Bills of Exchange, Final Accounts & Incomplete Records
Weightage: Chapters 7, 8 and 10 of ICAI's Paper 1 syllabus, together worth roughly 20 marks. Final accounts is the first point in the paper where everything learned so far must operate together, and it is the foundation on which partnership and company accounts are built.
Bills of Exchange and Promissory Notes
Why the instrument exists
A seller who grants credit holds a debt. A debt is an unattractive asset: it is evidence of nothing but an entry in the seller's own books, it cannot easily be transferred to anyone else, and if the buyer disputes it the seller must prove the underlying transaction.
A bill of exchange converts that debt into a document. Section 5 of the Negotiable Instruments Act, 1881 defines it as an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of the instrument.
Three features follow from that definition and explain why the instrument is useful:
- The order is unconditional, so payment cannot be resisted on the ground that something else went wrong in the underlying transaction.
- The sum is certain and the date is fixed, so the holder knows exactly what is due and when.
- The instrument is negotiable, so it can be transferred to another party who then holds the claim in their own right.
That last feature is what makes a bill more than a receipt. Having accepted a bill, the seller can endorse it to a creditor in settlement, or discount it with a bank and receive cash immediately, instead of waiting for the credit period to expire.
Parties and the distinction from a promissory note
A bill of exchange has three parties. The drawer is the creditor who draws the bill ordering payment. The drawee is the debtor on whom it is drawn, who becomes the acceptor by signing across it — until acceptance the bill is only an order, not an obligation. The payee is the person to be paid, who is usually the drawer but need not be.
A promissory note has only two parties. The maker is the debtor, who promises to pay, and the payee is the creditor. The difference in substance is direction: a bill is an order by the creditor to the debtor, and requires acceptance to become binding; a note is a promise by the debtor, and is binding from the moment it is made because the person promising is the person liable.
Due date and days of grace
Every time bill is allowed three days of grace beyond its nominal term. A bill drawn on 10 June 2026 payable three months after date matures on 10 September, and with grace the due date is 13 September 2026.
Two adjustments recur in questions. Where the due date falls on a public holiday, the bill matures on the preceding business day. And a bill payable "after sight" runs its term from the date of acceptance, not the date of drawing, so the acceptance date must be identified before counting.
The four things a holder can do with a bill
The accounting depends entirely on which of four routes the holder takes, and identifying the route is the first step in every question.
Retain until maturity. The holder keeps the bill and presents it on the due date. In the drawer's books, Bills Receivable is debited on receipt and closed on maturity against cash.
Discount with a bank. The holder sells the bill to a bank before maturity and receives its value less a discounting charge. The charge is a finance cost of obtaining money early and is debited to Discount on Bill, a nominal account, in the drawer's books. The acceptor's books are unaffected — the acceptor owes the same amount on the same date and has no interest in what the drawer did with the instrument. Candidates who record something in the acceptor's books on discounting have misunderstood what discounting is.
Endorse to a creditor. The holder transfers the bill to a third party in settlement of a debt. Bills Receivable is credited and the creditor's account debited. Again the acceptor's books are unaffected.
Send for collection. The bill is lodged with a bank as agent, not sold. Because ownership has not passed, an intermediate account — Bills Sent for Collection — is used, and it is closed when the bank collects and credits the proceeds.
Dishonour
Dishonour is where the topic is genuinely examined, because the entries depend on the route taken and candidates who learned one pattern by rote get the others wrong.
On dishonour the original debt revives. The acceptor becomes liable again to whoever holds the bill, and the person who transferred it is liable to the transferee.
- Bill retained. The drawer debits the acceptor and credits Bills Receivable.
- Bill discounted. The bank returns the dishonoured bill and recovers from the drawer, so the drawer debits the acceptor and credits Bank — not Bills Receivable, which was already closed on discounting.
- Bill endorsed. The endorsee recovers from the drawer, so the drawer debits the acceptor and credits the endorsee.
- Bill sent for collection. The drawer debits the acceptor and credits Bills Sent for Collection.
Noting charges are the fee paid to a notary public to record the dishonour formally, creating evidence for later legal proceedings. They are always borne ultimately by the acceptor, whose default caused them, so whoever pays them debits the acceptor's account for the amount.
Renewal and retirement
Renewal occurs where the acceptor cannot pay at maturity and asks for more time. The old bill is cancelled and a new one drawn. Interest for the extended period is charged to the acceptor and is either paid in cash or added to the amount of the new bill. The entries are: cancel the old bill by debiting the acceptor and crediting Bills Receivable; charge interest by debiting the acceptor and crediting Interest; then draw the new bill by debiting Bills Receivable and crediting the acceptor.
Retirement is the opposite situation — the acceptor pays before maturity. The holder receives money early and therefore allows a rebate, which is a discount for early payment. In the holder's books the rebate is a loss and is debited to Rebate on Bill; in the acceptor's books it is a gain and is credited to Rebate. Note the symmetry, and note that a rebate on retirement and a discount on discounting are different things arising from opposite events.
Accommodation bills are drawn and accepted without any underlying sale, purely to raise money on the credit of one or both parties. The bill is discounted and the proceeds are shared in the agreed ratio. Accounting proceeds normally, but there is no trade debt behind it, so the parties settle between themselves on maturity. Where proceeds are shared, the discounting charge is shared in the same ratio.
Final Accounts of Sole Proprietors
The three statements and what each answers
The Trading Account computes gross profit — the margin on goods, before any expense of running the business. It is charged with opening stock, purchases less returns, direct expenses such as carriage inwards, wages, freight and import duty, and credited with sales less returns and closing stock.
The Profit and Loss Account takes gross profit and arrives at net profit by charging indirect expenses — administrative, selling and distribution, and financial — and crediting other incomes.
The Balance Sheet states the position at the year end: assets on one side, liabilities and capital on the other.
The distinction between direct and indirect expenses is examined constantly and has one test: does the expense relate to bringing goods to a saleable condition and location, or to running the business and selling? Carriage inwards is direct; carriage outwards is indirect. Wages paid to factory workers are direct; salaries paid to office staff are indirect.
Adjustments: the actual content of the chapter
A final accounts question is a trial balance plus a list of adjustments. The trial balance is arithmetic. The adjustments are the examination.
Every adjustment has a double effect — one in the Trading or Profit and Loss Account and one in the Balance Sheet — and the single largest cause of lost marks is giving an adjustment only one of its two effects. The rule that catches this is simple and worth applying mechanically: an item appearing inside the trial balance is given effect once; an item appearing only in the adjustments is given effect twice.
The recurring adjustments:
Closing stock. Credited in the Trading Account and shown as a current asset. If it already appears in the trial balance it has been adjusted through purchases and is shown only in the Balance Sheet.
Outstanding expenses. Expenses incurred but unpaid. Added to the relevant expense and shown as a current liability. This is matching in operation — the expense belongs to the period that benefited, not the period that paid.
Prepaid expenses. Paid but relating to a future period. Deducted from the expense and shown as a current asset.
Accrued income. Earned but not received. Added to the income and shown as a current asset.
Income received in advance. Received but not yet earned. Deducted from the income and shown as a current liability, because the enterprise still owes the service.
Depreciation. Charged to the Profit and Loss Account and deducted from the asset.
Bad debts written off. Charged to the Profit and Loss Account and deducted from debtors. Where bad debts appear both in the trial balance and in the adjustments, both amounts are charged but only the adjustment amount is deducted from debtors — the trial balance figure was already deducted when written off.
Provision for doubtful debts. Created on debtors after deducting further bad debts. Only the increase over the existing provision is charged to the Profit and Loss Account; a decrease is credited. This is the adjustment most often done wrongly, because candidates charge the whole new provision rather than the movement in it.
Provision for discount on debtors. Computed on debtors after deducting both bad debts and the provision for doubtful debts, since a discount will only ever be allowed to those who actually pay.
Interest on capital is an expense of the business and an addition to capital. Interest on drawings is an income of the business and a deduction from capital.
Goods taken by the proprietor for personal use are deducted from purchases and from capital as drawings. They are not a sale, because the business entity has not sold anything to an outsider, and treating them as sales is a standard error.
Goods distributed as free samples are deducted from purchases and charged as advertisement expense.
