The statements which report the profitability and the financial position of the business at the end of the year are known as financial statements.
In the words of John N. Myer, ‘The financial statements provide a summary of the account of the assets, liabilities and capital as on a certain date and the income statement showing the results of operation during a certain period.’
Financial statements include the following statements:
Trading Account : It is prepared to find out the gross profit or gross loss incurred in a business by doing the business activities for one year.
Profit and Loss Account : This account is prepared to know the net profit or net loss of the business for an accounting period. In this account, all the expenses, losses and gains are written. It is also known as income statement.
Balance Sheet : The balance sheet presents the financial position of an enterprise at a certain date, which is the last day of the accounting year. All the assets and liabilities of a business are shown in this statement.
These financial statements are known as ‘final accounts’.
In addition to the two basic financial statements two other statements namely a ‘statement of retained earnings’ and a ‘cash flow statement’ are also included in financial statements.
Financial statements are used by the management, investors, creditors, employees, government, etc.
Utility of financial statements
Management : The financial statements help the management in assessing the profitability of its activities and departments. The management can review the progress of business and take decisions to control the profitable activities with the help of these statements.
Investors : Investors can assess short term and long term financial soundness and earning capacity of the business. These statements are helpful to them to study the trade of sale, profit, shortcomings and progress of the enterprise.
Short-term creditors : They assess, with the help of these statements whether the enterprises will be in the position to pay debts when they become due for payment. As such, they can make up their mind to restrict, maintain or extend the credit allowed to the enterprises.
Long-term creditors : Financial statements indicate if the business will be in a position to make payment of debts when they become due.
Employees : Employees are in a position to judge how much bonus and increase in their salaries will be possible in the future.
Taxation authorities : Financial statements are helpful for the purpose of assessment of income tax and sales tax.
Government : Government makes use of these statements to study the profit margins of various industries to announce or withdraw various concessions and to increase or decrease the excise duty.
Other users : Trader associations, consumer organisations, research institutions also make use of financial statements.
Financial statements
Income statement is divided into two parts :
(i) The first part is called ‘Trading Account’. It shows the gross profit or gross loss.
(ii) The Second part is called Profit & Loss Account. It shows the net profit or net loss.
Gross Profit is the excess of revenue over cost. Revenue means sales of goods.
Equations
Gross Profit=Net sales–Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses–Closing Stock
Net Sales=Total Sales–Sales Returns
Net Purchases=Total Purchases–Purchases Returns
Cost of Goods Sold=Net Sales–Gross Profit
Operating Profit : It is the profit which is earned by an enterprise through normal operations and activities of business. Operating profit is the excess of operating revenue over operating expenses. Operating profit is the profit before interest and tax. Similarly, non-operating expenses or losses such as loss due to fire etc. are not taken into account. Operating profit can be calculated as follows :
Operating Profit=Gross Profit–Operating Expenses or
Operating Profit=Gross Profit– Administrative and Distribution Expenses
Operating Incomes=Commission Earned on Sale of Goods
Non-Operating Expenses=Tax, Interest, Dividend Loss by Fire Loss on sale of Fixed Assets, Charities, Donations.
Non-Operating Incomes=Dividends on Investments, Gain on Sale of Fixed Assets.
Operating Profit=Gross Profit–Operating Expenses–Operating Income.
Net Profit
Net Profit is the difference between operating Profit–Non-Operating Ex-penses + Non-operating Income
Net Profit = Net Sales–Cost of Goods Sold + Non-Profit Income–Non-operating Expenses–Operating Ex-penses.
Features of trading account
(i) It is prepared at the end of the closing year.
(ii) It indicates the gross loss or gross profit of the enterprise.
(iii) It records cost of goods sold, direct expenses and net sales.
(iv) It is the first stage in the preparation of final accounts.
(v) It is nominal account.
(vi) The balance of Trading Account is transferred to profit and loss account.
Importance of trading account
(i) It shows the result of buying and selling of goods.
(ii) It shows comparison of closing stock with that of previous year.
(iii) It shows gross profit or gross loss.
(iv) It provides data about direct expenses.
(v) It indicates distinction between direct expenses and indirect expenses.
Closing entries of trading account
All those entries which are required for the transfer of all the items appearing in the Trading Account are called closing entries.
Journal Entries
(i) Trading A/c Dr
To Opening Stock A/c
To Purchases A/c
To Sales Returns A/c
To Direct Expenses A/c
(Being transfer of account of debit side)
(ii) Sales A/c Dr.
Purchases Returns A/c Dr.
Closing Stock A/c Dr.
To Trading Account
(Being transfer of account of debit side)
Trading A/c Dr
To Profit & Loss A/c
(Being transfer of gross profit/loss to profit and loss account)
Profit & Loss A/c Dr
To Trading A/c
(Being transfer of gross profit to profit and loss account)
Profit and loss account
Profit and Loss Account is prepared after Trading Account. This account shows net profit or net loss.
Features of profit and loss account
(i) The balance of profit and loss account is net profit or net loss.
(ii) Profit and loss account is prepared by matching revenues and expenses.
(iii) It relates to a particular period.
(iv) It is a nominal account.
(v) It is the second stage in preparation of final accounts.
(vi) Profit and Loss Account is prepared on the accrual basis of accounting.
Importance of Profit and loss account
(i) This account helps in forecasting future of the business.
(ii) It shows earning power of the business.
(iii) It helps in ascertaining net profit or net loss of the business.
(iv) It is helpful in preparation of balance sheet of business.
(v) It helps in comparison of actual profit/loss with estimating profit/loss.
(vi) It is an account of business revenue, expenses and profits.
The difference
(i) Profit and Loss Account is an indicator of how successfully the business is running. Trading Accounts shows profit earning capacity of business.
(ii) Profit and Loss Account discloses the net profit or net loss. Trading Account ascertains gross profit or gross loss.
(iii) Profit and Loss Account is the second stage of financial accounts. The Trading Account is the first stage account.
(iv) Whereas the Profit and Loss account records gross profit, income and indirect expenses and losses, Trading Account deals with sales and direct expenses.
(v) In Profit and Loss Account, the valuation of assets other than stock has a direct impact on its presentation. In Trading Account, the valuation of stock has a direct impact on the presentation of it.
Indirect expenses
Indirect expenses can be divided into—
1. Office and administrative expenses
2. Selling and distribution expenses
3. Financial expenses.
4. Other expenses. Office and Administrative Expenses include salaries, printing, stationery, postage, telegrams, insurance premium, rent rates, taxes, audit fee, telephone expenses, sundry expenses, trading expenses, general expenses, export duty, establishment expenses, law charges, salaries, wages, office lighting, etc. Selling and Distribution Expenses are advertisement expenses, distribution expenses, packing expenses, godown rent, freight outward, carriage outward, travelling expenses, commission paid, samples, salesmen’s salaries, delivery expenses, travelling expenses, commission, sales tax, bad debts, provision for bad debts, etc. Financial Expenses include interest paid, interest on loan, interest on capital, bank charges, discount allowed interest on overdrafts, etc. Other Expenses are depreciation repairs, renewals, donation/charity, loss on sale of asset loss by fire, etc. Distinction between Gross profit & Net Profit (i) Net profit is the difference between gross profit and indirect expenses. Gross profit is the difference between sales and costs. (ii) Income from other sources may be included in net profit but not in gross profit. (iii) Whereas net profit is transferred to balance sheet, gross profit is transferred to profit and loss account. (iv) Net profit measures returns on capital employed but gross profit measures profit earning capacity of the business. (v) The drawings of the owner depends on the net profit of the business. But the drawings do not depend on the gross profit of the enterprises. Closing Entries
Profit and Loss A/c Dr
To Expenses A/c
To Losses A/c
(Being all expenses and losses debited to profit & loss A/c)
Income A/c Dr
Gains A/c Dr
To Profit & Loss A/s
(Being all incomes and gains credited to profit and loss account)
Profit & Loss A/c Dr
To Capital A/c
(Being net profit credited to capital account)
Capital A/c Dr
To Profit & Loss A/c
(Being net loss debited to capital account)
Balance sheet
In the words of J.R. Batliboi, “A balance sheet is a statement prepared with a view to measure the exact financial position of a business on a certain fixed date.”
According to Palmer, “The balance sheet is a statement at a particular date showing on one side the trader’s property and possessions, and on the other hand the liabilities.”
Karlson said, “A business firm showing what is owed and what the proprietor is worth is called a balance sheet.”
Importance of balance sheet
The following is the need and importance of preparing a balance sheet:
(i) Balance sheet helps in preparing the opening entries of the next year.
(ii) Balance sheet is helpful in knowing the nature and amount of liabilities of the enterprise.
(iii) The main objective is to find out the true financial position of the enterprise at a particular point of time.
(iv) Balance sheet is helpful in determining the nature and cost of various assets of the enterprise viz. amount of closing stock, amount owing from debtors, amount of ficticious assets etc.
(v) Balance sheet is helpful in ascertaining whether the firm is solvent or not. If the assets of a firm exceed the external liabilities, it is solvent. In case its assets are less than external liabilities, the firm will be insolvent.
(vi) The balance sheet provides information about the exact amount of capital at the end of the year and the addition or deduction made into it during the current year.
Characteristics of balance sheet
(i) The totals of two sides of a balance sheet must be equal.
(ii) Balance sheet shows the financial position of the enterprises according to the going concern concept.
(iii) Balance sheet is prepared on a particular date and not for a fixed period. It discloses the position of an enterprise on a particular date. It is true only for the date on which it is prepared because even a single transaction would cause a change in the assets and liabilities.
(iv) It is a part of final accounts. Balance sheet is a statement unlike Trading Account and Profit and Loss account. To and By are not used before the names of the accounts placed there in. It has liabilities and assets sides in place of debit and credit.
(v) It is summary of real and personal accounts which are still open and have not been closed by transfer to the Trading and Profit and Loss account. Debit balances of all personal accounts are put on assets side and credit balances are put on the liabilities side.
Assets are resources acquired by the business either from the funds made available by the owners or creditors of the business.
Classification of assets
(i) Fixed Assets are those assets which are acquired for long term use for carrying out business of the enterprises, such as land and buildings, plant and machinery, furniture and fixtures, etc.
(ii) Intangible Assets are those assets which cannot be seen or touched, such as patents, trade marks, goodwill.
(iii) Fictitious or Nominal Assets are those assets which cannot be realized in cash, such as debit balance profit and loss account, expenses not written off, and advertisement expenses.
(iv) Wasting Assets are those assets which are exhausted or consumed over a period of time such as leasehold premises, mines, etc.
(v) Liquid assets are those assets which can he immediately converted into cash. These assets include cash, bank, bills receivable and debtors.
(vi) Current Assets are those assets which are either in the form of cash or can easily be converted into cash within one year, such as cash in hand, cash at bank, bills receivable, debtors, short-term investment and prepaid expenses.
Liabilities
The term liabilities denotes claims against the enterprises as a separate entity. The term entity stands both for the owner’s, as well as for the outsiders equity.
classification
(i) Current Liabilities are short-term liabilities which are likely to be paid within one year. They include bills payable, outstanding expenses, cre-ditors, bank-overdraft etc.
(ii) Contingent Liabilities are those liabilities which will become payable after some happenings, such as bills discounted before maturity, disputes for payments pending in law courts-like tax. These liabilities are shown as footnote in the balance sheet after total.
Adjustments in financial statements
(i) Closing Stock : Closing stock is balance of unsold goods at the end of the year. It is credited to the trading account. Closing stock consists of : (a) Finished Goods (b) Semifinished goods, and raw material.
The closing stock is valued at the cost price or selling price, whichever is less. Closing stock of the current year becomes the opening stock of the next year. It is journalised as follows :
Adjustment Entry
Closing Stock A/c Dr
To Trading A/c
(Being closing stock adjusted)
(ii) Depreciation : Due to wear and tear, the value of fixed assets becomes less with the passage of time. This type of decrease is called depreciation and is treated as expenditure. It is decreased from the assets and debited to the profit and loss account.
Adjusting Entry
Depreciation A/c Dr
To Assets A/c
(Being depreciation adjusted)
Note : When depreciation is shown on debit side of trial balance, it will be shown only in P & L A/c on debit side and not in balance sheet.
(iii) Income Received in Advance or Unearned Income : Sometimes it happens that a certain income is received in the current year but the whole amount of it does not belong to the current year. Such portion of the income which belongs to the next year is called Income Received in Advance or Unearned Income.
Such income is deducted from the concerned income on the credit side of profit and loss account and also shown on the liabilities side of the balance sheet. For example rent is received in advance :
Adjustment Entries
Rent A/c Dr
To Rent Received in Advance A/c
(Being adjustment for rent received in advance)
Effects on Final Accounts
Profit & Loss A/c
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
By Rent A/c
Less-Rent recd. —
in advance
Balance sheet
Liabilities Amount Assets Amount
Rs. Rs.
Unearned Rent
Income receivable or accrued income : Accrued income is that income which has became due but not received by the business. Accrued income is added to the particular income in the profit and loss account and is shown on the assets side in the balance sheet.
Expenses paid in advance or Prepaid Expenses are the expenses which have been paid in advance for the next year during the current year. In trading and profit and loss account, prepaid expenses will be deducted from the particular expenses and shown on the assets side of the balance sheet.
Outstanding Expenses are those expenses which remain unpaid or due or outstanding during the current accounting year. In Trading or Profit and Loss Account, outstanding expenses are added to a particular expense and shown on the liabilities side of the balance sheet.
Adjusting Entry
Carriage A/c Dr.
To Outstanding Carriage A/c
(Being carriage expense due but not paid)
Bad Debts : Goods are sold on credit to those customers only from whom seller is fully confident to receive payment. But sometimes, due to certain reasons, payments are not recovered from the customers. It is known as bad debts. This is a loss to the business.
Journal Entry
Bad Debts A/c Dr
To Debtors A/c (By Name)
(Being bad debts written off)
At the end for the year, it is transferred to Profit and Loss Account :
Journal Entry
Profit & Loss A/c Dr
To Bad Debts A/c
(Being transfer of bad debts)
Provision of Reserve for Doubtful Debts : Even after deducting the actual amount of bad debts from sundry debtors, there may be still some bad or doubtful debts at the end of the year. Provision is created to cover any possible loss due to bad debts at a certain percentage of debtors. It is called provision for bad and doubtful debts.
The amount of provision for doubtful debts is shown on the debit side of profit and loss account and also deducted from sundry debtors to be written on the assets side of the balance sheet.
Notes :
(i) If provision for doubtful debts is given in adjustments, it is called as ‘New Provision’. It is added in bad debts in Profit and Loss account and deducted from debtors in the balance sheet.
(ii) In case provision for doubtful debts is given in the trial balance itself, it is called old provision. It is recorded on the debit side of profit and loss account only by deducting it from the total of old and new bad debts.
(iii) If bad debts are given in adjustments, they will be written on debit side of P & L A/c and will also be deducted from Sundry Debtors on the assets side of the balance sheet.
(iv) Sales tax collected is a liability because it has been collected from the customers and is payable to government.
(v) When old provision exceeds the total of bed debts and new provision, the balance will be shown on the credit side of the Profit & Loss A/c. New provision as usual, will also be deducted from sundry debtors on the assets side.
Provision for Discount on Debtors: To motivate debtors for making prompt payment, business allows discount to them. It is an expense of the business. Therefore, it is debited to the profit & loss account. It should be noted that discount is given only to those debtors who make payment. As such, the provision for discount is calculated on good debtors given in the adjustments and provision for doubtful debts required to be made at the end of the year. In other words, first of all further bad debts given in the adjustments will be deducted from the debtors and then provision for doubtful debts be deducted will be calculated as the balance of debtors and lastly, provision for discount will be calculated on the remaining amount of debtors.
Such provision is shown on the debit side of the profit & loss account and is also deducted from sundry debtors on the assets side of the balance sheet.
Provision for Discount on
Creditors : Just as we allow discount to our debtors for making early payment, our creditor also allow discount to us for timely payments.
Such discount will be shown on the credit side of the Profit & Loss account and will also be deducted from sundry creditors on the liabilities side of the balance sheet.
Interest on Capital is an expense for the business and hence it is shown on the debit side of profit & loss account. At the same time, it is a gain to the proprietor and, therefore, added to his capital.
Interest on Drawings is income to the business and, hence, it is shown on the credit side of the profit and loss account. At the same time, it is an expense from the proprietors view and, hence, will be deducted from the capital on the liabilities side of the balance sheet.
Interest on Loan taken by the business is an expense and, hence, it will be recorded on the debit side of the profit and loss account. Outstanding amount of such interest will be added to the loan account on the liabilities side of the balance sheet.
Sales Tax : (i) If only the item of ‘Sales Tax Paid’ is given in the question, it will be shown on the debit side of profit & loss account.
(ii) If only the item of ‘Sales Tax Paid’ and ‘Sales Tax Collected’ are given in the question, these will be deducted from each other and only the amount of difference will be shown in profit and loss account.
Adjustments relating to goods
Abnormal Loss
Loss of Goods : If the goods are destroyed, Loss on Accident account is debited and purchases account is credited and then transferred to Profit & Loss Account.
(i) Loss by Accident A/c Dr.
To Purchases A/c
(Being loss of goods in accident)
(ii) Profit & Loss A/c Dr.
To Loss by Accident A/c
(Being loss by accident transferred to profit and loss account)
In case the goods are insured and the insurance company admits a claim the account of insurance company will be debited for the amount of the claim admitted in place of profit and loss account.
Insurance Co. A/c Dr.
To Loss by Accident A/c
(Being loss recoverable from the insurance company)
In the final accounts, the full amount of loss of goods is deducted from purchases account. Amount of claim admitted by the insurance company is shown on the assets side of balance sheet and also deducted from the value of assets on the assets side of the balance sheet.
Loss of Fixed Assets : If some fixed asset of the firm is destroyed by some accident, such as fire etc, the loss be shown on the debit side of P & L A/c and also deducted from the value of asset on asset side of the balance sheet.
Charity in the Form of Goods : When goods are given in charity, the following entry is passed :
Charity A/c Dr
To Purchases A/c
(Being goods given as Charity)
Goods Distributed as Free
Samples : When goods are distributed as free samples for the purpose of advertising, the following adjusting entry will be passed :
Free Samples A/c Dr
To Purchases A/c
(Being goods distributed as free samples)
Treatment in Final Account : Free samples will be deducted from purchases in the Trading account and will also be shown on the debit side of profit and loss account because it is an expense of business.
Drawings in Goods : When the proprietor withdraws some goods from business for personal use, the following entry will be made :
Drawings A/c Dr
To Purchases A/c
(Being goods withdrawn for personal use)
Treatment in Final Accounts : It is deducted from the purchases in the trading account and will also be deducted from capital on the liabilities side of the balance sheet as drawings.
Use of Goods in Business : When a part of the goods is kept in the business itself, it is recorded as an asset, e.g.
Furniture A/c Dr
To Purchases A/c
(Being goods purchased, kept in business as an asset)
Treatment is Final Accounts : First of all, it will be deducted from the purchases in trading account and then it will be shown on the assets side of the balance sheet.
Implied Interest : In case trial balance shows ‘Loan Account’ incurring a fixed rate of interest it is necessary to calculate interest on the loan raised by the business, even if nothing is mentioned in the adjustments for interest. When the amount of interest is not given in the trial balance, full amount of interest is shown as outstanding. In case, some amount of interest is given in the trial balance, it needs be compared with the full amount of interest and the difference, if any, is shown as outstanding.
Deferred Revenue Expenditure : In business, there are certain expenses from which benefit is derived for years together. Such expenditure are known as deferred expenses. A portion of expenditure is transferred to Profit and Loss A/c and the balance is written as an asset in the balance sheet. Suppose Rs. 80,00,000 are spend by a firm in a particular year and its benefits in the business will be derived for five year. Under the circumstances 1/5th of Rs. 80,00,000 i.e. Rs. 16,00,000 will be debited to the advertisement account and the balance i.e. Rs. 80,00,000 –16,00,000 or Rs. 64,00,000 will be shown on assets side of the balance sheet.
Manager’s Commission on Net Profit : In certain cases, in addition to salary, a manager may be given certain commission. Business may do this to motivate the manager to work harder. As the amount of commission is calculated at the end of the accounting period, it is treated as an outstanding expenses and the following entry may be passed for it:
Commission A/c Dr
To Outstanding Commissions A/c
(Being commission due to manager)
Treatment in Final Accounts : It is recorded on the debit side of profit and loss account because it is business expense. It is also shown on the liabilities side of the balance sheet as an outstanding expense.
The commission is calculated…
(a) On profits before charging such commission. It is calculated as follows :
Manager’s Commission =
(b) On profits after charging such commission, it is calculated as follows :
Contingent Liabilities : These are not the actual liabilities on the date of balance sheet. They may become payable on the happening of some specific events, such as bills discounted from the bank not matured. These liabilites are not recorded in the books. They are simply mentioned as foot note in the balance sheet.
Note : If the items of outstanding expenses and unearned income are given inside the trial balance, these will be shown only on the liabilities side of the balance sheet. Similarly, if the items of prepaid expenses, accrued income, and closing stock are given inside the trial balance, these will be shown only on the assets side of the balance sheet.
The difference
1. Revenue expenditure is recorded in trading or profit and loss account, whereas capital expenditure is recorded in the balance sheet.
2. Revenue expenditure results in benefit for a period of one year, whereas capital expenditure results in benefit for a number of years.
3. Revenue expenditure is done for the day to day expenses of business, whereas capital expenditure is done for the erection or of fixed assets.
4. Revenue expenditure is meant for the maintenance of the earning capacity of the business, whereas capital expenditure aims at increasing the earning capacity of the business.
When Capital expenditure is wrongly recorded as Revenue Expenditure
(a) Amount spent for the erection of car-shed was included in repairs.
In order to rectify the mistake, the amount thus included will be deducted from the repairs and added to the building.
(b) Wages include the amount spent on the installation of new machine.
The mistake will be rectified by deducting the amount from wages and adding to machinery.
(c) Goods purchased for the construction of building were debited to Purchase Account.
The mistake will be rectified by deducting the amount from purchases and added to building.
Goods Sold and Despatched but Omitted to be Despatched
The following entry is to be made to make a record of such sales :
Debtors A/c Dr
To Sales A/c
(Being goods sold on credit but omitted to be recorded now rectified)
Accounting Treatment : The amount will be added to sales on the credit side of trading account and also added to the debtors on the assets side of the balance sheet.
Goods Purchased and Included into Stock but Omitted to be
Recorded : The following entry is to be passed in order to make a purchase of such goods.
Purchases A/c Dr
To Creditors
(Being goods purchased on credit omitted to be entered, now rectified)
Accounting treatment : The amount of purchases will be added to purchases on debit of the trading account and also added to the creditors on the liabilities side of the balance sheet.
Sales of Goods on Approval Basis : Goods sent to customer for sale on the basis of his approval cannot be regarded as sale. The customer may keep the goods or may return if he does not approve the goods. If the goods have been recorded as the actual sale and the consent of the customer is not received upto the end of the accounting period, the following entry is passed to cancel the sale :
Sales A/c Dr
To Debtors (customer) A/c
(Being goods sent to customer on sale or return basis wrongly recorded as sales, now rectified)
Accounting Treatment : ( a) Sales will be reduced on the credit side of the trading account. Debtors will also be reduced on the assets side of balance sheet.
(b) Cost price of goods buying with the customer will be calculated and treated just like closing stock. Therefore, it is added to the closing stock of the credit side of trading account and on the stock shown on the assets side of the balance sheet.
Goods in Transit : In case the goods are not received till the time of closing of accounts books, such goods are called goods in transit if their information is duly given by the supplier. The following entry is passed for that :
Goods in transit Account Dr.
To Supplier’s (Creditors) A/c
(Being the goods in transit)
Accounting Treatment : Such goods are recorded on assets side as goods in transit and added to the creditors on liabilities side of the balance sheet.
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