Start with the accounting equation

Assets = liabilities + capital. Every entry preserves that equation. In the modern rule, increases in assets and expenses are debits; increases in liabilities, capital and income are credits. Decreases take the opposite side. Debit is not a synonym for loss and credit is not a synonym for profit.

Transaction	Entry	Effect
Owner introduces cash ₹50,000	Cash Dr 50,000; Capital Cr 50,000	Asset and equity increase
Buy machinery for cash ₹20,000	Machinery Dr 20,000; Cash Cr 20,000	One asset replaces another
Buy goods on credit ₹8,000	Purchases/Inventory Dr 8,000; Supplier Cr 8,000	Inventory/expense and liability increase
Accrued salary ₹3,000	Salary Dr 3,000; Salary payable Cr 3,000	Expense and liability increase

Partnership appropriation and capital accounts

First calculate the firm’s net profit. Then prepare the profit-and-loss appropriation account for agreed interest on capital, partners’ salary/commission and interest on drawings. The residual profit is shared in the agreed ratio. Partner salary is an appropriation in the usual partnership final-account format; employee salary is a business expense.

Fixed capital accounts normally retain capital while drawings, interest and profit shares pass through current accounts. Fluctuating capital accounts record these changes in the capital account itself. Do not assume interest on capital is payable in the absence of an agreement.

Example: A and B share 3:2. Net profit is ₹1,00,000; agreed interest on capital is ₹10,000 and ₹8,000; A has an agreed salary of ₹12,000. Residual profit = ₹70,000. A gets ₹42,000 residual + ₹10,000 interest + ₹12,000 salary = ₹64,000. B gets ₹28,000 + ₹8,000 = ₹36,000. Total appropriation reconciles to ₹1,00,000.

Admission: sacrificing ratio, goodwill and revaluation

Sacrificing ratio = old share − new share. It determines which old partners are compensated for giving up profit rights. It is not automatically the old ratio. A revaluation account records pre-admission asset/liability changes, generally allocating its result to old partners in their old ratio.

Example: A:B = 3:2. C is admitted for 1/5, taken equally from A and B. A’s new share = 3/5 − 1/10 = 1/2; B’s = 2/5 − 1/10 = 3/10; C’s = 1/5. New ratio = 5:3:2. Sacrifice is 1/10 each, so sacrificing ratio = 1:1. If C brings ₹20,000 goodwill premium, A and B each receive ₹10,000.

If stock appreciates by ₹6,000 and a liability increases by ₹2,000, revaluation profit is ₹4,000. On the old 3:2 ratio, A receives ₹2,400 and B ₹1,600. C does not share a pre-admission gain merely because the journal entry is passed after admission.

Retirement, death and dissolution

Gaining ratio = new share − old share. Continuing partners compensate the outgoing partner for the goodwill share they acquire. Revaluation and accumulated reserves arising before retirement are generally shared in the old ratio. A deceased partner’s share of profit to the date of death needs the agreement or the stipulated time/sales basis.

Example: A:B:C = 3:2:1 and C retires. A and B continue 3:2. A’s gain is 3/5 − 3/6 = 1/10; B’s gain is 2/5 − 2/6 = 1/15. Gaining ratio = 3:2. If firm goodwill is ₹60,000, C’s share is ₹10,000, borne ₹6,000 by A and ₹4,000 by B.

In dissolution, realisation of assets, payment of outside liabilities, partner loans and capital settlement must be kept separate. Cash/bank itself is not transferred to the realisation account in the usual format. An unrecorded asset realised and an unrecorded liability paid affect realisation in opposite ways.

Cash flow under AS 3: classify before calculating

Activity	Typical cash inflows	Typical cash outflows
Operating	Customer collections	Suppliers, employees and operating payments
Investing	Sale of PPE or non-cash-equivalent investments	Purchase of PPE or such investments
Financing	Share issue, debenture issue and borrowings	Loan principal repayment, share buy-back and distributions as classified

Cash equivalents are short-term, highly liquid investments readily convertible to known cash amounts and subject to insignificant value-change risk. A maturity of about three months or less from acquisition is the usual AS 3 guide. A non-cash acquisition of machinery by issuing shares is disclosed separately rather than invented as a cash inflow and outflow.

For a non-financial enterprise under AS 3, interest paid is financing; interest and dividends received are investing; dividends paid are financing. A financial enterprise’s interest paid and interest/dividends received are ordinarily operating. Do not silently switch between AS 3 and Ind AS 7 classification choices.

Indirect method: signs that commonly go wrong

Adjustment	Effect on operating cash flow	Reason
Depreciation	Add back	Non-cash expense reduced accounting profit
Profit on PPE sale	Subtract	Investing result included in profit
Loss on PPE sale	Add back	Remove non-operating loss from profit
Increase in operating receivables	Subtract	Sales exceed cash collection
Decrease in operating inventory	Add	Less cash tied up in stock
Increase in operating payables	Add	Expense/purchases not yet paid

Worked case: profit before tax ₹2,00,000; depreciation ₹30,000; gain on equipment sale ₹10,000; receivables rise ₹20,000; inventory falls ₹5,000; payables rise ₹15,000. Cash generated from operations = 2,00,000 + 30,000 − 10,000 − 20,000 + 5,000 + 15,000 = ₹2,20,000. With operating tax paid ₹40,000, operating cash flow = ₹1,80,000. The cash proceeds from the equipment sale belong in investing separately.

Ratio formula sheet

Ratio	Formula	Interpretation caution
Current ratio	Current assets / current liabilities	A high figure can conceal slow or obsolete stock
Quick ratio	Quick assets / current liabilities	Quick assets normally exclude inventory and prepaid expenses
Gross profit ratio	Gross profit / revenue from operations × 100	Use net sales consistently
Net profit ratio	Defined net profit / revenue × 100	State pre-/post-tax basis
Inventory turnover	Cost of goods sold / average inventory	Do not use sales when cost is required
Receivables turnover	Net credit sales / average trade receivables	Use comparable periods
Debt-equity	Defined long-term debt / shareholders’ funds	Some questions use total debt; follow the stated definition
Interest coverage	EBIT / finance cost	Cash interest ability can differ from EBIT coverage
ROCE	EBIT / capital employed × 100	Average or closing capital must be specified

Solved ratio cases and transaction effects

Case 1: current assets ₹3,00,000, inventory ₹80,000, prepayments ₹20,000 and current liabilities ₹1,50,000. Current ratio = 2:1. Quick ratio = (3,00,000 − 80,000 − 20,000)/1,50,000 = 1.33:1.

Case 2: pay a ₹50,000 current liability in cash from the same opening balances. The ratio becomes ₹2,50,000/₹1,00,000 = 2.5:1. Paying a current liability raises a current ratio initially above 1; it lowers one initially below 1. A one-line rule without the starting condition is unsafe.

Case 3: cost of goods sold ₹6,00,000; opening inventory ₹80,000; closing inventory ₹1,20,000. Average inventory = ₹1,00,000; turnover = 6 times. On a stipulated 365-day year, holding period = 365/6 = 60.83 days. Use 360 if the question instructs it.

Case 4: EBIT ₹2,40,000, interest ₹40,000 and capital employed ₹12,00,000. Interest coverage = 6 times; ROCE = 20%. Substituting net profit for EBIT changes the measure.

Final accounts and error checks

• Outstanding expense: add to expense and show liability. Prepaid expense: reduce expense and show asset.
• Accrued income: add to income and show asset. Income received in advance: reduce current income and show liability.
• Closing inventory outside the trial balance normally appears in trading and balance sheet; avoid double counting if it is already in an adjusted trial balance.
• Depreciation changes profit and carrying value; it does not create a cash fund by itself.
• A trial balance can agree despite an error of principle, complete omission or compensating errors.
• Capital expenditure can be wrongly charged as revenue without disrupting debit/credit equality.

Practice questions with explanations

Attempt each question before opening the answer. These are CrackTarget practice questions.

Q1. Old share 3/5, new share 1/2: what is the sacrifice?

• A. 1/10
• B. 1/5
• C. 1/2
• D. 1/3

Answer and explanation

A. 3/5 − 1/2 = 1/10.

Q2. A cash purchase of machinery is ordinarily which activity?

• A. Operating
• B. Investing
• C. Financing
• D. No cash flow

Answer and explanation

B. Acquiring long-term productive assets is investing.

Q3. Receivables increase by ₹8,000 in an indirect-method problem. What is the adjustment?

• A. Add ₹8,000
• B. Subtract ₹8,000
• C. Add ₹16,000
• D. No adjustment

Answer and explanation

B. The increase represents revenue not yet collected, assuming operating receivables.

Q4. Which normally uses cost of goods sold rather than sales?

• A. Net profit ratio
• B. Current ratio
• C. Inventory turnover
• D. Debt-equity

Answer and explanation

C. Inventory turnover compares COGS with average inventory.

Q5. Which error may leave a trial balance agreeing?

• A. Only debit recorded
• B. Debit posted twice
• C. Capital asset charged to expense with equal credit
• D. Unequal debit and credit

Answer and explanation

C. An error of principle can preserve arithmetic equality.

Frequently asked questions

Should I memorise ratios without definitions?

No. Debt, profit, capital employed and period averages must match the question’s definition.

Are partner salary and employee salary the same expense?

In ordinary partnership final accounts, agreed partner salary is an appropriation; employee salary is a business expense.

Sources and further reading

• UPSC Special Advertisement 52/2026: scheme and nine syllabus heads
• ICAI: Accounting Standards including AS 3
• ICAI: AS 3 Cash Flow Statements

Continue your APFC preparation

• Auditing, Vouching, Verification & Valuation: Advanced APFC Notes
• UPSC EPFO APFC / EO-AO 2025 Fully Solved Question Paper
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