What is trading account?

A trading account is a financial statement that shows the revenue, cost of goods sold, and gross profit or loss of a business for a given period of time. It is used to calculate the gross profit or loss of a business that is engaged in buying and selling goods.

The trading account is one of the first parts of the financial statements and is prepared before the profit and loss account.

The main objective of trading Account is to ascertain gross profit or gross loss of a business during an accounting period i.e. usually a year. It measures the overall performance of the business during a particular period.

In accounting terminology, gross profit means overall profit. It is the difference between sale proceeds of a particular period and the cost of the goods actually sold.

Format of Trading Account

The format of a Trading Account and the usually appearing entries therein are shown below:

Particulars	Amount (Rs.)	Amount (Rs.)	Particulars	Amount (Rs.)	Amount (Rs.)
To Opening Stock To Purchase Less: Returns Outwards To Direct Expenses Freight & Carriage Customs &Insurance Wages Packing (essential) Gas & Water Fuel & power			By Sales Less: Returns Inwards By Abnormal Losses Loss by fire Loss by Accident Loss by theft By Closing Stock By Gross Loss c/d
Factory expenses Royalty on production Dock Dues To Gross Profit c/d (Balancing figure			(Balancing figure)

Trading Account Items (Dr. Side)

The trading account items (Dr. Side) are:

Opening Stock

During the beginning of any accounting period, the closing balances of all assets, liabilities and capital of last financial year are brought forward by passing of the opening entry and entering the balance in respective account and stock is one of such account.

The amount of stock recorded in the beginning of the accounting period remained unchanged during the period and appears in the trial balance as stock or opening stock. This account is closed at the end of the period by transferring the same to trading accounts:

Trading account Dr.
To Opening Stock a/c

Purchases

This denotes the value of goods purchased either for cash or on credit for the purpose of resale. The balance of the purchase account, which appears in the Trial Balance, shows the total purchases made during a particular accounting period. In respect of purchases the following points must be noted:

• The purchase of any type capital asset should not be added with the normal purchases of the business. Because the nature of both the purchases are different. If it is already included in purchases, it should be deducted from there.
  
  
• If any type of personal goods have been purchased should be excluded from the purchases. This type of purchases should be treated as drawings.
  
  
• If some of the goods purchased are still in transit at the year-end i.e. it is not yet received by us then in that case it is always better to debit Stock-in-transit Account and pass reverse entry.
  
  
• If the purchases include goods which have been received on consignment, or on approval basis or on hire purchase, these should even be excluded from purchases they are not the part of purchases.
  
  
• This account is closed at the end of the period by transferring the same to trading accounts:
  

Trading account Dr.
To Purchases a/c

Purchases Returns / Returns Outwards

Purchase return is the return of goods or raw material to the supplier for any reason such as damages, goods not as per description, wrong items and not as per order etc. in such case the supplier’s account is debited and the Purchase return account is credited.

Thus a purchase return account shows a credit balance and appears on credit side of trial balance. This Purchase return account appears to the debit side of trading account as a deduction from purchases. Purchase return is often termed as Return Outward.

This account is closed at the end of the period by transferring the same to trading account as:

Purchase Return A/c Dr.
To Trading A/c

Direct Expenses

In case of a trading concerns, direct expenses consist of all expenses incurred on the purchase of goods and bringing them in saleable condition. Whereas in the case of manufacturing concern this constitutes all expenses incurred on the manufacture of those goods in which the firm deals in.

Direct expenses are debited to trading account as:
Trading account Dr.
To wages a/c
To Carriage inward a/c

To factory lighting, heating a/catch.

• Wages incurred on manufacture or merchandise is called direct wages. These wages are to be recorded on trading account debit side.While indirect wages are to be debited to profit and loss account. When there is no prefix like direct or indirect, wages are to be treated as direct and debited to trading account.
  
  Moreover when the phrase „wages and salary? issued and no explanation of the same is given, in such case the account is to be transferred to trading account debit side. Whereas when the term salary and wages? is used the account is to be transferred to profit and loss account. All the wages incurred on installation of machinery or on construction or repairs of building do not form part of wages.
  
