Accounting Cycle: From Journal to Trial Balance

4.1 Introduction

Accounting cycle is a step-by-step process of recording, classifying and

summarizing accounting information.

Following are the major steps involved in the accounting cycle.

Step 1: Recording transactions via journal entries
Step 2: Posting journal entries to ledger accounts
Step 3: Preparing unadjusted trial balance
Step 4: Preparing adjusting entries at the end of the period
Step 5: Preparing adjusted trial balance
Step 6: Preparing Income Statement & Balance Sheet

4.2 Recording Transactions via Journal Entries

The first step of accounting cycle is to record business transaction in a Journal.

Following are the characteristics of a Journal.

1. A journal is a chronological record of transactions
2. It shows debit and credit entry of each transaction.
3. A narration is written below the entry to explain it.
4. It has a particular format as shown below:

Page 1
Journal
Debit Credit
Date Particulars L.F.
$ $
1.1.2016 Machinery Account 50000
To Cash Account 50000
Machinery is purchased.
1.1.2016 Furniture Account 5000
To Cash Account 5000
Furniture is purchased.

There are two types of journal entries; Simple Entry & Compound Entry. A
simple entry is that entry which consists of only two accounts. On the other
hand, a compound entry is that entry which consists of more than two accounts.
The transactions recorded in above extract of Journal are simple transactions.
These transactions can also be recorded using one compound entry instead of
using two simple entries as follows:

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12 Unit 4: Accounting Cycle: From Journal to Trial Balance

Page 1
Journal
Debit Credit
Date Particulars L.F.
$ $
1.1.2016 Machinery Account 50000
Furniture Account 5000
To Cash Account 55000
Non-current assets purchased

Note: Had the two assets purchased on different dates then the compound
entry would not been passed.

Following are advantages of a journal:

1. Transaction is recorded as soon as it takes place.

2. Transaction is recorded chronologically. So it is easy to locate any specific
transaction.
3. Narration, which is written below the entry, explains the transaction.

Activity 4.1
Journalize the following transactions.
Date Transactions
01.1.2016 Mr. Khan started his business by investing $200000. The
amount was deposited in business bank account.
02.1.2016 Mr. Khan withdrew cash from business bank account
amounting $30000 for business purpose.
02.1.2016 Mr. Khan purchased furniture for $20000 to use in office. The
payment was made by cheque.
03.1.2016 Mr. Khan purchased goods for resale purpose for $25000. The
payment was made by cheque.
04.1.2016 Mr. Khan sold all the goods he purchased on 3.1.2016 for
$45000. The payment was made by cheque.
05.1.2016 Mr. Khan purchased goods for resale purpose from Mr. Ali on
credit amounting $30000.
06.1.2016 Mr. Khan sold all the goods purchased from Mr. Ali to Mr.
Waqas on credit for $55000.
07.1.2016 Mr. Khan paid $12000 to his creditor Mr. Ali. The payment was
made by cheque.
15.1.2016 Mr. Khan received cash amounting $5000 from his debtor Mr.
Waqas.
31.1.2016 Mr. Khan paid office rent amounting $5000 cash.
31.1.2016 Mr. Khan paid salaries through cheque amounting $20000.

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13 Unit 4: Accounting Cycle: From Journal to Trial Balance

Solution
Page 1
Journal
Debit Credit
Date Particulars L.F.
$ $

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14 Unit 4: Accounting Cycle: From Journal to Trial Balance

4.3 Posting Journal Entries to Ledger Accounts

The second step of accounting cycle is to post journal entries in accounts

contained in ledger. The account is a record which is used to summarize all
increase and decrease in a particular asset, liability, expense, income, or
capital. Ledger is the book which contains all such records. The format of a
ledger account is shown below:
Page 1
Cash Account
Date Particular Ref. $ Date Particular Ref. $

This side is known as Debit Side This side is known as credit Side
Debit entry is recorded here Credit entry is recorded here

The posting of journal entries in the ledger accounts is exhibited below:

Page 1
Journal
Date Debit Credit
Particulars L.F.
2016 $ $
st
1 May Cash Account 1 50000
Capital Account 2 50000
Capital is invested into the business.

Ledger
↓Debit Side Credit Side ↓
Page 1
Cash Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016
st
1 May Capital A/C 1 50000

Page 2
Capital Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016
st
1 May Cash A/C 1 50000

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15 Unit 4: Accounting Cycle: From Journal to Trial Balance

Note that:
In journal cash account is debited. So this is a debit entry and should be posted
on the debit side of the cash account in the ledger.
Similarly, in journal capital account is credited. So this is a credit entry and
should be posted on the credit side of the capital account.
In Particular’s column, title of the other account (the other side of the
transaction) is mentioned.
Activity 4.2
Post all the journal entries of Activity 4.1 in leger accounts.
Solution:
Page 1
Bank Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 2
Capital Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 3
Cash Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

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16 Unit 4: Accounting Cycle: From Journal to Trial Balance

Page 4
Furniture Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 5
Purchase Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 6
Sales Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

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17 Unit 4: Accounting Cycle: From Journal to Trial Balance

Page 7
Creditor Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 8
Debtor Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 9
Rent Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

Page 10
Salaries Account
Date Particular J.F. $ Date Particular J.F. $
2016 2016

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18 Unit 4: Accounting Cycle: From Journal to Trial Balance

