HOW TO PREPARE A BANK RECONCILIATION STEP BY STEP?

Bank reconciliations are made by a business to reconcile any differences between the bank statement of a business and its bank books.

These differences can exist due to many reasons. Bank reconciliations are used to identify any errors or attempts at fraud.

Bank reconciliations are carried out to reconcile the differences between the balance in the bank book (also known as the cash book or bank ledger) of a business and the balance in the bank statement of a business.

These are two different documents and, therefore, it is crucial that the differences between these two documents should be clear first.

Bank Book vs Bank Statement

The bank book and the bank statement of a business are both made up of the information about the bank balance of the business.

The bank book of the business is an internally prepared document and is prepared by the management of the business, or specifically the accounting department.

The bank statement, however, is prepared by the bank in which the account is held. The bank statement is sent to the business at the start of each month detailing all the transactions that took place in the account for the prior month.

Transactions in the bank statement are presented the opposite of transactions in a bank book. For example, a receipt will be a Debit in the bank book while it will be presented as a Credit in the bank statement.

A business can have many different bank accounts in different banks and, therefore, will receive multiple statements from each bank for each account of the business.

Therefore, it is a good practice for businesses to also have a separate bank book for every account so it is easier for them to find any differences between the balances and reconcile them.

Since the bank book is an internal document and the bank statement is an external document, there are bound to be differences between the two.

The business has to identify any differences between the balances in these two documents and reconcile them in order to ensure proper control over it bank balances.

There are a limited number of reasons due to which differences may exist. These might be either due to unrecorded differences or timing differences.

Apart from these types of differences, errors may also occur on either the business’ side of the records or the bank’s side of the records.

Basically, any difference that cannot be justified by either unrecorded differences or timing differences are errors that must be rectified.

Types of Differences

As discussed above, the differences between the bank book and bank statement of a business can be classified into two categories, unrecorded differences and timing differences.

The differences are classified in one of these two categories based on which document, the bank book or the bank statement has the difference and the differences must be adjusted against.

Unrecorded Differences

Unrecorded differences, as the names suggests, are differences that are not recorded. These are differences that are recorded in the bank statement of a business but not in the bank book of the business.

When performing a bank reconciliation, unrecorded differences are recorded in the bank book of the business to arrive at an adjusted bank book balance.

Examples of unrecorded differences are any type of bank charges, taxes, direct deposits, standing orders, dishonored cheques, or a customer deposited an amount but didn’t notify the business, etc.

These differences mainly occur because the bank, in which the account is held, updates the accounts but the business does not know about the updates until the start of next month when the bank statement is received.

Therefore, once the business gets the bank statement and identifies these differences, these are recorded in the bank book of the business.

Timing Differences

Timing differences are differences due to timing of different transactions. These are differences that are already recorded in the bank book of the business but do not appear on the bank statement of the bank account.

Timing differences, unlike unrecorded differences, are not recorded in either the bank book or the bank statement.

These differences are adjusted against the bank statement balance but are not recorded in the bank statement. These are differences that will appear in the bank statement after some time, most probably in the next bank statement.

For example, if a business pays a cheque to a supplier but the supplier does not cash the cheque in the bank in that month.

For the business, the transaction will already have been recorded in the bank book because the cheque was issued. For the bank, because there was no cheque presented, the transaction never occurred. These are called outstanding payments.

Another example is a cheque that the business received from the customer but hasn’t yet taken to the bank or did take to the bank, but the bank did no clear the cheque before the end of the month. These are called outstanding lodgments.

Errors

Any difference that is not an unrecorded difference or a timing difference is an error. As previously mentioned, errors can occur on both sides, the bank book or the bank statement.

For example, the bank credited the business account for a transaction that did not relate to the account. Errors are generally rectified promptly if they are caused due to an error in the bank book.

For errors in the bank statement, the bank is contacted and details are given about the transaction.

Mostly, errors occur in the bank book of the business rather than the bank statements. These errors are then investigated properly to ensure they were not committed intentionally.

This is one of the reasons bank reconciliations are a major part of a business’ internal control procedures.

Bank Reconciliation Step By Step

To prepare a bank reconciliation, it is important that both the bank book and the bank statement of the business are available.

Once both these documents are available, the following steps must be followed to prepare a bank reconciliation statement.

1.    Compare the balance from the bank statement with the bank book

Once the bank statement is received, the business must check the balance on the bank statement against the balance on the bank book.

It must ensure that the bank book balance is taken for the last date of the previous month or the month for which the bank statement is considered.

For example, if a bank statement is received for August, the bank book balance taken should be the closing balance on August 31.

Once the balances are compared, if no differences exist, the bank reconciliation statement is not prepared. However, that is highly unlikely. The balances will almost always be different and, therefore, the next step is followed.

2.    Identify the type of differences

Once it is established that the bank reconciliation statement should be made, it is then important to identify the type of differences that exist between the bank book and the bank statement.

These differences, as discussed above, will either be due to unrecorded or timing differences.

3.    Adjust the bank book and bank statement balances

Once the types of differences are identified, they should be taken and adjusted against the relevant document balance.

Unrecorded differences will be adjusted and recorded in the bank book and timing differences will be adjusted against the bank statement balance.

4.    Compare the balances again

Once the types of differences are identified and adjusted against their relevant balances, the balances should be compared again.

At this point, there should be no differences remaining. However, if differences still exist, it either means that the type of those differences was not correctly identified or there are errors in either of the two balances.