  All such expenses which are incurred on machinery to bring it in working condition shall be considered as cost of that very machine and therefore capitalized Thus payments to the workers for manufacture or merchandise only are considered as part of wages and thus debited to trading account.
  
  
• Carriage inward, freight, insurance, etc. incurred on purchases are also to be debited to trading account. As they are considered as the cost of the purchases hence part of that purchase. It should always be kept in mind that all these expenses such as carriage inward, freight, insurance should be considered as cost of purchase as these have been incurred to bring the goods to our store are considered as the cost of purchases.
  
  However all those expenses which have been incurred on the Carriage outward, freight outward etc., are not debited to trading account because those have been incurred on sales so they will not be considered as direct cost but will be considered as indirect cost.
  
  Trading account contains on direct expenses thus they will not be considered as indirect cost and be taken to P&L account. Thus the transportation expenses incurred on purchase of raw material or merchandise are to be debited to trading account. The phrase inward or in indicates the expenses are related to purchases, whereas the phrase outward out indicate the expenses are related to sales.
  
  
• Factory lighting, heating, power and fuel etc. are to be debited to trading account as all the expenses that have been done in the factory are treated as direct expenses the reason being that production takes place in factory and all the expenses relating to factory are considered as direct cost of production.
  
  Sometimes separate manufacturing account is opened and all expenses related to manufacturing are transferred to manufacturing account first and then to trading account in the form of cost of production.
  
  
• Custom duty: Whenever the goods or raw is bought from a vendor in abroad, then in that case the tax or duty paid on import of goods is called custom duty. This is an expense and thus debited to trading account.
  
  
• Royalty: This is the amount paid by a lessee to the owner of an asset for the use of that asset. E.g. royalty paid for extracting coal from a coalmine, royalty paid to the author of a book, etc. Royalty based.on the raw material extracted e.g.
  
  coal, iron ore, etc. is charged to trading account as direct expenses. Whereas the royalty which is based on sale e.g. royalty paid to the author of a book on the basis of number of copies sold is to be charged to profit and loss account.
  
  
• Other expenses: The expenses like repairs of plant, depreciation of plant, factory building, etc. are considered as expenses related to manufacturing activity and hence debited to trading account.

Trading Account Items (Cr. Side)

The trading account items (Cr. Side) are:

Sales

It refers to the sale of goods in which the business deals in and includes both cash and credit sales. It does not include sale of old, obsolete or depreciated assets, which were acquired for use in business. However goods sent to customers on approval basis, free samples and GST, if any, included in the sales figure should be excluded.

GST sometimes included in the total sales revenue, should also be deducted as it is the tax collected and to be deposited with tax authorities. Sales account is a revenue account (nominal account), which denotes income earned from the main business activity or activities. The income is earned when goods or services are sold to customers. As per the accrual concept, income should be recognized as soon as it is accrued and not necessarily only when the cash is paid for.

Revenue should be recognized only when significant risks and rewards (vaguely referred to as ownership in goods) are transferred to the customer. For example, if an invoice is made for sale of goods and the term of sale is door delivery; then sale can be recognized only on getting the proof of delivery of goods at the door of customer.

If such proof is pending at the end of accounting period, then this transaction cannot be taken as sales, but will be treated as unearned income. Sales account in trail balance constitutes gross sales made during the accounting period and it is to be transferred to trading accounts:

Sales A/c Dr.
To Trading A/c

Sales Returns / Returns Inward

Whenever goods are returned by the buyers to the sellers for some reasons, in the books of account “Returns Inwards Account or “Sales Returns Account” is debited and that particular buyer is credited. In the Trial Balance such trial balance appears on the debit side. There are two ways in which such return may be reflected in the trading account. It can be shown as deduction from sales in Trading Account or as sales returns on the debit side of the Trading Account. It is transferred to trading account by passing an entry as:

Trading account Dr.
To Sales Return a/c

Abnormal Loss

Any loss in excess of normal loss is considered as abnormal loss of stock due to fire, theft or accident. Since Trading Account is prepared under normal conditions of the business, abnormal loss if any is credited fully to the Trading Account.