4.4 Balancing Off Ledger Accounts and Preparing Trial Balance

A trial balance is a list of all the balances in the nominal ledger accounts. It
serves as a check to ensure that for every transaction, a debit recorded in one
ledger account has been matched with a credit in another. If the double entry
has been carried out, the total of the debit balances should always equal the
total of the credit balances.
In order to prepare a trial balance, we first need to balance off the ledger
accounts. Balancing off ledger accounts is done as follows:
1. Total both sides of the ledger account and find the larger total.
2. Put the larger total in the total box on the debit and credit side.
3. Insert a balancing figure to the side of the ledger account which does
not currently add up to the amount in the total box. Call this balancing
figure ‘balance c/d’ (carried down).
4. Carry the balance down diagonally and call it ‘balance b/d’ (brought
down).
The nature of the balance would be debit if the debit side increases the credit
side and the nature of the balance would be credit if credit side increases the
debit side.
Note that the nature of the normal balance of an asset account or an expense
account is ‘debit’ whereas the nature of the normal balance of a liability
account, an income account or capital account is ‘credit’.
Activity 4.3
Prepare the trial balance after balancing off all the ledger accounts which are
prepared in activity 4.2.
Solution:
Trial Balance
Dr. Cr.

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19 Unit 5: Accounting Cycle: Adjusted Trial Balance

Unit 5: Accounting Cycle: Adjusted Trial Balance

5.1 Adjusting Entries

Accrual concept, as explained in Unit 1, requires that income should be

recorded in the period in which they are earned regardless whether they are
receipt not. Similarly, expenses should be recorded in the period in which they
are incurred regardless whether they are paid or not. To meet this requirement
of accrual accounting adjusting entries are made.
Adjusting entries are passed for the following items:
1. Prepaid Expenses (Expenses paid but not incurred, e.g., office rent
expense paid in advance).
2. Outstanding/Accrued Expenses (Expenses incurred but not paid, e.g.,
unpaid salaries at the end of the month).
3. Deferred Income (Income received but not yet earned, e.g., rental
income received in advanced for the next accounting period)
4. Accrued Income (Income earned but not yet received, e.g., interest
earned on saving account but not yet credited in the account by the
bank).
Adjusting entries relating to these items are explained below.

Item Entry Already Effect of Original Purpose of Adjusting Entry

Passed Entry or Omission of Adjusting Entry
Entry
Prepaid Dr. Rent Expense A/C 1. Rent expense is 1. To reduce Dr. Prepaid Rent A/c
Expenses Cr. Cash A/c overstated (as this overstated Cr. Rent Expense A/c
(E.g., rent expense is not rent expense
paid in incurred yet, but (Increase in asset is
advance) paid in advance) recorded by debit and
decrease in expense is
2. No asset is 2. To record the recorded by credit)
recorded (Prepaid asset
rent is an asset (prepaid
because its benefit rent)
will be received in
future)
Accrued None 1. Salary expense is 1. To record the Dr. Salary Expense A/c
Expenses understated as salary Cr. Accrued Salary A/c
(E.g., expense is incurred expense (or Salary payable A/c)
unpaid but not recorded.
salary at 2. No liability is 2. To record the
the end of recorded; however liability (Increase in expense is
month.) an obligation exists (Accrued recorded by debit and
to pay the salary or increase in liability is
expenses. salary recorded by credit).
payable)

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20 Unit 5: Accounting Cycle: Adjusted Trial Balance

Item Entry Already Effect of Original Purpose of Adjusting Entry

Passed Entry or Omission of Adjusting Entry
Entry
Deferred Dr. Cash A/c 1. Income is 1. To reduce Dr. Rental Income A/c
Income Cr. Rental Income overstated as it is overstated Cr. Deferred Rental Income A/c
(E.g., Rent not earned yet or it income
received in does not related to (Decrease in income is
recorded by debit and
advance for current accounting
increase in liability is
the next period.
recorded by credit)
accounting 2. Liabilities are 2. To record
period) understated liability
because an (Deferred
unrecorded Rental
obligation exits to Income)
provide services in
future without
receiving any
further benefit.
Accrued None 1. Assets are 1. To record the Dr. Interest Receivable A/c
Income understated as asset Cr. Interest Income A/c
(E.g., income receivable (Interest
interest is an asset (its receivable)
earned but benefit will inflow
not to the business in
received future).
yet). 2. Value of income is 2. To record the
understated as an interest
income is not income
recorded whereas
actually it has been
earned.

5.2 Adjusted Trial Balance

After passing the adjusting entries, an adjusted trial balance is prepared from
the revise balances of ledger accounts.

5.3 Work Sheet

A work sheet is used at the end of accounting period to prepare adjusted trial
balances and financial statements (discussed later). However, for the sake of
simplicity, this section will explain the preparation of work sheet to find out
adjusted trial balance only.

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21 Unit 5: Accounting Cycle: Adjusted Trial Balance

Activity 5.1
Following trial balance relates to MM Enterprises for the year ended 31
December 2016.

Debit Credit
$ $
Building 350000
Furniture 26000
Cash in Hand 45000
Cash at Bank 115000
Debtors 210000
Creditors 100000
Purchases 229000
Sales 515000
Capital 300000
Long Term Loan 100000
Rental Income 35000
Salary Expense 70000
Interest Expense 5000
Total 1050000 1050000

Following information is relevant.

1. Salary expense included an advanced salary paid to an employee for
January 2017 amounting $5000.
2. Total interest expense incurred in the year amounting $10000. Half of it
was paid during the year (shown in the trial balance) while remaining
half is still payable.
3. On 1st July 2016, MM Enterprises rented out its spare building for an
annual rent of $35000. The whole rent was received in advanced on 1st
July 2016. So half of the rental income (shown in the trial balance)
relates to the next year.
4. Ignore closing inventory/stock.
Required:
Prepare work sheet showing adjusted entries and adjusted trial balance.

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22 Unit 5: Accounting Cycle: Adjusted Trial Balance

Solution:
Work Sheet
Original Trial Balance Adjustments Adjusted Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
$ $ $ $ $ $
Building 350000 000000 000000 000000 000000
Furniture 26000
Cash in Hand 45000
Cash at Bank 115000
Debtors 210000
Creditors 100000
Purchases 229000
Sales 515000
Capital 300000
Long Term Loan 100000
Rental Income 35000
Salary Expense 70000
Interest Expense 5000

Total 1050000 1050000

Compiled by Muhammad Mansoor Javed

23 Unit 6: Completion of Accounting Cycle

Unit 6: Completion of Accounting Cycle

6.1 Preparing Income Statement

Two financial statements are prepared from adjusted trial balance. The first
financial statement which is prepared form the adjusted trial balance is known
as ‘Income Statement’. This statement shows performance of the business, i.e.,
how much profit is earned or loss is suffered during the particular accounting
period.

Balances of all income and expense accounts, shown in the adjusted trial
balances, are used in the preparation of income statements as profit or loss of
the business is calculated by deducting all types of expenses from all types of
incomes. It should be noted that balances of all assets, liabilities and capital
accounts are not used in the preparation of Income Statement; rather they are
used in the preparation of Balance Sheet or Statement of Financial Position
(discussed later).

The format of a simple income statement (for a sole trader) is given below.

ABC Enterprises
Income Statement
For the Year Ending 31 December 2016
$
Sales (Note 1) X Trading Account
Less Cost of Sales (Note 2) (X)
Gross Profit (Note 3) X
Other Income (Note 4) X
Distribution expenses (Note 5) (X) Profit & Loss
Administration expenses (Note 6) (X) Account
Interest Expense (X)
Tax (X)
Net Profit (Note 7) X

Notes:
1. Sales: This figure shows total value of sales made by normal trading.
Sale of assets (other than stock/inventory) is not shown here.
2. Cost of Sales: These are those expenses which are directly associated
with sales. For a retail business, cost of sales is normally include:
i. Purchase price of the units sold
ii. Carriage inwards (cost of transporting goods into a business
from a supplier)

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24 Unit 6: Completion of Accounting Cycle

For a manufacturing business, cost of sales may include other items

which are beyond the scope of these notes.
3. Gross Profit: The word gross means ‘before any deduction’. Gross profit
is the trading result of the business’ operations (i.e., sales & purchase)
before the deduction of indirect expenses.
4. Other Income: Income generated from activities other than normal
business operations. Examples are:
i. Rental income
ii. Interest received on investments
iii. Discount received (a deduction in amount payable when
payment is made to the creditor before the due date).
iv. Profit on disposal of asset
5. Distribution Expenses: These are those expenses which are indirectly
relates to sale; hence not included in cost of sales. Examples are:
i. Advertisement Expense
ii. Salaries of sale staff
iii. Carriage outwards (cost of transporting goods from a business
to a customer)
iii. Discount Allowed (a deduction in amount receivable when
payment is received from the debtor before the due date).
6. Administration Expenses: These are those expenses which are not
related directly to the functions of manufacturing or sales; rather they
are associated with the general administration of the business.
Examples are:
i. Salaries of accountants
ii. Office rent
iii. Insurance Expense
iv. Utility Cost
v. Loss on disposal of assets
7. Net Profit: The word net means “after all deductions”. Net profit shows
net earnings of the business after deducting all types of expenses.

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25 Unit 6: Completion of Accounting Cycle

Activity 6.1
Following adjusted trial balance relates to MM Enterprises for the year ending
31 December 2016

Debit Credit
$ $
Building 750000
Furniture 5000
Equipment 140000
Debtors/Trade Receivable 35000
Prepaid Rent 14000
Cash at Bank 300000
Capital 700000
Long Term Loan 100000
Accrued Interest 2500
Creditors/Trade Payables 15000
Interest Expense 5000
Salary 20000
Sales 900000
Purchases 425000
Discount Received 2000
Discount Allowed 1500
Insurance 10000
Advertisement 5000
Carriage Inwards 1000
Carriage Outwards 3000
Utility Bills 5000
1719500 1719500

Required:
Prepare the income statement of the business for the year ending 31 December
2016.

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26 Unit 6: Completion of Accounting Cycle

Solution

MM Enterprises
Income Statement
For the Year Ending 31 December 2016
$

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27 Unit 6: Completion of Accounting Cycle

6.2 Preparing Statement of Financial Position

Second financial statement which is prepared from the adjusted trial balance is
known as ‘Balance Sheet’ or ‘Statement of Financial Position’. This statement
shows the financial position of the business on a particular date; i.e., how many
assets the business owns and how many liabilities the business owes. It also
shows the value of capital (also known as owner’s equity).

The format of ‘Statement of Financial Position’ (for a sole trader) is given below:

ABC Enterprises
Statement of Financial Position
As at 31 December 2016
$ $
Non-Current Asset
Land & Building X
Plant & Machinery X
Furniture & Fittings X
Current-Asset
Stock/Inventory X
Trade Receivable/ Debtors X
Prepaid Expense X
Cash at Bank X
Cash in Hand X
X
Total Assets X
Capital X
Add Profit for the year X
X
Non-Current Liabilities
Long Term Loan X
Current Liabilities
Trade Payable/Creditors X
Accrued Expenses X
X
Total Capital & Liabilities X

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28 Unit 6: Completion of Accounting Cycle

Activity 6.2
Using the information given in activity 6.1, prepare Statement of Financial
Position

Solution:

MM Enterprises
Statement of Financial Position
At 31 December 2016
$ $

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29 Unit 6: Completion of Accounting Cycle

6.3 Classification of Accounts

Ledger accounts can be broadly classified into two heads:

1. Personal Account
Accounts of individuals, firms, companies are known as personal accounts.
The personal accounts may further be classified into three categories:
I. Natural Personal Accounts: Accounts of natural/real persons are
known as natural personal account; e.g., Akbar Account.
II. Artificial Personal Accounts: Accounts of artificial persons i.e.,
companies are known as artificial personal accounts; for example,
MM & Co Account.
III. Representative Personal Accounts: The accounts which represent
some person such as Wage Outstanding account, Prepaid Insurance
Account, and Accrued Interest Account.
2. Impersonal Account
Accounts which are not related to individuals (either natural or artificial) are
known as impersonal accounts. These can be further classified into real
account and nominal account.
I. Real Accounts: Real accounts are the accounts related to
assets/properties such as Building Account, Machinery Account,
Cash Account, and Furniture Account.
II. Nominal Accounts: The accounts relating to income, expenses,
losses and gains are classified as nominal accounts. For example
Wages Account, Rent Account, Interest Account and Salary Account.

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30 Assignment 2

Assignment 2

KK Enterprises started its business on 1st January 2016. Following trial balance shows the
balances of ledger accounts of the business as at 31st December 2016.

Dr. Cr.
$ $
Building 750000
Furniture 5000
Equipment 140000
Debtors/Trade Receivable 35000
Cash at Bank 300000
Capital 700000
Long Term Loan 100000
Creditors/Trade Payables 15000
Interest Expense 5000
Salary 20000
Sales 900000
Purchases 425000
Rent Received 2000
Discount Allowed 3000
Insurance 20000
Advertisement 5000
Carriage Inwards 1000
Carriage Outwards 3000
Utility Bills 5000
1717000 1717000

Following adjustments are required:

(i) Inventory at 31 December 2016 was valued at $125000.

(ii) There was prepaid insurance expense amounting $5000.
(iii) Interest expense amounting $1500 was payable on 31 December 2016.
(iv) Rent amounting $1000 was receivable at the year end.

Required:

Prepare Income Statement and Statement of Financial Position of KK

Enterprises.

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31 Unit 7: Accounting for Inventories

Unit 7: Accounting for Inventories

7.1 Introduction

Matching principles requires that expenses should be matched with the income
that is generated with those expenses. Similarly, accrual concept requires that
expenses should be recorded when they are incurred and not when they are
paid.

One example of the application of the above concepts is to adjust cost of sale
for opening and closing inventories. For example, a business is started on 1
January 2016. Throughout the year, the business purchased 100000 units of a
certain commodity at Rs. 5 each, thus the purchase expense for the year is
500000 (100000 x 5). During the same year, the business sold 80000 units at Rs.
9 each. Thus the total sale of the year is 810000 (80000 x 9). Now, if total
purchase is deducted from total sales to find out the gross profit then the
resulted gross profit would be incorrect because total units sold are 80000 while
total units purchased are 100000. Therefore, deducting the cost of 100000 units
from the sale of 80000 units will be incorrect. To find out the correct gross
profit, cost of only 80000 units should be deducted from the sale of 80000 units
which is the application of the matching principles, i.e., expense should be
matched with the income that is generated with those expenses. Thus expense
of 80000 units relates to current accounting year whereas expense of remaining
20000 units relates to the next accounting year as these 20000 units will
generate income in next year. So expense related to these 20000 units should
be considered prepaid expense and should be treated as asset (i.e., inventory) in
the balance sheet.

The extract of the income statement of the business would be:

Rs. Rs.
Sales (80000 x 9) 810000
Less cost of sales
Purchase (100000 x 5) 500000
Less Closing Inventory (20000 x 5) (100000)
(400000)
Gross Profit 410000

In above example the value of closing inventory is calculated at the rate of Rs. 5
per unit as inventory is usually recorded at cost and all the goods are purchased
at Rs. 5 each. However, in practice, same commodities can be purchased at
different prices throughout the year. If this would be the case then the question
arises that at what cost closing inventory should be recorded? The next section
will answer this question.

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32 Unit 7: Accounting for Inventories

7.2 Methods of Inventory Valuation

There are three methods of stock or inventory valuation. Any of these methods
can be used for inventory valuation.

1. First in First Out (FIFO): This method assumes that stock is used or sold in
the same order in which it was received.
2. Last in First Out (LIFO): This method assumes that the last item of inventory
purchased is sold first.
3. Weighted Average Cost (AVCO): This method involves calculating the
weighted average cost of stock in hand after every delivery to the business.

It should be noted than each method will give different value. So it is important
to be consistent with a specific valuation method.

Activity 7.1
A business started on 1 May 2016. During the month of May following
transactions took place.
Quantity Cost/Unit Selling Price/Unit
Units $ $
2 May Purchased 100 2
3 May Purchased 400 3
4 May Sold 200 5
9 May Purchased 300 3.5
11 May Sold 400 7
18 May Purchased 100 4
20 May Sold 100
Required:
Calculate value of closing inventory at 30 May 2016 and gross profit using
following methods of inventory valuations:
(i) FIFO
(ii) LIFO
(iii) Weighted Average Cost
Solution
1. FIFO

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33 Unit 7: Accounting for Inventories

2. LIFO

3. Weighted Average Cost

7.3 Types of Inventory System

Two types of Inventory systems are used to maintain inventory records:

Perpetual Inventory System and Periodic Inventory System.

1. Perpetual Inventory System: In a perpetual inventory system, inventory

records are updated whenever a transaction of purchase or sale occurs.

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34 Unit 7: Accounting for Inventories

Following journal entries are passed in perpetual inventory system.

At the time of purchase of goods:

Debit Inventory Account

Credit Cash/Trade Payables Account

At the time of Sales of goods:

Debit Cash/Trade Receivable Account

Credit Sales Account

Debit Cost of Goods Sold Account

Credit Inventory

Gross profit is calculated by deducting the balance of cost of goods sold

account from the balance of sales accounts.

2. Periodic Inventory System: In a periodic Inventory system, inventory

records are only updated after the end of a specific period normally a year.

Following entries are passed in periodic inventory system.

To transfer the opening inventory to trading account:

Dr. Income Statement

Cr. Inventory Account
(With the value of opening inventory)

To transfer the closing inventory to trading account:

Dr. Inventory Account

Cr. Income Statement
(With the value of closing inventory)

Cost of goods sold is ascertained as follows:

Purchases
Add Opening Inventory
Less Closing Inventory

Cost of goods sold (as ascertained above) is deducted from sales to find out
gross profit.

In practice, perpetual inventory system is used by large businesses while

periodic inventory system is used by small businesses.

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7.4 Adjustment of Inventory Shrinkage

Inventory shrinkage is the excess amount of inventory listed in the accounting

records, but which no longer exists in the actual inventory. Excessive shrinkage
levels can indicate problems with inventory theft, damage, miscounting,
evaporation, or similar issues.

Inventory shrinkage should be considered as a loss/expense and should be

recorded as follows.

Debit Inventory Shrinkage Expense Account

Credit Inventory Account

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36 Unit 8: The Control of Cash Transactions

Unit 8: The Control of Cash Transactions

8.1 Cash book

The book in which all cash transactions are recorded is known as cash book. It
plays a dual role. It serves as a book of original entry as well as a ledger account.
So all the cash transactions are originally recorded in it (not in general journal)
and only the non-cash aspect of the transaction is posted to the ledger (cash
book itself serves as a cash account for cash aspect of the transaction).

8.2 Advantages of Cash Book

1. Daily cash receipts and payments are easily recorded.

2. Cash in hand at any time can be easily ascertained.
3. Mistakes can be easily detected at the time of verification of cash.
4. It reduces burden of posting to ledger as only non-cash aspect of the
transaction need to be posted.

8.3 Distinction between Cash Book and Cash Account

Cash Book Cash Account

It is a separate book in which cash It is an account in the ledger.
transaction are directly recorded.
It serves the purpose of both journal It serves the purpose of ledger
and ledger accounts so no need to account only. So if business does not
record the cash transaction in journal keep cash book, all cash transactions
and then post them to ledger. need to be recorded in general
journal fist and then need to be
posted to ledger book.

8.4 Types of Cash Book

There are three types of cash book.

1. Single Column Cash book: Use to record only cash transaction (No need
to open cash account in the ledger)
2. Double Column Cash book: Use to record both cash and bank
transactions (No need to open both cash and bank accounts in the
ledger).
3. Three Column Cash Book: Discount columns are also shown along with
cash and bank columns. Discount allowed column is shown on receipt
side and discount received column is shown on the payment side of the

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 37 Unit 8: The Control of Cash Transactions

cash book. Note that discount column in the cash book are only
memorandum columns only; hence discount allowed account and
discount received account are open in the ledger as normal.

8.5 Specimen of Three Column Cash Book

Cash Book

Discount Received
Discount Allowed
Voucher No.

Voucher No.
Ledger Folio

Ledger Folio
Date Particulars Cash Bank Date Particulars Cash Bank

Rs. Rs. Rs. Rs. Rs. Rs.

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38 Unit 8: The Control of Cash Transactions

Activity 8.1
Record following transactions in a three column cash book.
Date Transactions
01.1.2016 Mr. Khan invested $200000 into his business. The amount was deposited in
business bank account.
02.1.2016 Mr. Khan withdrew cash from business bank account amounting $30000
for business purpose.
02.1.2016 Mr. Khan purchased furniture for $20000 to use in office. The payment
was made by cheque.
03.1.2016 Mr. Khan purchased goods for resale purpose for $25000. The payment
was made by cheque.
04.1.2016 Mr. Khan sold all the goods he purchased on 3.1.2016 for $45000. The
payment was made by cheque.
07.1.2016 Mr. Khan paid cheque of $12000 to his creditor in full settlement of his
account amounting $12500.
15.1.2016 Mr. Khan received cash amounting $5000 from his debtor in full
settlement of his account amounting $5200.
31.1.2016 Mr. Khan paid office rent amounting $5000 cash.
31.1.2016 Mr. Khan paid salaries through cheque amounting $20000.
Solution:

Discount Received
Discount Allowed

Date Particulars Cash Bank Date Particulars Cash Bank

Rs. Rs. Rs. Rs. Rs. Rs.

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39 Unit 8: The Control of Cash Transactions

8.6 Reconciling the Bank Statement

Bank reconciliation is a schedule explaining any differences between the

balance shown in the bank statement (or pass book) and balance shown in the
cash book (bank column).

Items which create differences between bank statement and cash book can be
classified as follows:

1. Unrecorded Items in Cash Book: These are those items which are not
recorded in cash book but should be recorded. For example:
a. Bank charges
b. Direct debit (an arrangement made with a bank that allows a
third party to transfer money from a person's account on
agreed dates, typically in order to pay bills)
c. Standing orders (an instruction to a bank by an account holder
to make regular fixed payments to a particular person or
organization)
d. Amount directly deposited by trade debtors
e. Interest on deposits
2. Wrongly recorded items in cash book:
a. An entry is recorded on the debit side of the cash book instead
of credit side or vice versa.
b. An entry is recorded with wrong amount.
c. Casting errors
3. Unrecorded Items in Banks Statement:
a. Unpresented cheque
b. Uncredited cheque
4. Wrongly recorded items in Banks Statement:
a. Cheque of other parties are incorrectly debited
b. Deposits of other parties are incorrectly credited
c. Casting errors

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40 Unit 8: The Control of Cash Transactions

Items which create differences between the two balances

Items which require adjustment in Items which do not require

Cash Book adjustment in Cash Book

Wrongly
Unrecorded Wrongly Unrecorded
recorded Items
Items in Cash recorded Items Items in Bank
in Bank
Book in Cash Book Statement
Statement

Adjusting entries should be These items should be reconciled

passed for these items. Thus, cash through bank reconciliation
book balance would be revised. statement without revising the
cash book balance.

To prepare a bank reconciliation statement:

1. Compare the two records i.e., cash book and bank statement (or pass book)
and note all the items of disagreement.
2. Adjust cash book with those items which are not recorded in the cash book
or with those items which are incorrectly recorded in the cash book.
3. Prepare bank reconciliation statement for other items; i.e., unrecorded in
bank statement and/or incorrectly recorded in bank statement.

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41 Unit 8: The Control of Cash Transactions

Activity 8.2
At 31 December 2015, the bank column of K & K enterprises’ cash book showed
a debit balance of Rs.325000, which did not agree with the balance shown as
per bank statement. After comparing cash book with bank statement, it was
found that:
1. Cheques paid in but not yet credited by the bank amounted to Rs.50000
2. Cheques drawn but not yet presented to the bank amounted to Rs. 30000.
3. Bank charges of Rs.500 appeared in the bank statement but had not been
recorded by K & K enterprises.
4. A cheque for Rs.2,400 in payment for some motor repairs had been
mistakenly entered on the debit side of the cash book.
5. A cheque amounting Rs. 30000, which was belong to another customer, was
wrongly credited to K & K enterprises’ account by the bank.
6. The debit side of the cash book’s bank column was over-casted by Rs.
10000.

Required:
a) Calculate the revised closing balance of bank column of the cash book after
making required adjustments in the cash book.
b) Prepare Bank reconciliation statement.

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42 Unit 9: Accounting for Receivables

Unit 9: Accounting for Receivables

9.1 Important Definition

1) Accounts Receivable/Trade Receivable/Receivable

A receivable is a person or organization who owes money to the

business because business has sold it goods on credit.

2) Bad Debts

Bad debt is that debt which is not collectible and therefore worthless for
the business. This occurs after all attempts are made to collect the debt
because either the debtor has gone into bankruptcy or where the
additional cost of pursuing the debt is more than the amount which is
business could collect.

3) Doubtful Debts

Doubtful debts are those debts which a business or individual is unlikely

to be able to collect. The reasons for potential non-payment can include
disputes over supply, delivery, the condition of item or the appearance
of financial stress within a customer's operations.

4) Allowance for Doubtful Debt Accounts/Provision for Doubtful Debt

Accounts

An allowance for doubtful Debts accounts is a contra-asset account that

records the portion of a company's receivables, which it expects may
not be collected. The allowance for doubtful accounts is only an
estimate of the amount of accounts receivable which are expected to
not be paid.

5) Prudence Concept

An accounting principle which requires that business transactions

should be recorded in such a way that assets and income should not be
overstated whereas liabilities and expense should not be understated.
In other words, this concept requires that liabilities and expenses should
be record as soon as possible, i.e., even when they are only probable or
expected but not confirmed, while assets and income/revenue should
be recorded only when they are assured.