Abnormal loss of stock — by fire or theft — is deducted from purchases at cost. The insured portion becomes a claim receivable from the insurer and is shown as an asset; the uninsured portion is charged to the Profit and Loss Account as a loss.
Manager's commission is the one adjustment requiring an algebraic step. A commission "at 10% on net profit before charging such commission" is simply 10% of that profit. A commission "at 10% on net profit after charging such commission" requires solving: if profit before commission is P, the commission C satisfies C = 0.10 × (P − C), so C = P × 10/110. The general rule is that a commission at rate r on profit after charging it equals profit before commission multiplied by r/(100 + r).
Method for a final accounts question
Work in a fixed order and the question becomes mechanical:
- Read every adjustment before writing anything, and mark on the trial balance which items each one touches.
- Prepare the Trading Account, taking direct items only.
- Prepare the Profit and Loss Account.
- Prepare the Balance Sheet.
- Check that every adjustment has been given both of its effects, ticking each off the list.
Step 5 is worth more marks than any amount of speed in the earlier steps, and it is the step most often skipped under time pressure.
Accounts from Incomplete Records
What single entry is, and is not
Incomplete records — loosely called single entry — is not a system of accounting. It is the absence of one. A trader maintains a cash book and personal accounts of debtors and creditors because these are needed to run the business day to day, and keeps no real or nominal accounts at all because nobody chases him for them.
The consequences are exactly what the missing accounts imply. There is no trial balance, so arithmetical accuracy cannot be checked. There is no direct means of computing profit, since no nominal accounts exist. The accounts are unreliable for tax, for lenders and for any purchaser of the business. Frauds are hard to detect because there is no independent check.
Two methods exist for extracting a profit figure from such records.
The Statement of Affairs method
This method computes profit by comparing capital at two dates, and it rests on a single equation: any increase in the proprietor's capital that did not come from fresh introduction must have come from profit.
A Statement of Affairs is a balance sheet drawn from whatever information can be gathered — assets counted or estimated, liabilities established from creditors' records. Capital is the balancing figure, and this is precisely what distinguishes it from a balance sheet, where capital is a known figure derived from the books.
Profit is then:
Profit = Closing capital + Drawings − Additional capital introduced − Opening capital
The logic of each term is worth stating rather than memorising. Closing capital less opening capital gives the increase. Drawings are added back because they reduced capital without being a loss. Additional capital is deducted because it increased capital without being a profit.
Its limitation is decisive: it produces a single profit figure and nothing else. There is no gross profit, no expense analysis, no way to see why profit changed. The figure is also only as reliable as the estimates of assets and liabilities at both dates.
The conversion method
Here the incomplete records are converted into a double entry set, and full final accounts are prepared. It is more work and yields far more information.
The technique is the recovery of missing figures from the accounts that do exist, and two reconstructions do most of the work:
Credit sales are found from a Total Debtors Account. Opening debtors plus credit sales, less cash received from debtors, less discount allowed, less bad debts, less sales returns, equals closing debtors. Every term except credit sales is usually known, so credit sales is the balancing figure.
Credit purchases are found from a Total Creditors Account on the same principle. Opening creditors plus credit purchases, less cash paid, less discount received, less purchase returns, equals closing creditors.
Cash and bank figures come from the cash book, which the trader does maintain. Expenses are found from payments adjusted for opening and closing outstanding and prepaid amounts. Where the gross profit ratio is given, it can be used to derive whichever of sales, cost of goods sold or closing stock is missing.
How these three chapters are examined
Bills of exchange appears as journal entries in the books of both parties across a bill's life, usually with a dishonour and often a renewal. Identify the route the bill took before writing anything, since the dishonour entry depends entirely on it, and remember that discounting and endorsement do not affect the acceptor's books.
Final accounts is the largest single question on most papers. Present the three statements in correct form with correct headings, show each adjustment's computation as a working note, and tick adjustments off as you give each its second effect.
Incomplete records appears either as a Statement of Affairs computation of profit, which is short, or as a full conversion, which is long. In the latter, present the Total Debtors and Total Creditors accounts as working notes — they are separately markable and they are where the examiner looks to see whether the method was understood.