Example

A business, ABC Co. received their bank statement from XYZ Bank Ltd. for the month of May20xx. The statement is as below:

Its bank book for the month of May 20xx was as below:

The bank reconciliation of the ABC Co. for the month of May 20xx can be prepared by using the steps above.

#1 Compare the balance from the bank statement with the bank book

First of all, the balance from the bank statement is compared with the bank book. The balance in the bank statement is $500 while the balance on the bank book is $2,350.

This means there is a difference of $1,850 between the two balances. Since there is a difference between the two, the next step should be followed.

#2 Identify the type of differences

As apparent, there are differences between the two statements. First of all, the unrecorded differences are identified and recorded.

These are differences that exist in the bank statement but are not recorded in the bank book.

As apparent from the bank statement, the following differences are unrecorded in the bank book:

DateDescriptionPayments (Dr.)
9-MayDirect Debit              1,500
16-MayBank charges                 150
23-MayInterest charges                 300

Therefore, these must be recorded. The bank book of ABC Co. will be credited with the above amounts because they are all payments from the bank account.

There are no unrecorded Receipts (Cr.) but if they did exist, they would be debited to the bank book. The other side of the entries will be taken to their relevant accounts, for instance, bank charges account.

Next, timing differences are identified. These are differences that are recorded in the bank book but do not exist in the bank statements. These are as below:

DateDescriptionDr.Cr.
10-MayCheque # 1131 paid to supplier            –        2,000
28-MayCheque received from customer      4,200            –  
30-MayCheque # 1133 paid to supplier            –        2,000

#3 Adjust the bank book and bank statement balances

The bank book of ABC Co. must be adjusted for the unrecorded differences. This will be:

Bank book balance before adjustments      2,350
Unrecorded differences:
Direct debit     (1,500)
Bank Charges        (150)
Interest charges        (300)
Adjusted Bank Book Balance         400

Similarly, the timing differences need to be adjusted against the bank statement balance.

Bank Statement balance before adjustments         200
Timing differences
Outstanding lodgements      4,200
Outstanding payments (Chq # 1131)     (2,000)
Outstanding payments (Chq # 1133)     (2,000)
Adjusted Bank Statement Balance         400

#4 Compare the balances again

Now that the adjustments have been made, the balances can be compared again.

Since the adjusted balance for both the bank book and bank statement is $400, it means there are no extra items that need to be reconciled.

The above bank reconciliation can also be presented as following:

Balance as per bank book      2,350
Unrecorded differences:
Direct debit     (1,500)
Bank Charges        (150)
Interest charges        (300)
Adjusted Bank Book Balance         400
Timing differences
Outstanding lodgements     (4,200)
Outstanding payments (Chq # 1131)      2,000
Outstanding payments (Chq # 1133)      2,000
Balance as per Bank Statement         200

Conclusion

Bank reconciliations are an important part of a business’ internal control system. Bank reconciliations must be performed to find the differences between the bank book balance of a business and its bank statement balance.

These differences can be classified into unrecorded differences or timing differences. Bank reconciliations are performed by comparing the balances from the bank book and bank statement and identifying differences and the types of those differences.

Once the types of differences are identified, these differences are adjusted against the respective document balance. Finally, the balances are compared again, at which point, both should be equal.

HOW TO PREPARE PRO FORMA FINANCIAL STATEMENTS STEP BY STEP?

Pro forma financial statements are projected financial statements that are produced using several presumptions or projections.

The business preparing the pro forma financial statements make some presumptions and prepare projected financial statements based on those presumptions.

For example, the business might prepare pro forma financial statements to see the impact of possible litigation on the business.

Since pro forma financial statements are based on certain projections and presumptions, the accuracy and reliability of the financial statements must be ensured.

Any presumptions made in the preparation of these financial statements must be disclosed clearly.

Once initial pro forma financial statements are prepared, they must constantly be updated from time to time to reflect the most accurate information.

Pro Forma Financial Statements Uses

Pro forma financial statements have many uses. Some of the uses of pro forma financial statements are as follows.

Planning and Control

Pro forma financial statements can be used to estimate future sales and budgets. These can be used as a planning tool to set standards for the future operations and activities of the business.

Once standards are established, these financial statements can be used to monitor and control actual performance according to the set standards.

This can be achieved by using different tools such as ratio analysis and variance analysis.

Financial Modeling

Pro forma financial statements can also be used to make a summary of all the incomes and expenses of a business.

The financial models are based on presumptions made by the business. Financial modeling is a great decision-making tool.

These models can be used to estimate the income and costs of a business or a project that the business is undertaking.

Reporting

Some businesses such as public listed companies may be required by legislation or standards to prepare pro forma financial statements.

For example, businesses may be required to report any effects of changes in the accounting policies of the business using pro forma financial statements.

Furthermore, pro forma financial statements can be used as a reporting tool to the stakeholders of the company, for instance, the owner, potential investors, creditors, etc.

Pro Forma Financial Statements

There are three main financial statements that are prepared based on presumptions and projections. These are the balance sheet, the income statement and the cash flow statement.

The pro forma financial statements should all be prepared in conjunction with each other.

The presumptions used for the preparation of these financial statements must be consistently applied to all financial statements.

Pro Forma Income Statement

When preparing pro forma financial statements, the pro forma income statement should be prepared first because the other two pro forma financial statements rely on figures from the pro forma income statement.

