Chapter Notes - Financial Statements - I

Table of Contents
1. Stakeholders and their Information Requirements
2. Distinction between Capital and Revenue
3. Financial Statements
4. Trading and Profit and Loss Account
5. Operating Profit (EBIT)
6. Balance Sheet
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Stakeholders and their Information Requirements

• The main goal of a business is to share important information with different stakeholders so they can make informed decisions.
• A stakeholder is anyone who is involved with a business, whether directly or indirectly.
• They can have either monetary interests, such as making profits, or non-monetary interests, like ensuring legal compliance or promoting social welfare.
• For instance, owners and lenders have a monetary interest, while the government, consumers, and researchers have non-monetary interests.
• Each stakeholder has unique goals and therefore different information needs from the business.

Types of Stakeholder Interests

Stakeholder interests can be:

1. Active or Passive: Active stakeholders actively participate in business activities, while passive stakeholders have an interest but do not engage directly.
2. Direct or Indirect: Direct stakeholders have a clear, immediate interest in the business, while indirect stakeholders are affected by the business's activities but not directly involved.

Examples of Stakeholders

• Financial Interest: The owner of the business and lenders are mainly concerned about profits, returns, and financial stability.
• Non-Financial Interest: The government may be interested in tax compliance, consumers may care about product quality, and researchers may focus on business practices for studies.

Users and Their Classification

Stakeholders are also called users, and they can be classified into two categories:

1. Internal Users: People within the business, like managers and employees, who need detailed information to make decisions.
2. External Users: People outside the business, such as investors, government agencies, and consumers, who require information for various purposes like investment decisions, regulatory compliance, or product evaluations.

Since users join the business for different reasons, their information needs vary significantly. Understanding these needs is essential for effectively analyzing and communicating accounting information.

Accounting Process (up to Trial balance) :

• The accounting process involves a series of systematic steps to record, classify and summarise financial transactions.
• Only transactions that can be measured in monetary terms are recorded.
• Accounting follows the double-entry system, where each transaction affects two aspects - a debit and a credit.
• Frequently occurring transactions of similar nature are recorded in subsidiary books (also called special journals) rather than the general journal.
• Common subsidiary books include:
  • Sales Book (for credit sales)
  • Purchases Book (for credit purchases)
  • Return Inwards Book and Return Outwards Book
  • Cash Book (for cash and bank transactions)
• Transactions not recorded in subsidiary books are entered in the Journal Proper (residual journal).
• Balances from journals and subsidiary books are posted to respective ledger accounts.
• Ledger accounts are balanced to prepare a trial balance.
• If total debits equal total credits in the trial balance, the accounts are free from arithmetical errors.
• The trial balance provides the basis for preparing financial statements such as the Trading and Profit and Loss Account and the Balance Sheet.

Distinction between Capital and Revenue

• The difference between capital and revenue items is crucial in accounting.
• Revenue items are included in the trading and profit and loss accounts.
• Capital items are used to prepare the balance sheet.

What is Expenditure?

• Expenditure means any payment made for reasons other than paying off existing debts.
• Businesses make expenditures with the hope of receiving benefits in return.
• The benefits from these expenditures can last for one accounting year or even longer.
• If the benefits last for up to one accounting year, it is known as revenue expenditure.
• Examples of revenue expenditure: salaries, rent, routine repairs - these are expenses for the current period.
• When benefits extend beyond one accounting period, the expenditure is called Capital Expenditure.
• Examples of capital expenditure: purchase of furniture, plant and machinery or construction of buildings - these acquire or improve fixed assets.

Key Differences Between Capital and Revenue Expenditure

• Capital expenditure boosts a business's ability to earn money, while revenue expenditure is spent to keep that ability intact.
• Capital expenditure involves purchasing fixed assets, like buildings and machines, whereas revenue expenditure covers day-to-day costs.
• Revenue expenditure usually occurs often, while capital expenditure happens less frequently.
• Capital expenditure benefits the business over several accounting years.
• Capital expenditure benefits are spread over several accounting years; the periodic allocation is recorded as depreciation.
• Capital items appear in the Balance Sheet; revenue items (after necessary adjustments) are shown in the Profit and Loss Account.
• Occasionally, classification is difficult (e.g., advertising may benefit multiple years). Such items may be treated as deferred revenue expenditure and written off over their benefit period.

Receipts

• Receipts refer to cash inflows, while expenditures are cash outflows.
• Capital receipts are inflows that either create a liability or represent owner's capital (e.g., capital introduced by owner, loans received, proceeds from sale of fixed assets).
• Revenue receipts are inflows from regular business operations that do not create liabilities (e.g., sales revenue, interest received, commission earned).