Closing Stock

This is the value of goods lying unsold at the end of any accounting year. The stock at the end is valued either at cost or market price whichever is less. As trial balance generally does not include closing stock, the following entry is recorded to incorporate the effect of closing stock in the Trading Account.

Closing Stock A/c Dr.
To Trading A/c

It should be kept in mind that if closing stock form the part of Trial Balance then it will not be transferred to Trading Account but taken to Balance Sheet only. In case the goods have been sent to customers on approval (Sale/Return) basis, such goods should be included in the value of closing stock.

Balancing of Trading Account

After posting all the above items, on the respective side of the Trading Account, Gross Profit or Gross Loss is found by calculating the balance. If the credit side shows more than the debit side then it is said to be gross Profit and if the debit side is more than the credit side then it is the gross loss. Later the Gross Profit is transferred to the Profit side of the account and vice versa.

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Profit and Loss Account

With the above statement and the profit and loss account the trader understands which way his business is moving. And to what percentage is the profit earned or loss incurred. For trading this is the first step i.e. the Profit and Loss account.

Next is writing indirect expenses and losses are entered in the P&L account. Then comes the incomes and gains that are credited. Excess in income left after cutting down the losses incurred is the net profit.

Anything less than the figure after cutting down the losses is the Net Loss. The account is closed after transferring the net profit or loss to capital account.

The format of Profit and loss account is as follows:

Particular	Amount	Particular	Amount
To Trading A/c	**	By Trading A/c	**
To Office and administrative Expenses:	**	By Interest received	**
To Salaries for Office Staff	**	By Dividend Received	**
To Office Rent, Rates & Taxes	**	By Rent Received	**
To Printing and Stationery	**	By Discount Received	**
To Printing and Stationery	**	By Discount Received	**
To Books and Periodicals Postage and Telephones	**	By Profit on sale of fixed assets	**
To Insurance Premium for office	**	By Profit on sale of investments	**
To Audit Fees	**	By Dividend from shares Insurance Claims	**
To Repairs & Maintenance	**	By Duty Drawbacks	**
To Audit Fees	**	By Apprenticeship	**
To Legal Expenses		By Premium
To Office Lighting		By Miscellaneous Receipts Bad Debt recovered	**
To Depreciation of Office Assets	**
To Other office expenses	**
To Selling and Distribution Expenses:	**
To Salesmen’s Salaries	**
To Selling Commission	**
To Traveling Expenses	**
To Brokerage	**
To Trade Expenses	**
To Advertisement & Publicity	**
To Sales Promotion Expenses	**
To Carriage Outward	**
To Godown rent	**
To Bad debts	**
To Provisionfor Bad debts	**
To Repairs of Vehicles	**
To Godown Insurance	**
To Delivery Van Expenses	**
To Packing Expenses	**
To Rebate to Customer
To Royalty (based on units sold)	**
To Financial Expenses:	**
To Discount Allowed
To Interest on Loan paid
To Interest on Capital
To Discount on Bills
To Bank Charges
To Abnormal Losses:
To Loss on Sale of machinery
To Loss on sale of Investment
To Loss by fire
To Misc. Expenses	**
To Net Profit transferred to CapitalA/c (Balancing figure)	**
	**		**

Profit And Loss Account Items (Dr. Side)

Let us discuss those items that will appear in the debit side of a Profit and Loss Account:

Management Expenses

For meeting day to day business expenses these type of expenses are met, they generally include office salaries, office rent and lighting, printing and stationery and telegrams, telephone charges, etc.

Selling and Distribution Expenses

These are incurred to meet all the expenses which are incurred in order to make our sales and all the expenses which are incidental to its distribution. Without meeting all these expenses the sales of a trading concern will not take place. These expenses are necessary to effect and continue our sales and distribution into the market.

Maintenance Expenses

These expenses are necessary for maintaining the fixed assets of the administrative office in a good and working condition. They include repairs and renewals, etc.

Financial Expenses

These expenses have to be incurred for arranging finance which is necessary for running the business because finance is the most required thing in any business. So this includes all the expenses which have been incurred in order to arrange finance forth organization. These include interest on loans, discount on bills, brokerage and legal expenses for raising loan, etc.

Abnormal Losses

Abnormal expenses and losses are those losses which occur over and above the normal loss. In every type of business there are certain losses which are incidental to the nature of the business. The normal losses generally occurs if such a business is conducted .

They are generally pre estimated that these will take place but any loss that arises over and above the normal losses or which was not pre estimated or calculated then it will be treated as abnormal loss. These type of losses may or may not occur during an accounting year.

All types of abnormal losses are treated as extra ordinary expenses and debited to Profit and Loss Account. Examples are stock lost by fire and not covered by insurance, loss on sale of machinery, cash defalcation, etc.

Expenses

Whether salary are paid or unpaid these are considered while preparing the profit and loss account and in the same way rent, electricity, telephone expenses are to be taken into consideration whether paid or outstanding during the accounting period.

To ascertain the amount of expenses to be debited to the Profit and Loss Account, four types of event are needed to be considered and the cash payment made in connection with these events. They are as under:

Expenses incurred and paid out in that year

If expenditure has been incurred during a year and also paid in the same year, the same will be debited to the Profit and Loss Account.

Expenses incurred but not paid out, partly or fully during the current year

There are a few expenses, although which have been incurred in the current accounting period, but not paid or paid partly or they are fully unpaid, by the end of the period, they are termed as “Outstanding Expenses”.

Liabilities are the unpaid expenses, which are calculated at the end of accounting year. In fact, on the date of the final accounts, outstanding expenses, both an expenses and a liability exists without having been recorded in the books of account. For recording it, the following entry is to be passed:

Expenses A/c Dr. (will be shown in the P & L A/c)
To Outstanding Expenses A/c (will appear in the liabilities side of
Balance Sheet)

Expenses paid for during the current year, but not yet incurred, partly or fully

Sometimes in business, it happens that few of the expenses are paid during the current year, but they have not yet been incurred, these are known as “Prepaid Expenses”. Prepaid expense is an asset to the business and will be shown in the Balance Sheet. The journals entry to be passed”.

Prepaid Expenses A/c Dr. (to be shown as asset in the Balance Sheet)
To Expenses A/c (balance of this account is to be
deducted from Expenses remaining
amount is debited to P&L A/c)

There may be expenses of the current year which may arise in subsequent period:

Sometimes in business an expense or a loss may arise in the future which is the result of with current year’s business. In all the cases, we make a provision of that future anticipated loss and a charge is created against the profit for the current period. This is called contingent liability. In a balance sheet it is seen as deduction from some other asset such as provision for bad debts.

Profit And Loss Account Items (Cr. Side)

Below mentioned are the items included in the debit side of profit and loss account:

Gross Profit

It is transferred from trading account and it is the first item of profit and loss account.

Non-trading Income

They are those income which are income apart from our business activities example of such income are interest received from bank, dividend and interest incomes received from outside investments like share and debenture are known as non-trading incomes.

Other incomes

All those incomes are those incomes which arise apart from income from sale of goods. As for example discounts or commission received.

Balancing Profit And Loss Account

Once the balances of all the accounts have been transferred from trial balance to P&L account, gross profit/loss transferred from trading account and and adjustments are take care of, the next step in preparation of P&L which is balancing of the account.

Here the total of debit and credit side is computed and difference of these totals is either the net profit or net loss. If the total of credit side exceeds that of debit side then it is net profit and vice versa. Net profit is the last item to be entered in the debit side and vice versa. After computing net profit/loss the totals of two sides of P & L match.