The pro forma income statement is based on the most recent income statement of the business, which is usually the financial statements of the last period.

Once the most recent income statement of the business is available, the pro forma income statement can be prepared using the following steps:

  1. A percentage should be determined to use to add or subtract to the recent income statement figures to forecast future figures. This percentage is based on the presumptions a business makes. For example, if the business expects its revenues to increase by 20% next year, this should be the percentage used to inflate all other items of the pro forma income statement as well.
  2. Once a percentage is determined, it should be applied to both the revenues and cost of goods sold of the business in its last income statement. By doing this, the business will ensure that a consistent rate is applied to all the variable expenses.
    So, according to the previous example, if the business determines that its sales will increase by 20%, it is highly likely that the cost of sales will raise by the same percentage. The predicted gross profit should then be calculated by subtracting the project cost of goods sold from the projected revenues.
  3. For operating expenses, every item should be evaluated individually. If the business determines that the rent expense will increase in the period for which the pro forma income statement is prepared, then it should increase the expense accordingly. Similarly, if the business is looking forward to cutting down any expenses in the future, then the expenses should be adjusted in the pro forma income statement.
  4. Once the operating expenses are adjusted, the net profit of the business can be calculated. This net profit should then be multiplied with the expected tax rate for the period for which the pro forma income statement is prepared to calculate the estimated tax expense. Once an estimate tax expense is determined, the net profit after tax should be calculated.

Once the pro forma income statement is prepared, the figures are then taken to the pro forma balance sheet.

Pro Forma Balance Sheet

Since the preparation of the balance sheet depends on figures obtained from the income statement, the pro forma balance sheet is the next pro forma financial statement to be prepared.

The step by step method to prepare a pro forma balance sheet is as follows:

  1. The net profit after tax figure should be transferred from the pro forma income statement and adjusted in the retained earning balance on the balance sheet.
  2. Based on the adjustments in the pro forma income statement, other balances in the pro forma balance sheet should also be adjusted. For example, if the business based its pro forma income statement on 20% expected increase in its revenues, then it is highly likely that the debtor balances of the business will also go up. Similarly, the cost of goods sold will also increase in line with the increase in the revenues of the business, thus, resulting in higher creditor and inventory balances.
  3. Once the balances related to the figures in the pro forma income statement are adjusted, the remaining balances should be evaluated individually for any expected changes. For example, if the business expects to purchase a fixed asset during the period for which the pro forma financial statements are prepared, then the fixed asset balances are adjusted accordingly. Similarly, all other asset, equity and liability balances should be evaluated.

Once the pro forma balance sheet is prepared, the pro forma cash flow statement can be prepared.

Pro Forma Cash Flow Statement

When preparing pro forma financial statements, the pro forma cash flow statement is prepared at last.

This is because the cash flow statement relies on figures from both the pro forma income statement and the pro forma balance sheet.

The pro forma cash flow statement can be prepared using either the direct method of cash flow statement preparation or the indirect method. The steps to prepare them are as follows:

Direct Method

  1. For the direct method of pro forma cash flow statement preparation, the most recent cash and cash equivalent balances of the business should be taken. These balances should be taken from the same financial statements that the pro forma income statement is based on.
  2. Any expected receipts of cash should be added to the cash and cash equivalent balances. These expected receipts should be in line with the expected fluctuations in the pro forma income statement and any expected changes in the debtor and inventory balances of the business. Any expected receipts from other sources should also be added to the balances.
  3. Any expected payments of cash should be subtracted from the cash and cash equivalent balances. Like the receipts, these payments should be in line with the fluctuations in the cost of goods sold and operating expenses in the pro forma income statement. They should further be adjusted for any expected changes in the inventory and creditor balances in the pro forma balance sheet. Furthermore, any special payments, for example, purchase of a fixed asset, should also be adjusted in the payments.
  4. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances taken in step 1 to arrive at the closing cash and cash equivalent balances.

Indirect Method

  1. For the indirect method of pro forma cash flow statement preparation, the net profit before taxation figure should be taken from the pro forma income statement. Any non-cash expenses, such as depreciation and amortization, should be added back to the amount.
  2. Any cash flows from operating activities should be adjusted against the net profit before taxation figure. These may include changes in current assets and current liabilities balances such as debtor balances, inventory balances and creditor balances.
  3. Any cash flows from investing activities should be adjusted against the net profit before taxation figure. These may include any cash inflows or outflows from investing activities of the business such as purchase of fixed assets or investments made.
  4. Any cash flows from financing activities should be adjusted against the net profit before taxation figure. These may include cash inflows from receipt of equity or debt finance or outflows for payment of long-term debt obligations.
  5. Finally, the net movement in the cash and cash equivalent balances should be calculated and added to the opening cash and cash equivalent balances to arrive at the closing cash and cash equivalent balances of the business. This opening cash and cash equivalent balance is taken from the most recent financial statements of the business.

The closing cash and cash equivalent calculated using both methods should be equal to the cash and cash equivalent balances in the pro forma balance sheet.

Conclusion

Pro forma financial statements are forecasted financial statements of a business based on certain presumptions or projections.

Pro forma financial statements are used for many purposes such as planning and control, financial modeling or reporting.

There are three main pro forma financial statements that businesses prepare. These are the pro forma income statement, balance sheet and cash flow statement.

The pro forma income statement is prepared first, followed by the pro forma balance sheet and finally, the pro forma cash flow statement.