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43 Unit 9: Accounting for Receivables

9.2 Accounting Treatment for Bad Debts

1) Bad Debts Incurred
Dr. Bad & Doubtful Debts Account
Cr. Debtors Account
2) Bad Debts Recovered in Subsequent Year
Dr. Cash Account
Cr. Sundry Income/Bad & Doubtful Debts Account

9.3 Accounting Treatment for Doubtful Debts

1) Increase in Doubtful Debts
Dr. Bad & Doubtful Debts Account
Cr. Allowance for Doubtful Debts/Provision for Doubtful Debts
2) Decrease in Doubtful Debts
Dr. Allowance for Doubtful Debts/Provision for Doubtful Debts
Cr. Bad & Doubtful Debts Account
[

Activity 9.1
Mr. Khan starts his business on 1 January 2010. During the year he sold goods
on credit amounting Rs. 500000. Mr. Khan collected Rs. 260000 from these
customers during the year. However, out of remaining debtors, one debtor, Mr.
Butt, refused to pay his debt amounting Rs. 40000 on due date as he became
bankrupt. At the yearend Mr. Khan estimated that another debtor, Mr. Rana,
amounting Rs. 70000 is facing financial difficulties so he will not pay his debt on
the due date so it is appropriate to create an allowance for this customer.
Required:
Draw Receivable Accounts, Bad & Doubtful Debt Account and Allowance for
Doubtful Debts Account
Solution

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44 Unit 9: Accounting for Receivables

Activity 9.2
At 1 January 2016, receivable accounts of SRK enterprises show a debit balance
of Rs. 9,50,000 while allowance for doubtful debts had a credit balance of
Rs.1,20,000. Summary of the relevant transactions made during the year is
given below:
– Total Sales Rs. 27,00,000 (This include cash sales amounting Rs. 1,00,000
– Total Sales return from credit Rs. 1,50,000
– Total Cash received from credit customers Rs. 13,00,000
– Total Bad debts written off amounting Rs. 1,70,000
– Total Bad debts recovered which were written off previously Rs. 200000
At 31 December 2016, SRK enterprises estimated that the closing balance of
allowance for doubtful debts should be 5% of the closing balance of receivables.
Required: After explaining why ‘Allowance for Doubtful Account’ is made,
prepare Receivables Accounts, Bad & Doubtful Accounts and Allowance for
Doubtful Accounts.
Solution:

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45 Unit 10: Depreciation of Non-Current Asset

Unit 10: Depreciation of Non-Current Asset

10.1 Definition of Depreciation

Depreciation is the gradual decrease in the monetary value of an asset due to its
usage and wear & tear. It is considered as an expense of the business.

10.2 Causes of Depreciation

 Wear and tear

 Perishability
 Usage rights
 Natural resource usage
 Inefficiency/obsolescence

10.3 Need of Provision of Depreciation

Matching concept suggests that cost should be matched with revenue it

produces. This requires provision of depreciation so that the cost of the asset
can be allocated to the period in which revenue is generated using that asset.
 Accounting for depreciation will assist in:
 Ascertaining of correct cost of production
 Ascertaining of correct profit or loss
 Ascertaining of correct value of asset
 Making correct decision about replacement of asset

10.4 Difference between Depreciation and Fluctuation

Fluctuation refers to increase or decrease in market value of asset. Fluctuation

is different from depreciation due to following reasons:
 Depreciation indicates decrease in productive capacity of the asset
whereas fluctuation in market value of asset does not necessarily
indicate this.
 Depreciation always decreases the value of asset whereas fluctuation
may either increase or decrease the value of asset.
 Depreciation of depreciable asset will always occur however fluctuation
may or may not occur.
 Depreciation always indicates loss whereas fluctuation may indicate
either profit or loss.

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46 Unit 10: Depreciation of Non-Current Asset

10.5 Characteristics of Depreciation

 Only those assets are depreciated

– Which are non-current
– which have limited life and
– There values normally decrease over their useful life.
 It cause continuous and gradual fall in the value of asset
 It occurs till the last time of asset’s useful life.
 It is an expense which does not affect cash flows.
 Normally, the amount of depreciation cannot be determined precisely it may be
estimated.
 Depreciation does not depend on fluctuations of asset’s market value.

10.6 Methods of Depreciation

Method Formula of Calculating Depreciation

Straight Line Method Cost – Residual/Scrap Value
(Fixed Installment Method) Useful life
Reducing Balance Method Net Book Value x Relevant %
(Reducing Installment Method) Net Book Value = Cost – Accumulated Depreciation

Activity 10.1
ABC Ltd., purchased some furniture for Rs. 220000 on 1st January 2015. The scarp value
of the furniture was 20000 while the useful life was estimated to be five years. Calculate
depreciation of the furniture for first three years using straight line method.
Solution:

Activity 10.2
ABC Ltd., purchased some machinery for Rs. 520000 on 1st January 2015. The scarp
value of the furniture was 70000 while the useful life was estimated to be ten years.
Calculate depreciation of the machinery for first three years using reducing balance
method at 25%.
Solution:

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47 Unit 10: Depreciation of Non-Current Asset

10.7 Fixed Installment Method vs. Reducing Installment Method

Fixed Installment Method Reducing Installment Method
Rate and amount of depreciation remain Rate remains the same however
the same amount of depreciation diminishes
gradually.
Depreciation rate is applied on cost. Depreciation rate is applied on net
book value.
This method is suitable for that asset This method is suitable for that
which value decreases evenly over its asset which loses its value more in
useful life such as building. its earlier years of life than that of
later years.