The balance in the Profit and Loss Account represents the net profit or net loss. The following entry is made when the Profit and Loss Account shows a net profit:

Profit & Loss A/c Dr.
To Capital A/c
If the Profit and Loss Account shows a net loss, the entry will be reversed.

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Difference between Trading A/c and Profit & Loss A/c

• Trading Account shows the result of trading operation of an enterprise whereas Profit and loss Account shows the overall result of the business as a whole.
  
  
• Trading Account takes into account only the direct cost involved including direct expenses whereas Profit and Loss Account deals with the remaining costs and expenses, which are of indirect in nature.
  
  
• Trading Account is prepared under normal conditions of the business & hence normal loss if any, is credited to this account. Profit and Loss Account accounts for all abnormal losses.

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Balance Sheet

The balance sheet details out the financial position of the company. It not only lists the items controlled or owned by the company, but also includes the debts owed by the organization. A well evaluated balance sheet should have the value of company assets equaling the total of the value of the equity held by stock holders and a lost the liability of the company. Balance sheet includes five basic elements.

They are current and non current assets, current and non current liabilities and also equity. The word ‘current’ refers to a period which is one year from the date of preparation of balance sheet or lesser. Hence, if we refer to current assets, it implies hard cash present in the company during the period of one year or the assets that would be turned into cash during this time period.

The current assets include accounts receivable and also the inventory. Services companies do not have any inventory and hence it would be a total of cash as well as the accounts receivable. Non current Fixed assets refer to the equipment invested that affects your accounting process. Typically, this refers to machinery, building as well as vehicles purchased and used on a daily basis.

Net fixed assets refer to the value obtained from actual value of purchase minus the depreciated value. Current liabilities refer to those debts that would be settled within one year of the preparation of balance sheet. Non current liabilities refer to long-term debts and mortgages of the organization. Equity includes the equity of stock holders, preferred stocks, treasury stock, retained earnings and paid-in capital.

Preparation and Presentation of Balance Sheet

The Process of preparation and presentation of Balance Sheet involves two steps:

• Grouping and
  
  
• Marshalling

The first step refers to proper grouping of the various items, which are to be shown in the Balance Sheet as assets and liabilities. For this purpose items of similar nature are grouped under one head so that the Balance Sheet could convey true message to its users. For example, stock, debtors, Bills receivables, Bank, Cash in Hand etc. are ground under the heading „Current Assets? and Land and Building, Plant and Machinery, Furniture and Fixtures, Tools and Equipments under “Fixed assets”.

Similarly „Sundry creditors? for goods must be shown separately and distinguished from money owing other than due to credit sales of goods. The second step involves marshalling of assets and liabilities. It means orderly arrangement in which various assets and liabilities are presented or shown in the Balance Sheet. There are two methods of presentation:

• In the order of liquidity
  
  
• In the order of permanence

Under liquidity order, assets are shown on the basis of liquidity or reliability. These are rearranged in an order of most liquid, more liquid, and liquid, least liquid and not liquid (Fixed) assets. Similarly, liabilities are arranged in the order in which these are to be paid or discharged. Under the “Order of permanence” the assets are arranged on the basis of their useful life.

The assets, which are to serve business for the longest period of time, are shown first. In other words, this method puts the first method in the reserve gear. Similarly, in case of liabilities, after capital, the liabilities are arranged as long term, medium term, short term and current liabilities. New format is given in companies Act, 2013

Following are the respective formats of Balance Sheets to bring out the clarity of concept

1. Liquidity Order
   balance sheet of as on.

Liabilities	Amt (Rs.)	Assets	Amt (Rs.)
Current Liabilities Bank Overdraft Outs trading Expenses Bills Payable Sundry Creditors Income Received in Advance Long Term Liabilities		Current Assets Cash in hand Cash at bank Marketable Securities Short term Investment Bills Receivables Sundry Debtors Prepaid Expenses
Mortgaged Loan Loan from Bank Capital Add Profit Less Loss Less Drawings		Accrued Income Long term Investment Fixed assets Furniture & Fixtures Motor Vehicles Tools & Equipments Plant & Machinery Land & Building Intangible Assets Patents Copyrights Trademarks Goodwill

Order of Permanence (As per companies Act, 2013)
Balance sheet of as on.