WHAT IS ACCOUNTANCY?

In the past, accountancy used to refer to the process of communicating information about the financial position and performance of a business to its owners.

This communication was usually made in the form of financial statements such as the balance sheet and the income statement of a business.

The word accounting, on the other hand, used to refer to one of the three principles of accountancy. Accounting was known as the process of reading and maintaining the financial records of a business.

This was separate from the other two principles of accountancy which were bookkeeping and auditing.

Today, the words accountancy and accounting refer to the same thing. Accountancy or accounting is the process of identifying, measuring, processing, classifying, recording, and reporting financial information of a business.

This information is mainly reported in the form of five key financial statements.

These financial statements are prepared in accordance with relevant standards to provide useful information to the users of these financial statements. The two most important and most used accounting standards are IFRS and US GAAP.

Accounting is one of the key functions of every business. Every business around the world will have an accounting department to look after its transactions.

The size of the accounting department of a business depends on the size and nature of the business. For bigger businesses, the accounting department may have many more employees as compared to smaller businesses where one or two bookkeepers can be assigned to the tasks.

Similarly, businesses with a larger number of transactions per day will need more employees in their accounting department than ones with a smaller number of transactions.

History of Accountancy

Accountancy has a very old and rich history. The basis for the modern accounting principles was laid thousands of years ago in ancient Mesopotamia, a historical region in Asia.

The concept of accounting is believed to have been developed at the same time as the concepts of counting, money, and writing were developed.

The ancient systems of accounting were later organized by the Romans.

The modern concept of a double-entry bookkeeping system was first introduced by an Italian mathematician named Luca Pacioli in 1494.

He was the first to describe the concept of debits and credits in journals and ledgers.

His work in the field of accounting earned him the title of “Father of accounting”. His work laid the foundation of modern accounting systems.

During the time of the industrial revolution in the mid to late 18th century, the need for a more advanced system of accounting arose.

The ancient accounting systems, while foundationally strong, did not provide a solution for the modern structures of corporations.

For example, corporations had complex structures of ownership that did not exist in ancient times. Investing in these corporations was also difficult due to the lack of information available to investors.

To tackle this problem and attract more investors, corporations adopted a system of reporting their financial activities by publishing financial statements.

At the beginning, these financial statements were limited to the balance sheet, income statement, and cash flow statement. The rise of the system of financial statements also gave rise to agency problems.

Agency problems arose because the shareholders of a corporation did not believe the management. This led to the development of a mainstream auditing system.

While the concept of auditing was already developed in ancient Egypt, it became mainstream during these times.

Accountant

An accountant is a professional practitioner of accountancy. Accountants are competent professionals that have gone through different professional certification exams.

Accountants are members or associates of professional accounting bodies such as the Association of Chartered Certified Accountants (ACCA), Institute of Chartered Accountants in England and Wales (ICAEW), etc.

In ancient times, accountants were viewed as solicitors that offered accounting services to their clients. However, in the mid-19th century, the Institute of Accountants in Glasgow petitioned Queen Victoria for a royal charter.

This allowed them to distinguish themselves as accountants rather than solicitors. Even before the petition, the accountant profession was distinct in Scotland, however, this petition allowed for accountants to be seen as professionals in accountancy rather than mere solicitors in the rest of the world as well.

This petition also laid the foundation for many professional accounting bodies such as the London Association of Accountants, later renamed to Association of Chartered Certified Accounts (ACCA) in the United Kingdom and the Certified Public Accountants (CPA) in the United States.

This was helped by the industrial revolution which created a demand for technically sound professionals who were capable of handling modern accountancy problems. 

Branches of Accountancy

Most people think of accountancy as simple bookkeeping and debits and credits. While it is a part of accountancy, there are several branches of accountancy that are different from each other. The branches are as following:

1) Financial Accounting

Financial accounting is the most popular and widely implemented branch of accountancy., Financial accounting branch is related to the reporting of the financial status of a business, through the financial statements, and any process that helps with the preparation of these financial statements.

For example, any process involved from entering source documents into the accounting systems of the business up to the preparation of the key financial statements falls under the financial accounting branch.

2) Management Accounting

While financial accounting has to do with the preparation of the information that is reported externally, management accounting is related to the preparation of information for internal use.

Daily or monthly operating reports, budgets, variance analysis, etc. all fall under management accounting.

The information produced through management accounting is used by the management of the business to make decisions for the future of the business. These can be used for short-term or long-term strategy making.

3) Cost Accounting

Cost accounting is similar to management accounting and often considered a type of management accounting.

Cost accounting is the branch of accountancy that is commonly used in the manufacturing industry. Cost accounting is used to derive the cost of a product for decision-making purposes.

This cost can be calculated using different costing techniques such as absorption costing, marginal cost, activity-based costing, target costing, etc. Once costs are determined, cost accounting is also concerned with monitoring those costs.

4) Auditing

While auditing does not involve preparing any accounting information, it is related to reviewing the information produced through other branches of accounting.

Auditing can either be internal or external. Internal auditing is performed by the management of the business to review accounting information produced for internal use.

External accounting is related to reviewing the information produced for external use, which mainly includes reviewing the financial statements of a business.

Auditing can also be used to determine level of internal control of an organization.

5) Forensic Accounting

Forensic accounting is closely related to auditing. Forensic accounting is related to the use of accountancy techniques, skills, and knowledge in circumstances that might have legal implications.