10.8 Accounting for Depreciation

Journal entry for recording depreciation is given below:
Dr. Depreciation Account
Cr. Accumulated Depreciation Account

Depreciation is an expense so this expense is recorded by debiting depreciation

account. The other effect of the transaction is decrease in the asset’s value
which is recorded by crediting Accumulated Depreciation Account. The balance
of accumulated depreciation account shows the total decline in the value of
relevant asset. Hence, while preparing statement of financial position, the
balance of accumulated depreciation account is off set from the balance of
relevant asset account to show the asset at its net book value.

Activity 10.3
Using the data of Activity 10.2, prepare Machinery Account, Depreciation
Account and Accumulated Depreciation Account.
Solution:

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48 Unit 11: Accounts for Corporations/Companies

Unit 11: Accounts for Corporations/Companies

11.1 Definition

A corporation is a legal entity that is separate and distinct from its

owners. Corporations enjoy most of the rights and responsibilities that an
individual possesses; that is, a corporation has the right to enter into contracts,
loan and borrow money, sue and be sued, hire employees, own assets and pay
taxes.

11.2 Characteristics of Corporation

Ownership:
Ownership in a corporation is represented by stock certificates (also known as
share certificate) and the owners of these certificates are called stockholders
(shareholders). Every stockholder has a right to transfer/sale his stock even
without the consent of other shareholders.
Separate Legal Entity:
The corporation is considered a separate legal entity, conducting business in its
own name. Therefore, corporations may own property, enter into binding
contracts, borrow money, sue and be sued and pay taxes. Stockholders are
agents for the corporation only if they are also employees or designated as
agents
Perpetual Existence:
As a corporation is owned by stockholders and managed by employees, the sale
of stock, death of a stockholder, or inability of an employee to function does not
impact the continuous life of the corporation.
Limited liability:
The liability of stockholders is limited to the amount each has invested in the
corporation. Personal assets of stockholders are not available to creditors or
lenders seeking payment of amounts owed by the corporation. Creditors are
limited to corporate assets for satisfaction of their claims.
Professional centralized management:
Investors in a corporation need not actively manage the business, as most
corporations hire professional managers to operate the business. The investors
vote on the Board of Directors who are responsible for hiring management.
Government regulations:
Corporation are required to abide by different types of government regulations.

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11.3 Types of Corporations

Company Limited By Shares

"Limited by shares" means that the liability of the shareholders to creditors of

the company is limited to the capital originally invested. This type of company is
further divided into:
1) Public company (whose shares are freely traded on stock exchange)
2) Private company (whose shares are not freely traded on stock
exchange)

Company Limited By Guarantee

Unlike a company limited by shares, a guarantee company has no share capital

or shareholders. Instead it has members who undertake to contribute a nominal
amount towards any shortfall in the company's assets to settle its debts in the
event of its being wound up.

11.4 Formation of Public Limited Company

Formation of public limited company can be split up into three stages:

1) Promotion
2) Incorporation
3) Commencement of Business

1) Promotion
It involves:
- Discovery of business idea
- Investigation of business projects
- Verification of the results of investigation
- Chalking out definite course of action for establishing a
company
- Financing of the business
2) Incorporation
Following documents are required to file with the ‘Registrar of Companies’
for the incorporation of company.
- Memorandum of Association
- Article of Association
- Notice of the address of registered head office

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50 Unit 11: Accounts for Corporations/Companies

- A statutory declaration that all the provisions of the Company

Ordinance with regard to registration have been fulfilled
- Original copy of the receipted challans in respect of payment of
duty on share capital and prescribed filing fee.
After scrutinizing the above documents, the registrar registered the
company on the “Register of Companies” and issue certification of
incorporation.

3) Commencement of Business
After receiving certificate of incorporation, a public company required to
wait for certificate of commencement of business to start the business. This
certificate is issued after fulfilling certain additional requirement such as:
- Shares have been allotted to the amount of minimum
subscription.
- Every director of the company has paid the full amount of share
- Copy of Prospectus

11.5 Important Legal Documents of Public Limited Company

Memorandum of Company (MOA)

This document defines company’s relationship with shareholders. The MOA

and the Articles of Association serve as the constitution of the company.
The contents of Memorandum include following clauses:
– Name Clause: State legal and recognized name of the company
– Situation Clause: State physical location of registered head office
– Object Clause: State main objectives for establishing the company with
reference to the requirements for shareholding and use of financial
resources.
– Liability Clause: State the extent to which shareholders of the company
are liable to the debt obligations of the company in the event of the
company dissolving.
– Capital Clause: State company’s authorized share capital

Article of Association (AOA)

It contains rules and regulation of internal management of company such as:

– Power of directors and other officers of company
– Right of voting of shareholders
– Procedures of holding meeting
– Procedure of issuing shares
– Payments of dividends

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– Maintenance of accounts
– Alteration of capital
– Winding up procedures

Prospectus

The document is issued for raising the capital. The main objective of this
document is to arouse the interest of the investors in the company and to
induce them to invest in the shares.

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