Liabilities	Amt (Rs.)	Assets	Amt (Rs.)
Capital Add Profit or (Less Loss) Less Drawings Long Term Liabilities Mortgage Loan Loan from Bank Current Liabilities Income Received in Advance Sundry Creditors Bills Payable Outstanding Expenses Bank Overdraft		Non Current Assets : Fixed assets Goodwill Land and Building Plant & Machinery Tools & Equipments Motor Vehicles Furniture & Fixtures Patents Trademarks Investments (Long Term) Current Assets Stock Accrued Income Prepaid Expenses Sundry Debtors Bills Receivables Short term Investments Marketable Securities Cash and Bank Balance Fictitious Assets Advertisement Profit and Loss Account Miscellaneous Expenses

Difference between Trial Balance and Balance Sheet

The following are the points of distinction/difference between trial balance and balance sheet:

Trial Balance	Balance Sheet
It is a list of balance extracted from the ledger accounts	It is a statement of assets and liabilities
It contains the balance of all accounts – real, nominal and personal.	It contains the balance of only those accounts which represents assets and liabilities.
It is prepared before the preparation of trading and profit and loss account.	It is prepared after the preparation of trading and profit and loss account.
Generally it does not contain the value of the closing stock of goods.	It contains the value of closing stock, which appears on the assets side
Expenses due but not paid and incomes due but not received do not appear in the trial balance	Expenses due but not paid appear on the liability side and income due but not received appear on the asset side of the balance sheet.

Explanation and Clarification of Certain Items

For a better understanding of how various items should be placed, it is important to know the type and nature of assets and liabilities that are to be classified and arranged in either of two orderly manners discussed earlier. For the purpose of presentation of assets in the Balance Sheet, assets are classified as under:

1. Fixed Assets
   
   
2. Intangible Assets
   
   
3. Current Assets
   
   
4. Fictitious Assets
   
   
5. Wasting Assets
   
   
6. Contingent Assets

Fixed assets

Fixed assets are those assets, which are acquired for the purpose of producing goods or rendering services. These are not held for resale in the normal course of business. Fixed assets are used for the purpose of earning revenue and hence these are held for a longer duration.

These are also treated as Gross Block and Net Block (Fixed assets after depreciation). Investment in these assets isknown as Sunk Cost.

Examples of fixed as set share Land & Building, Plant and Machinery, Furniture and Fixtures, Tools and Equipment, Motor vehicles, etc. All fixed assets are tangible by nature.

Intangible assets

Intangible assets are those capital assets, which do not have any physical existence. Although these assets cannot be seen or touched, they are long lasting and prove to be profitable to owner by virtue of the right conferred upon them by mere possession.

They also help the owner to generate income. Goodwill trademarks, copyrights and patents are the examples of intangible assets. Fixed assets and intangible assets are subheads of non current assets.

Current assets

Current assets include cash and other assets, which are converted or realized into cash within a normal operating cycle or say, within a year. These are acquired for resale, assisting and helping the process of production, rendering service or supplying of goods.

These assets constantly keep on changing their form and contribute to routine transactions and operations of business. Examples are Cash, Bank, Bills Receivables, Debtors, Stock, Prepaid expenses etc. Current assets are also known as Floating Assets or Circulating Assets.

Liquid or quick assets

Those current assets, which can be converted into cash at a very short notice or immediately, without incurring much loss or exposure to high risk, are quick assets. Quick assets can be worked out by deducting Stock (raw materials, work-in-progress or finished goods) and prepaid expenses out of total current assets.

Fictitious assets

These are the non-existent worthless items which represent unwritten-off losses or costs incurred in the past, which cannot be recovered in future or realized in cash.

Examples of such assets are preliminary expenses (formation expenses), Advertisement suspense, Underwriting commission, Discount on issue of shares and debentures, Loss on issue of debentures and Debit balance of Profit & Loss Account. These fictitious assets are written off or wiped out by debiting them to Profit & Loss Account.

Wasting assets

An asset that has a limited life and therefore dwindles in value over time is a wasting asset. This type of asset has a limited useful life by nature and depletes over a limited duration. These assets become worthless once their utility is over or exhausts fully.

During the life of productive usage, assets of this type produce revenue, but eventually reach a state where the worth of the assets begins to diminish. Such assets are natural resources like timber and coal, oil, mineral deposits, etc.

Contingent assets

Contingent assets are probable assets, which may or may not become assets, as that depends upon occurrence or nonoccurrence of a specified event or performance or non-performance of a specified act. For example, a suit is pending in the court of law against ownership title of a disputed property.

Subsequently, if the verdict goes in favor of the business concern, it becomes the asset of the concern. However, if the business firm does not win the lawsuit, it will not have ownership rights of the property; it will be of no use to it.

Thus, it remains a contingent asset as long as the judgment is not pronounced by court. Such assets are shown by means of footnotes and hence do not form part of assets shown in the Balance Sheet. Besides this, hire purchase contract, uncalled share capital, etc. are the other examples of contingent assets.

Classification of Liabilities

Long-term liabilities

These are the obligations that the business enterprise is expected to meet after a relatively long period. Such liabilities do not become due for payment in the ordinary course of business operation or within normal operating cycle. Debentures, long-term loans from banks or financial institutions are the examples of long-term liabilities.

Current liabilities

Current liabilities are those liabilities that are payable within normal operating cycle, i.e. within a given accounting year. These may arise out of realization from current assets or by creating fresh, current liability (obligation). Trade creditors, Bills payable, Bank overdraft, outstanding expenses, short–term loan (payable within twelve months or within the accounting year) are examples of current liabilities.

Contingent liabilities

These liabilities may or may not be sustained by an entity depending on the outcome of a future event such as a court case. These liabilities are recorded in a company’s accounts and displayed in the Balance Sheet when both probable and reasonably estimable. It is not an actual liability but an anticipated (probable) liability, which May or May not become payable. It depends upon the occurrence of certain events or performance of certain acts.

An element of uncertainty is always attached to a contingent liability; it is a potential liability that may or may not become a sure liability. Contingent liabilities are exemplified in the liability for bills discounted, liability for acting as surety, liability arising on a suit for damages pending in the cour to flaw, liability for calls on partly paid shares etc.

If a parent guarantees a daughter’s first car loan, the parent has a contingent liability. If the daughter makes her car payments and pays off the loan, the parent will have no liability. If the daughter fails to make the payments, the parent will have a liability. Contingent liabilities are shown as footnotes under the Balance Sheet.

In accounting, a contingent liability and related contingent loss are recorded with a journal entry only if the contingency is probable as well as estimable. If a contingent liability is only possible (not probable) or if the amount cannot be estimated, a journal entry is not required. However, a disclosure is required. When a contingent liability is remote (such as a nuisance suit), neither a journal nor a disclosure is required.

Limitations of Balance Sheet

Balance Sheet is prepared by company to reveal its financial position.

Following are the limitations of balance sheet:

• Fixed assets are shown in the Balance Sheet at historical cost less depreciation up to date. A conventional Balance Sheet cannot reflect the true value of these assets. Again, Intangible assets are shown in the Balance Sheet at book values, which may bear no relationship to market values.
  

• Sometimes, Balance Sheet contains some assets which command no market value such as preliminary expenses, debenture discount, etc. The inclusion of these fictitious assets unduly inflates the total value of assets.
  
  
• The Balance Sheet cannot reflect the value of certain factors such as skill and loyalty of staff.
  
  
• A conventional Balance Sheet may mislead untrained readers in inflationary situations.

The value of majority number of current assets depends upon some estimates, so it cannot reflect the true financial position of the business.

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FAQ