Forensic accounting is the process of carrying out forensic investigations to present in a legal proceeding. Forensic accounting is mainly used for fraud investigations within the business, professional negligence cases, or insurance claims. 

6) Accounting Information System

Accounting Information System (AIS) is related to the collection, development, deployment, implementation and monitoring of the accounting procedures and systems that are used in the accounting process.

With the computerization of the accounting process, AIS has become a computerized methodology for conducting accounting processes with information technology resources.

7) Tax Accounting

Tax accounting is the branch of accountancy that deals with the application of tax planning to benefit the business and preparation of tax returns.

It also involves calculating the income tax and other taxes of the business. Tax accounting is used to legally decrease the taxes of the business. Tax accounting should not be used for tax evasion.

The rules of tax accounting are defined and dictated by the local tax body of the country the tax is being paid in.

8) Fiduciary Accounting

Fiduciary accounting is the branch of accountancy that is related to the management of funds in trusts. This branch is mainly concerned with the trustee communicating any financial information about the trust to the beneficiaries.

Fiduciary accounting is regulated by the law and court and, therefore, the information produced through this branch must be accurate and precise.

9) Nonprofit Accounting

Nonprofit accounting mainly applies to nonprofit organizations. In this branch of accountancy, incomes and expenses are recorded according to the nonprofit accounting standards.

This is the alternative of financial accounting for nonprofit organizations. In this branch of accounting, expenses are recorded in the statement of functional expenses.

Furthermore, both the income and expenses are recorded in the statement of activities.

10) Social Accounting

Social accounting is the branch of accountancy that is related to reporting the effect of the business’ activities on the society and environment.

For companies, social accounting is used in the context of Corporate Social Responsibility (CSR) and companies may be required by law to do so.

However, other types of organizations such as nonprofits, charities or government agencies may also choose to adapt social accounting voluntarily.

Conclusion

Accountancy or accounting is the process of identifying, measuring, processing, classifying, recording, and reporting financial information of a business.

Accounting was developed thousands of years ago and the concept of double-entry bookkeeping and debits and credits was introduced in 1494 by Luca Pacioli. Professionals of accountancy are known as accountants.

Accountancy has many branches such as financial accounting, management account, cost accounting, auditing, tax accounting, etc.

Capitalization of Profits

Any business is run by finances, there are two ways a company can finance its operation.

Either through debt finance or equity finance. Debt financiers look for mortgages against their cash and seek a return on it, the cost associated with debt financing is higher.

Shareholders also seek return for their investments, but that can be in the form of regular dividend payments or in the form of share price capitalization in the long run.

Any company’s main objective is to maximize shareholders’ wealth by creating value in products and investing in positive NPV projects.

Capitalization refers to the concept of creating value using an asset, or in accounting terms may refer to converting short term costs/profits to long-term.

Generally, when associating with profits or reserves, the term capitalization means the conversion of accumulated profits to shareholders’ equity.

A company’s income statement reflects the amount of retained earnings and profits for the current period, and the balance sheet shows the same amounts accumulated over the life of the company (Updated to the latest reporting date).

When a company generates profits, it may decide to utilize it in different ways e.g. investments in projects, pay off debts, or issue dividends.

When a company has surplus cash and accumulated profits, and it does not have any projects to invest in, the management may decide to convert those profits to shareholders’ equity.

There are very few options for the company management for converting profits in equity directly, one of such options is issuing of Bonus Shares. Important: The Dividend issue is different from equity capitalization.

The management may decide to use the Bonus Issue option for various purposes, the Prime purpose being the share capitalization.

Also, when a company has no positive NPV projects in the short-term, the management may decide to utilize the reserves to reward the shareholders.

In some cases, the company may be facing covenant from the debt financiers for not issuing any dividends until a certain amount of debt is paid off.

In that situation, to satisfy the shareholders the management may decide to issue bonus shares instead of cash dividends.

One important factor with profit capitalization is that when the company pays its reserves accumulated over the years in the form of bonus shares the profits are permanently converted into share capital.

The profits and reserves can be used for investing purposes too, which eventually also results in positive cash flow and increase the share price of the company.

The indirect methods of investing the profits and share price increase are rarely successful in the capitalization of profits.

From the shareholders’ perspective, the capitalization of profits in the form of Bonus Issues may signal negatively.

The increased number of shares will result in lower EPS, and the pressure to maintain the dividend payout ratio will increase.

The shareholders receive the bonus shares in proportion of their existing shareholdings, so it does not affect their voting rights.

In an efficient market, a profit capitalization may also mean that a company does not have any positive NPV projects to invest in, business expansion plans, or any research and development processes going on.

Profit capitalization achieves the strategic objective of wealth maximization for the shareholders, as temporary reserves are cultivated back to the share capital.

If the Bonus Issue of shares option is used, the shareholders may have the option of selling the bonus shares to the outsider investor too.

In an indirect approach, when the management decides to pay off debts or invest in positive NPV projects with the accumulated profits, the end result is also the share price increase which is another form of Capitalization.

In conclusion, capitalization of profits or reserves refers to the share capital. Given the choices the profits may be used for investing, debt pay off, or Share and dividend issues.

The shareholders’ wealth maximization is achieved when periodic profits are converted to permanent Share Capital.

The total market capitalization for the company, however, does not change with this practice, as reserves or profits are converted from one form to another.

The difference between gross and net income

Income is any inflow of economic benefits. The term “Economic benefits” means any benefits that can be quantified in terms of money.

Businesses generate income through various means. Usually, income is generated through the sale of goods or services.

Income generated through a business’ main activity is also known as revenue. Businesses can also generate through activities apart from their main business activity.

These incomes may come in the form of incomes from investments or income from the sale of fixed assets, for example.

For employed individuals, income is generated mainly through basic salary or wage they get from the organization they are working for. Their income may further be increased by some other benefits they may receive from their employer.

These benefits may be in the form of bonuses, overtime premiums, commissions, holiday pays, sick pays, golden handshakes, etc.

Income is a fairly straightforward concept for both businesses and individuals. However, for both individuals and businesses, there are two types of income which may be confusing.

These are gross income and net income. While they may sound similar and are closely related to each other, they are completely different in what they mean and how they are calculated.

Gross Income vs Net Income

Gross income generally means the full amount of income for an entity. For businesses gross income means all the incomes from business’ activities specially sales.

For individuals, on the other hand, it means all the incomes from the individual’s employer whether that is salaries, bonuses, overtime premiums, or anything else.

On the other hand, net income describes any income that is left after certain deductions from gross income. For businesses, net income is the figure that is calculated after subtracting all of the business’ expenses from its revenues.

For individuals, net income is the figure that is the amount they actually get paid. This figure is calculated after deducting different rates and taxes from the individual’s gross income.

For businesses, gross income is the amount they are generating from their business activities. This amount denotes the actual efforts of the business in generating income for the business.

Investors look at the gross income of the business to determine the total revenue the business is generating from its activities. However, this isn’t the only figure that investors consider when making a decision about a business.

When making a decision about investing in a business, investors also consider the net income of a business.

While the gross income tells the investors how much the business is generating from business activities, the net income tells investors about how much of the revenue generated is being converted into profits.

Since the net income is calculated after all of the expenses of the business are subtracted from its gross income, the net income also tells the investors about the control the business has over its expenses that are not part of their sales.

For individuals, gross income is the amount they have earned for their work. This includes all earnings that an individual is entitled to as stated above.

The gross income of an employed individual is generally pre-determined and agreed upon with the employer.

For example, before joining the organization, the employer and the individual will sign a contract detailing the salaries or wage rates, the overtime premium rates, any possible bonuses, etc.

In contrast, net income for individuals is the actual amount they get paid. Like net income for businesses, net income for individuals is also calculated after deducting some expenses from the gross income of the individual.

These deductions from salaries depend on different rules and regulations of the country the individual is working in or the country the payment is being made in.

For instance, taxes are deducted from the gross income of individuals based on different tax rates in different countries. Other examples of possible deductions include pension payments, unemployment benefit payments, child support payments, etc.

Gross Income

Gross income is any income that is earned over a specific period of time. For both businesses and individuals, gross income is calculated in different ways.

For businesses, gross income is also known as gross profits and requires some deductions to be made from the revenues of the business to be calculated. For individuals, gross income doesn’t need any deductions.

Businesses

For businesses, gross income is also known as gross profits. Gross profits, in business terms, is the residual amount after deducting all the expenses related to producing or purchasing a product.

These expenses may include but are not limited to, raw material purchase costs, factory costs, freight and forward expenses, utility expenses related to production, depreciation related to machinery or factory, etc.

For a services-based business, gross profit is calculated by subtracting any expenses that are directly related to the provision of the services.

For example, a consultancy will deduct the fee of the consultants from the revenue generated from clients to reach the gross profit.

The gross profit of a business can simply be traced in the Statement of Profit or Loss (also known as Income Statement) of a business. The gross profit is calculated using the following formula:

Gross Profit = Revenues – Cost of Sales/Goods Sold or Cost of Services Provided

The Cost of Sales also known as Cost of Goods Sold are all the expenses of a business that are directly related to the product sold that generated the revenue.

They do not include other costs such as administrative costs that do not directly add to the cost of a product. Furthermore, financial costs such as interest charges or marketing costs do no constitute the Cost of Sales as they do not relate to the cost of producing/purchasing a product.

Taxes are also not directly related to the cost of a product and therefore, not a part of the Cost of Sales. However, any sales tax that cannot be claimed on the purchases of raw materials is a part of the Cost of Sales as they are directly related to the product.

Individuals

Gross income for individuals is defined in their contracts. If an individual has a fixed salary, the fixed salary amount is their gross income.

If the individual has an hourly rate wage, the hourly rate multiplied with the total hours worked is their gross income.

Any overtime premium rate is also agreed upon in the contract or in the employer’s policy manuals. This can also be easily calculated using the guidelines for calculating overtime premiums and make a part of the gross income of individuals.

Furthermore, bonuses may also be pre-determined or can be given whenever the employer chooses to. Either way, bonuses are still included in the gross income of an individual.

Simply put, for an employed individual, any income the individual earns from the employer is their gross income for the period.

Individuals that are not employed may have other sources of income. For example, a local business owner may run a small store. For them, any income they generate, before any deductions is their gross income.

Net Income

Net income is a term used to describe income after all deductions have been made from the gross income. Net income for businesses means deducting any remaining expenses that are not directly related to the production or purchase of the product.

For individuals, it means subtracting taxes, pension payments and any other mandatory or voluntary payments from the gross salary.

Businesses

For businesses the other term used for net income is net profit. Net profit is the residual amount after deducting all of the business’ expenses from the revenues of the business.