Importance of Distinction between Capital and Revenue

• Correct classification determines where an item appears - either in the Trading and Profit and Loss Account or in the Balance Sheet.
• Misclassification can distort reported profit or loss and asset values, leading to incorrect decision-making and incorrect tax reporting.
• Example: If revenue expenses of ₹20,000 are wrongly capitalised, reported profit will be overstated; conversely, treating capital expenditure as revenue will understate profit and understate asset value.
• Therefore, accurately identifying and categorizing items in accounts is essential for clear financial reporting.
• This accuracy is also important for tax purposes, as capital and revenue profits are taxed differently.

Financial Statements

• It is important to recognize that different users have various needs for information. 
• Instead of creating specific details for each user, the company prepares a collection of financial statements that generally meet the information needs of users. 
• The main goals of creating financial statements are: 
  1. To provide a true and fair view of the business's financial performance.
  2. To provide a true and fair view of the business's financial position.
• To achieve these goals, the company typically prepares the following financial statements: 
  1. Trading and Profit and Loss Account
  2. Balance Sheet
• The Trading and Profit and Loss Account, also called the Income Statement, displays the financial performance in terms of profit made or loss incurred by the business. 
• The Balance Sheet shows the financial position by listing assets, liabilities, and capital. 
• These statements are prepared based on the trial balance and any additional information that may be available.

Example: Observe the following trial balance of Ankit and signify correctly the various elements of accounts and you will notice that the debit balances represent either assets or expenses/ losses and the credit balance represents either equity/liabilities or revenue/gains. [This trial balance of Ankit will be used throughout the chapter to understand the process of preparation of financial statements]

• The balance sheet and profit and loss account are now called position statement and statement of profit and loss in the company's financial statements.
• Since Chapters 8 and 9 deal with the preparation of financial statements of sole proprietorship firm, the terms balance sheet and profit and loss account are retained.

Trading and Profit and Loss Account

• Purpose: To determine the profit or loss of a business for a specified accounting period by summarising incomes and expenses.
• Calculation of Profit: Profit = Total Income - Total Expenses. If expenses exceed income, there is a loss.
• Performance Summary: It gives users an overview of business performance during the accounting period using items from the trial balance and adjustments.
• Structure: Two sides - Debit (expenses and losses) and Credit (revenues and gains).

Relevant Items in Trading and Profit and Loss Account

Items on the Debit Side:

• Opening Stock: Value of unsold goods at the beginning of the year (carried from prior year).
• Purchases (less Returns): All goods bought for resale; returns to suppliers are deducted to arrive at Net Purchases.
• Wages: Payments to workers directly involved in production.
• Carriage Inwards: Transport cost to bring purchased goods to the factory or place of business.
• Fuel/Water/Power/Gas: Utilities used in production.
• Packaging Material: Containers and packing used for goods; classification (direct or indirect) depends on use.
• Salaries: Payments to administrative or non-production staff.
• Rent Paid: Rent of premises used for business (factory, office, warehouse) and related taxes.
• Interest Paid: Interest on borrowings treated as expense.
• Commission Paid: Commissions to agents and others.
• Repairs: Routine repairs and maintenance.
• Miscellaneous Expenses: Small or sundry expenses that do not fit other heads.

Items on the Credit Side:

• Sales (less Returns): Total sales, including cash and credit sales; returns by customers are deducted to arrive at Net Sales.
• Other Incomes: Rent received, interest received, dividends, discounts received, commissions earned, etc.

Closing Entries 

• To prepare the trading and profit and loss account, you need to move the balances of all relevant accounts into it. 
• The following accounts are closed by transferring their balances to the debit side of the trading and profit and loss account: 
  1. Opening stock account
  2. Purchases account
  3. Wages account
  4. Carriage inwards account
  5. Direct expenses account
• This is done by recording the following entry: 
  Trading A/c Dr.
  To Opening stock A/c
  To Purchases A/c
  To Wages A/c
  To Carriage inwards A/c
  To All other direct expenses A/c
• The purchase returns or returns outwards are closed by transferring their balance to the purchase account. This is recorded as:
  Purchases return A/c Dr.
  To Purchases A/c
• Similarly, the sales returns or returns inwards account is closed by transferring its balance to the sales account: 
  Sales A/c Dr.
  To Sales return A/c
• The sales account is closed by moving its balance to the credit side of the trading and profit and loss account: 
  Sales A/c Dr.
  To Trading A/c
• Expenses, losses, and similar items are closed with the following entries: 
  Profit and Loss A/c Dr.
  To Expenses (individually) A/c
  To Losses (individually) A/c
• Items of income, gains, etc., are closed with this entry: 
  Incomes (individually) A/c Dr.
  Gains (individually) A/c Dr.
  To Profit and Loss A/c

The entries needed to close the seven expense and revenue accounts shown in the trial balance (as seen in our example 1) are listed below: 

The posting done in the ledger will appear as follows :

• Now, we will learn how to create the trading and profit and loss account using the trial balance.
• The format for this account is shown in Figure 8.2.
• This list does not include everything. In reality, there can be many more items. As we go through each one, you will see how the format changes.

Concepts of Gross Profit and Net Profit

The Trading and Profit and Loss can be conceptually divided into two parts:

• Trading Account: Measures Gross Profit (or Gross Loss).
• Profit and Loss Account: Measures Net Profit (or Net Loss).

The trading account determines the outcomes from the basic operations of a business, which include: 
1. Manufacturing goods
2. Purchasing goods
3. Selling goods

Purchases are a major part of expenses in a business. Other expenses are categorised into: 

• Direct Expenses: Directly related to production or purchase of goods (e.g., carriage inwards, freight inwards, wages for production, factory lighting, fuel, royalty on production).
• Indirect Expenses: Not directly attributable to production (e.g., salaries of administrative staff, rent, bad debts).

Some other aspects:

• Sales are the primary source of revenue for the business. 
• The difference between sales and the sum of purchases plus direct expenses is called Gross Profit. 
• If purchases plus direct expenses exceed sales revenue, it results in Gross Loss. 
• The formula for calculating gross profit is: Gross Profit = Sales - (Purchases + Direct Expenses)
• The gross profit or gross loss is then recorded in the profit and loss account. 
• Indirect Expenses are recorded on the debit side of the profit and loss account. 
• All other revenue/gains apart from sales are noted on the credit side of the profit and loss account. 
• If the total on the credit side exceeds the debit side, the difference is the Net Profit for that period. 
• Conversely, if the debit side totals higher than the credit side, the difference is the Net Loss. 
• The formula for net profit is: Net Profit = Gross Profit + Other Incomes - Indirect Expenses
• The calculated net profit or net loss is then transferred to the capital account in the balance sheet through these entries: 
• For transferring Net Profit: 
  • Profit and Loss A/c Dr.
  • To Capital A/c
• For transferring Net Loss: 
  • Capital A/c Dr.
  • To Profit and Loss A/c
• We are updating the trading and profit and loss account to display the gross profit and net profit of Ankit for the year that ended on March 31, 2017.
• The revised trading and profit and loss account will be presented in the format shown below:

• Gross profit is the amount that shows how well the business is doing in its main activities, which is calculated as $42,000. 
•  This gross profit is moved from the trading account to the profit and loss account. 
•  In addition to the gross profit, the business has also earned $5,000 from commissions received. 
•  The business has incurred expenses totalling $42,500, which includes: 
  • $25,000 for salaries
  • $13,000 for rent
  • $4,500 for bad debts
•  As a result, the net profit is calculated to be $4,500.

Example 1: Prepare a trading account from the following particulars for the year ended March 31, 2017

Solution:

Example 2: Prepare a trading account of M/s Anjali from the following information related to March 31, 2017.

Solution: 

Cost of Goods Sold and Closing Stock - Trading Account Revisited

Have a look at the following account: 

• Without Opening or Closing Stock: When there is no opening or closing stock, the Cost of Goods Sold (COGS) is calculated by simply adding Purchases and Direct Expenses. 
• Example Calculation: In the given example, Purchases amount to ₹75,000 and Direct Expenses (wages) amount to ₹8,000. Therefore, COGS is: COGS = Purchases + Direct Expenses = ₹75,000 + ₹8,000 = ₹83,000
• With Closing Stock: If there is unsold stock at the end of the accounting period, COGS is adjusted. For instance, if out of the purchased goods worth ₹75,000, only ₹60,000 worth were sold, there would be a closing stock of ₹15,000. 
• Adjusted COGS Calculation: In this case, COGS would be calculated as: COGS = Purchases + Direct Expenses - Closing Stock
• Impact on Gross Profit: The presence of closing stock affects gross profit. In the example, gross profit changes from ₹42,000 (in the table above) to ₹57,000 (in the table below) with the inclusion of closing stock. 

•  Closing stock usually does not appear in the trial balance. Instead, it is recorded in the books through a specific journal entry. 
•  The journal entry for closing stock is as follows: 
• Closing Stock A/c Dr.To Trading A/c
•  This entry creates a new asset account for closing stock, valued at ₹15,000, which is then transferred to the balance sheet. 
•  Closing stock recorded this year will become opening stock for the next year and will be sold during that year. 
•  Typically, businesses have both opening stock and closing stock each year. The cost of goods sold (COGS) is calculated using the following formula: 
• Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses - Closing Stock
  

Operating Profit (EBIT) 

• It is the difference between operating revenue and operating expenses.
• When calculating operating profit, we do not consider financial income and expenses.
• Therefore, operating profit is also known as earnings before interest and tax (EBIT).
• Abnormal items, like losses from events such as a fire, are excluded from this calculation.
• The formula for calculating operating profit is:
  Operating profit = Net Profit - Non-Operating Expenses + Non-Operating Incomes
• In the example from Ankit's trial balance, there is a line item for 10% interest on a long-term loan taken on April 1, 2017.
• The total interest amounts to ₹500 (calculated as ₹5,000 × 10/100). 
• This interest has been recorded on the debit side of the trading and profit and loss account. 