Net profits can also be defined as the residual amount after deducting expenses that are not directly related to the production or purchase of products from the gross profit of the business.

The net profit of a business, like its gross profit can be simply traced from its income statement. The formula to calculate the net profit of a business can be written in 2 ways, as follows:

Net Profit = Revenue – Expenses (all business expenses)

Net Profit = Gross Profit – Other expenses (expenses that are not Cost of Sales)

The expenses deducted from the revenues of a business are all the business expenses including all taxes.

If these expenses are being deducted from gross profit, they include expenses such as administrative expenses, marketing expenses, research expenses, selling expenses, financial expenses, and taxes.

These are expenses that are not directly attributable to the sales of any specific product.

Individuals

For individuals, net income is the amount they actually get paid. The net income for individuals is the amount after deducting different amounts from the gross income of the individual.

These deductions can be for amounts that are either mandatory or voluntary deductions. These amounts might differ according to each employer and country the individual is working in.

The main deduction from the gross incomes of individuals is taxes which is mandatory. Whether the individual is working for an employer or self-employed, they have to pay taxes and deduct these taxes from their gross incomes to reach their net income figure.

Other expenses may include pension payments, medical expenses or insurance, leave deductions, and other voluntary deductions.

Conclusion

Income is any earnings made by a business or individual. There are two terms that are related to income which are gross income and net income.

Gross income for businesses, also known as gross profit, is the income after deducting expenses directly related to the products being sold from the business’ revenue.

For individuals, gross income is the amount they have earned whether from their jobs or other sources.

Net income, for businesses, is the amount after deducting all the business’ expenses from its revenues. For individuals, it is the amount of payment they actually receive after deduction of any taxes or other amounts.

RULE OF DEBIT AND CREDIT IN ACCOUNTING

Accounting can be defined as the recording, summarizing, analyzing, classifying, presenting, and reporting of financial information.

The financial information is mainly obtained when business transactions take place.

Once financial information about business transactions is obtained, it is entered into the accounting system, mainly the general ledgers, of a business.

At the end of every period, this data is presented and reported to the stakeholders of the business in the form of Financial Statements of a business.

The main entry point to the accounting system of a business, for any business transaction, is the business’ General Ledgers.

General ledgers record every business transaction that can reliably be measured. General ledgers are categorized by the type of transaction that is being recorded.

For example, if the company has incurred an expense, the transaction is recorded at the expense of the general ledger. These are also known as accounts. These accounts can also be extended to group transactions of a similar nature.

The general ledger has two sides on which transactions are recorded. The left side of a general ledger is known as the Debit (Dr.) side while the right side of a general ledger is known as the Credit (Cr.) side. When a business transaction occurs, it must be recorded in two ledgers.

One of the ledgers must have a Debit entry and another ledger must have a Credit entry for the same transaction. This is due to the Double Entry concept of accounting.

In this article, we will discuss the role of debit and credit in accounting on how it help to the business to record its daily accounting transactions.

Double Entry Concept

The double entry concept is the basis of accounting. The double entry concept states that every business transaction must be recorded in at least 2 accounts in the accounting system of a business.

Furthermore, it states that the amounts of the Debits and Credits must be equal at all times when recording a business transaction.

For example, if a business incurs an expense of $500 and pays it by cash. The business must record both the expense of the business that has increased by $500 and the cash of the business that has decreased by $500.

The expense is recorded in the related expense account while cash is recorded in the business’ cash account.

Here is now the debit and and credit of this transaction look like,

Debit (Dr) Expenses Account $500

Credit (Cr) Cash Account $500

Separate Entity Concept

Another concept that is crucial in accounting is the separate entity concept. The separate entity concept states that the business and its owner are two separate entities.

Any business transaction is independent of the owner and the owner is seen as a foreign entity. This concept identifies the owner of the business as an outsider to the business.

Therefore, any business transactions with the owner of the business must also be recorded as if the transaction took place with a third-party.

For example, a business receives an investment of $10,000 from the owner of a business.

This transaction must be recorded in the books of the business as if the business took place with a foreign entity while also keeping the double entry concept into consideration.

Thus, this transaction must again be recorded in two accounts. The first effect of this transaction is taken to the cash account where the cash has increased by $10,000 and the second effect is taken to the capital account, which keeps a track of the owner’s capital in a business.

Here is how the double entry of this transaction will look like,

Debit Cash Account $1,000

Credit Equity Account $1,000

Fundamental Elements of Accounting

There are 5 fundamental elements of accounting. All business transactions have two effects on the accounting system according to the double-entry concept.

The two entries, Debit and Credit can be categorized into one of the five fundamental elements of accounting.

Therefore, to understand the rule of Debit and Credit in accounting, it is necessary to understand the fundamental elements of accounting. These are:

1) Assets

Assets are resources controlled by a business that enables the business to benefit from them in the future. For example, a car bought by the business is considered an asset of the business.

Similarly, inventory of a business is its asset because the inventory will bring future benefits to the business when they are sold.

Other examples of assets include, but are not limited to, fixed assets, cash in bank accounts, physical cash in the business, investments made in other companies or instruments, etc.

In the rule of debit and credit, an increase of assets is recording on the debit side and the decrease of assets is recording on the credit side.

2) Liabilities

Liabilities are the opposite of assets. Liabilities are obligations of the business that the business has to pay to a third-party in the future due to legal or contractual obligations which result in benefits outflowing from the business.

The simplest example of liabilities is a bank loan. If a business takes a bank loan, it will have to pay the loan back to the bank in the future which will result in cash outflow from the business.

In the rule of debit and credit, an increase of liabilities is recording on the credit side and the decrease of liabilities is recording on the debit side.

3) Equity/Capital

Equity is a concept that is realized due to the separate entity concept. Equity is similar to a liability for the business except liabilities are payable to third-parties while equity is payable to the owner of the business.

Technically, equity is defined as the residual value of a business after reducing its liabilities from its assets. This means that if a business is liquidated, any assets that are left after paying all the liabilities of a business, are the owner’s right in the business.

Anything that an owner invests into the business is their capital and anything they take out is known as drawings.

In the rule of debit and credit, an increase of equity or capital is recording on the credit side and the decrease of equity or capital is recording on the debit side.

4) Income

Income is defined as an increase in the benefits of a business. Therefore, any inflow of benefits to a business is considered as the income of the business. The main source of income for any business is the revenues it generates from daily activities.

However, there might be other sources of income as well such as interest income, dividends from investments, profits on sales of assets, etc.

In the rule of debit and credit, an increase of income is recording on the credit side and the decrease of income is recording on the debit side.

5) Expense

Expense is defined as the decrease in benefits of a business. Therefore, any outflow of benefits from a business is considered as an expense for the business.

All businesses have a wide variety of expenses. For example, businesses may have purchases or production expenses, utility expenses, rent expenses, repair and maintenance expenses, etc.

In the rule of debit and credit, an increase of expenses is recording on the debit side and the decrease of expenses is recording on the credit side.

Rule of Debit and Credit in Accounting

As mentioned above, all business transactions can be categorized into one of the five fundamental elements of accounting.

This means any business transaction will either effect the assets, liabilities, equity, income or expense accounts of a company.

Therefore, the rules of Debit and Credit are associated with these 5 fundamental elements of accounting.

All general ledger accounts in a business will be of the 5 fundamental elements type.

Whether the account is debited or credited depends on the type of the account and whether it is increasing or decreasing. The rule of Debit and Credit for these accounts can be remembered using the acronym DEAD CLIC.

Debit

Expense

Asset

Drawing

Credit

Liability

Income

Capital

The above acronym can be used to determine whether an account should be debited or credited. However, this rule only applies when there is an increase in these accounts.

This means, an increase in expenses, assets and drawings of a business should always be debited in their respective accounts.

While an increase in the liabilities, income and capital of a business must always be credited in their respective accounts.

In contrast, when there is a decrease in these accounts, then the Debit and Credit rule for the above acronym gets reversed.

A decrease in expenses, assets, and drawings is always credited in their respective accounts. While a decrease in liabilities, income, and capital gets debited in their respective accounts.

Examples

A business, ABC Biz, has the following business transactions for a period, with the respective double entries:

1) Owner invested $10,000 in the ABC Biz.

Since the owner of the business invested cash into the business, there will be two effects of the business transaction on the business.

The first effect will be the cash of the business increasing by $10,000 which is an asset of the business. The second effect is that the business has to pay the owner back $10,000.

Or in simpler terms, the owner’s capital has increased by $10,000. Since there is an increase in assets and capital of the business, the double-entry is as follows:

Debit   Cash                                        $10,000

Credit  Capital                                    $10,000

2) ABC Biz took a loan of $5,000 cash from local bank.

The business took a loan from the bank. The cash of the business has increased by $5,000 while the liability of the business has also increased by $5,000. This is because the business is now obligated to pay the bank $5,000. The double entry is as follows:

Debit   Cash                                        $5,000

Credit  Loan (Liability)                       $5,000

3) ABC Biz bought goods for $1,000 for cash.

Goods bought for business are the expense of the business. There is an increase in expense for the business. While cash has been paid, therefore, it is a decrease in cash, an asset. The double entry can be done as:

Debit   Purchase (Expense)                 $1,000

Credit  Cash                                        $1,000

4) ABC Biz sold the goods for $1,200 for cash.

In this business transaction, cash of the business has increased by $1,200. This cash has increased due to income of $1,200 from sales, thus, this is an increase in income as well. The double entry is as below:

Debit   Cash                                        $1,200

Credit  Sales (Income)                         $1,200

5) The owner withdrew $200 cash from business.

Since the owner withdrew $200 from the business, it means the business’ cash has decreased by $200. Furthermore, the drawing of the business has increased. The drawings can also be viewed as a decrease in owner’s capital. The double entry is as follows:

Debit   Drawing                                  $200

Credit  Cash                                        $200

6) Business paid $1,000 loan amount back to bank in cash.

Since the business has paid $1,000 to bank, the cash of business has decreased by $1,000. Furthermore, the liability of the business has also decreased by $1,000. The double entry is as follows:

Debit   Loan (Liability)                       $1,000

Credit  Cash                                        $1,000

Conclusion

The modern account system is based on two major concepts. The first concept is the Double Entry concept which gives rise to the double entry bookkeeping system that is prevalent in accounting.

Business transactions are recorded in general ledger accounts using either a Debit or Credit double entry.

The second concept is the Separate Entity concept which gives rise to the concept of Equity. Equity is one of the five fundamental elements of accounting system.

Once a business transaction can be associated with the two corresponding accounts, using the base element of the account, the business can determine whether the account should be debited or credited.