Showing the treatment of interest on profitThe operating profit will be : 
Operating profit = Net profit + Non-operating expenses - Non-operating incomes
Operating profit = ₹ 19,000+ 500 - nil   =  ₹ 19,500

Balance Sheet

• Assets usually have debit balances; liabilities and capital have credit balances.
• The Balance Sheet is prepared after completing the Trading and Profit and Loss Account for the period.
• The term Balance Sheet reflects that it lists ledger account balances not transferred to Trading or Profit & Loss accounts.
• An opening entry is made at the start of the next accounting period to carry forward these balances.
• All accounts of assets, liabilities and capital are included in the Balance Sheet.
• In sole proprietorships and partnerships there is no statutory format; however, companies must follow the format prescribed in Schedule III of the Companies Act, 2013.

Format of Balance Sheet

For example:

• You will observe that the trial balance of Ankit depicts 14 accounts, out of which 7 accounts have been transferred to the trading and profit and loss accounts.
• These are the accounts of revenues and expenses.
• The analysis shows that the business has incurred total expenses of ₹ 1,25,500 and revenues generated are ₹ 1,30,000 making a profit of ₹ 4,500.
• The remaining seven items in the trial balance reflect the capital, assets and liabilities.
• We are reproducing the trial balance to show how the accounts of assets and liabilities of Ankit would be presented in the balance sheet.

Showing   the accounts of assets and liabilities in the trial balance of Ankit

Showing the balance sheet of Ankit

Relevant Items in the Balance Sheet

1. Current Assets

These are assets that are either cash or can be turned into cash within a year. 
Examples include: 

• Cash in hand or bank
• Bills receivable
• Stock of raw materials
• Semi-finished goods
• Finished goods
• Sundry debtors
• Short-term investments
• Prepaid expenses

2. Current Liabilities

These are debts that are expected to be paid within a year, typically using current assets. 
Examples include:

• Bank Overdraft
• Bills payable
• Sundry creditors
• Short-term loans
• Outstanding expenses

3. Fixed Assets

These are long-term assets held by the business that are not meant for resale. 
Examples include:

• Land
• Building
• Plant and machinery
• Furniture and fixtures

Sometimes referred to as Fixed Block or Block Capital. 

4. Intangible Assets

These are assets that cannot be seen or touched. Examples include: 

• Goodwill
• Patents
• Trademarks

5. Investments

Money invested in securities, shares, government bonds, etc., shown at cost. If market value is lower than cost, a note may be added.

6. Long-term Liabilities

Debts not due within one year. Examples include:

• Long-term bank loans
• Loans from financial institutions
• Capital: Owner's investment plus accumulated profits less drawings and losses. Capital is shown on the liabilities side.
• Drawings: Amount withdrawn by the proprietor; it reduces capital and is shown as a deduction from capital in the Balance Sheet after closing the Drawings account to Capital A/c.

Marshalling and Grouping of Assets and Liabilities

• Information in financial statements should be organised to be useful for users' decision making.
• Marshalling: The arrangement of assets and liabilities in a particular order - either by permanence (most permanent first) or by liquidity (most liquid first).
• Marshalling by permanence places long-term items (e.g., land, building) at the top, followed by less permanent items.
• Marshalling by liquidity reverses the order: cash appears first, followed by bank balance, receivables, inventory, and then fixed assets.

In the balance sheet of Ankit, you will find that furniture is the most permanent of all the assets. Out of debtors, banks and cash, debtors will take maximum time to convert back into cash. Bank is less liquid than cash. Cash is the most liquid of all the assets. Similarly, on the liabilities side, the capital, being the most important source of finance will tend to remain in the business for a longer period than the long-term loan. Creditors being a liquid liability will be discharged in the near future. 

In the case of liquidity, the order is reversed. The information presented in this manner would enable the user to have a good idea about the life of the various accounts. The assets account of the relatively permanent nature would continue in the business for a longer time whereas the less permanent or more liquid accounts will change their forms in the near future and are likely to become cash or cash equivalent.
The balance sheet of Ankit in the order of liquidity is:

• The items listed on the balance sheet can be organized into groups.
• Grouping means collecting similar items under one heading.
• For example, the balances of cash, bank accounts, and debtors can be combined and shown under the title 'current assets'.
• Similarly, the total values of fixed assets and long-term investments can be grouped together and labelled as 'non-current assets'.

Example: From the following balances prepare trading and profit and loss account and balance sheet for the year ended March 31, 2017.

The value of the closing stock on March 31, 2017 was 25,400. 

Solution: