Preparation of Financial Statements - 2 | Management Optional Notes for UPSC PDF Download

Classification of Balance Sheet’s Items

The balance sheet categorizes assets, liabilities, and capital separately, and it's conventionally accepted to organize them into sub-groups based on their liquidity or permanence. In the given example/format, the balance sheet is presented in the T account form, where assets are listed on one side and liabilities and owners' equity on the other. Another commonly used presentation is the report form, where liabilities and capital are listed above the assets. However, the manner of presentation is relatively inconsequential, as the primary purpose of the balance sheet is to represent the equality between assets, liabilities, and capital.

Current Assets

Current assets are those expected to be converted into cash within a year or the operating cycle. The operating cycle is the time taken by a unit to convert raw materials into finished goods, sell them, and collect cash from debtors. In a trading operation, for instance, the operating cycle includes the period during which merchandise inventory and receivables are held. The cycle begins with cash and concludes with the collection of cash. Current assets are considered liquid, and current liabilities can be met from the realization of these assets.

Cash

Cash includes legal tender, cheques, or any document circulating as cash. It is classified as a current asset when available for a firm's day-to-day operations. This encompasses cash kept in the cash chest and deposits on call in current accounts with banks. If cash is earmarked for a specific purpose and not available for transactions, it is better classified as another type of asset.

Accounts Receivable

Accounts receivable refer to amounts owed to the company by debtors, often referred to as sundry debtors. These amounts typically arise from routine commercial transactions and represent unpaid customer accounts. In the context of the balance sheet illustration, accounts receivable denote the sums owed to the company by customers on the balance sheet date. They are also known as trade receivables, arising directly from credit sales and offering valuable information for both management and external stakeholders. In most cases, these accounts are unsecured and rely solely on the personal security of the customer.
It is common for some accounts receivable to become uncollectible, resulting in collection losses known as bad debts. Management cannot precisely determine which accounts and what amount will become uncollectible. However, based on historical data, management can estimate the overall loss on accounts receivable or sundry debtors. These estimates are used to adjust the gross value of accounts receivable to their estimated realizable value.
For example,

The estimated collection loss is commonly referred to as provision for doubtful debts, provision for bad debts, or provision for collection losses. This practice helps account for the potential loss arising from uncollectible accounts.
Debts are typically evidenced by formal written promises to pay or acceptance of an order to pay. These formal documentary debts often take the form of Promissory Notes, Receivable, or Bills Receivable. These instruments are negotiable in trade, allowing traders to assign their receivables to other parties or banks for immediate liquidity.
Accounts receivables are often pledged or assigned, primarily to banks, as collateral against short-term credits such as cash credits or overdrafts.

Inventory (Stock-in-Trade)

• In trading firms, inventory refers to merchandise held for sale in the ordinary course of business. For manufacturing firms, inventory comprises materials needed for production, including raw materials, work in process, and finished goods. Additional inventory categories may include stores and supplies. The terms raw material inventory, work in process inventory, finished goods inventory, and stores and supplies inventory are commonly used.
• Inventory is typically valued based on the principle of the "lower of cost or market price," with market price representing the cost of replacement through purchase or reproduction of the material. Inventory costs encompass all normal expenses incurred to make the goods available for sale or use at the relevant location. In trading firms, inventory costs include freight-in, transit insurance costs, import or entry levies, and invoice cost. However, warehouse costs, handling costs, insurance costs in storage, and interest costs are not considered as inventory costs; they are treated as expenses for the firm during the period.
• In manufacturing units, the valuation of inventory costs is more intricate. Generally, all costs associated with materials, labor, and plant facilities used in the manufacturing process are considered in the valuation of inventory.
• When valuing inventory at the lower of cost or market price, it is essential to ensure that the valuation does not exceed the realizable value or selling price in the ordinary course of business.

Prepaid Expenses

In many instances, certain expenses are paid in advance, such as rent, taxes, subscriptions, and insurance. These prepayments are typically included as current assets. The rationale behind treating these prepayments as current assets is that if they were not made in advance, they would require the use of cash during the period.

Fixed Assets

• Fixed assets are tangible, relatively long-lived items owned by a business, providing benefits not only in the accounting period of their purchase but over multiple accounting periods. Unlike current assets, which offer benefits through their conversion into cash, fixed assets contribute value by facilitating production or trade, representing indirect rather than direct benefits.
• In accounting, the focus is on the useful life of fixed assets, i.e., the period for which an asset can be economically used. This implies that the benefits derived from fixed assets extend throughout their useful life, and the cost incurred during the asset's purchase period provides benefits over that duration.
• The valuation of fixed assets is typically based on the original cost. However, as fixed assets have a limited lifespan, the cost is considered to expire with the asset's life. Consequently, the valuation of the asset is reduced by an amount proportionate to the expired life, and this expired cost is referred to as depreciation in accounting.
• Fixed assets commonly include land, buildings, plant, machinery, and motor vehicles. Except for land, all these items undergo depreciation. Land, being an asset with an indefinite life, is not subject to depreciation and is therefore presented separately from other fixed assets on the balance sheet.

Intangible and Other Assets

Intangible assets are assets without physical dimensions, representing intrinsic value without a tangible presence. They cannot be touched and are incorporeal. One common example of an intangible asset is goodwill, which reflects a firm's ability to earn profits exceeding the normal return. Goodwill appears on the balance sheet when it has been purchased, typically in cases where a going concern is acquired, and the purchase price exceeds the fair value of the assets. This excess amount is classified as another asset, specifically 'goodwill,' on the balance sheet. Similar to fixed assets, the value of intangible assets also undergoes expiration over time, and this expiring cost is termed amortization, akin to depreciation.

Current Liabilities

Liabilities represent claims of outsiders against the business, amounts owed by the business to individuals or entities that have provided goods, services, or loans. When these liabilities are due within an accounting period or the operating cycle of the business, they are classified as current liabilities. Most of these liabilities are incurred in acquiring materials or services that form part of the current assets. Similar to current assets, current liabilities are listed in the order of their relative liquidity.

Accounts Payable

Accounts payable or sundry creditors are typically unsecured debts owed by the firm. They are also known as payables on open accounts and may not be evidenced by any formal written acceptance or promise to pay. Accounts payable represent credit purchases of goods or services for which payment has not been made as of the balance sheet date.

Accrued Liabilities

Accrued liabilities represent expenses or obligations incurred in the previous accounting period, but the payment for them will be made in the next period. In cases where periodic payments are made, such as wages or rent, the last month's payment may appear as accrued liabilities, especially if the practice is to pay on the first working day of the month. The obligation shown on the balance sheet indicates that the firm owed the specified amount on the balance sheet date.

Provisions or Estimated Liabilities

When liabilities are known but the amounts cannot be precisely determined, an estimation of the liability is made and provided for. An example is income tax payable, where the exact amount cannot be determined until the tax liability is assessed. Other examples include estimated liabilities for product warranty expenses. The common practice is to estimate these liabilities based on past experience and make a provision for them, which is shown as part of the liabilities on the balance sheet.

Contingent Liabilities

Contingent liabilities are distinct from estimated liabilities. Estimated liabilities are known liabilities with uncertain amounts, whereas contingent liabilities are not liabilities at the current moment. They may become liabilities only if a certain event occurs in the future. The amount and liability are uncertain until this specified event occurs. Examples include a claim against the company contested in court, which only becomes a liability if the court gives an unfavorable verdict. Contingent liabilities are not listed as liabilities in the body of the balance sheet, but a provision may be made for them at the discretion of the firm.

Long-Term Liabilities

Long-term liabilities typically extend beyond one year and encompass almost all liabilities owed to outsiders that are not included in current liabilities and provisions. These liabilities can be either unsecured or secured. Long-term loans are often secured by the firm's fixed assets, which are assigned to the lender through a pledge or mortgage. The balance sheet discloses details such as the interest rate, repayment commitment, and nature of the security. Common examples of long-term liabilities include debentures and bonds, as well as borrowings from financial institutions and banks.

Capital

We have seen earlier in this unit that the fundamental accounting equality states: assets = liabilities + owners equity. From the example of balance sheet we can easily establish this. See Ms. Naina’s balance sheet:
Total assets  Rs. 1,00,00,000
Total liabilities  Rs.  60,00,000
Owner’s equity  Rs. 40,00,000
We also know that the owner’s equity consists of the contributed capital and the retained earnings of the firm. Therefore, capital is that part of owner’s equity which is contributed by the owners. If Ms. Naina were an individual proprietorship business, the owner’s equity will be reflected directly as:
Capital  Rs. 40,00,000
If ‘M/s. Naina’ were a partnership firm with four partners W, X, Y and Z all sharing equally, the capital would be represented as:

Reserves and Surplus

• Reserves and surplus, also known as retained earnings, typically arise from profitable operations. It represents a surplus that the firm decides not to distribute as dividends but rather retain within the business. When a firm begins its operations, it has no retained earnings. For example, if it earns a profit of Rs. 10,000 in the first year and decides to distribute Rs. 5,000 as dividends, the reserves and surplus at the end of the year will be Rs. 5,000. In the second year, if the firm incurs a loss of Rs. 3,000, the retained earnings at the end of the year will be Rs. 2,000.
• Retained earnings or reserves and surplus are a form of earned capital for the firm. Dividends are limited to retained earnings, meaning that the original capital of the firm cannot be distributed as dividends at any point in time. The original capital contributed to the firm is to be maintained intact.
• Profits earned and accumulated as reserves or retained earnings can be allocated for specific purposes. Earmarked reserves are not distributed, and only non-earmarked or free reserves are available for distribution as dividends.

Adjustment Entries 

Accounts are prepared based on accounting concepts, conventions, and principles. As final accounts are prepared on an accrual basis, adjustments are necessary to ensure accuracy. These adjustments involve subtracting expenses paid during the current financial year but applicable to other accounting periods and adding expenses that benefit the current accounting period, regardless of whether the payment was made. Similarly, for earnings, adjustments involve subtracting revenue items received in the current accounting period but applicable to other periods and adding revenue items earned currently but not yet received.
These corrections in the final accounts are known as adjustments, and they are made through adjusting entries. Adjustments play a crucial role in ensuring a proper matching of costs and revenue, ultimately providing an accurate representation of profit or loss for the given accounting period. Adjustments are essential for maintaining the accuracy and reliability of financial statements.
Let us see the treatment and impact of  some adjustments on final account:

Closing Stock

Closing stock refers to the value of unsold stock. The stock is valued at cost or market price, whichever is lower. Generally, closing stock is not provided in the trial balance but is given in adjustments. It will appear on the credit side of the trading account and on the assets side of the balance sheet.

Depreciation

Depreciation is the amount charged due to the usage and passage of time on fixed assets used for earning revenue. The decrease in their value is considered operational expenses. To ascertain true profits and reflect the true value of assets in the balance sheet, depreciation is charged. The depreciation account is debited, individual asset accounts are credited, and then the profit and loss account is debited, while the depreciation account is credited.

Bad Debts

Bad debts are losses incurred due to uncollectable debts. When the amount due from debtors is irrecoverable, it is termed as bad debts. Bad debts, being a loss, are closed by transferring them to the debit side of the profit and loss account. The amount of bad debts is also deducted from debtors in the balance sheet. If it appears in the trial balance, no adjustment entry is needed, and debtors will be shown at their adjusted figure.

Provision for Bad and Doubtful Debts

A provision is made in advance for debts whose recovery is doubtful and for writing off bad debts. Enterprises create a provision for doubtful debts based on past experience to cover potential losses. This is done to reflect debtors in the balance sheet at their true value. Provisions for bad and doubtful debts appear on the debit side of the profit and loss account and on the credit side of the provision for bad debts account.

Outstanding Expenses (Liabilities)

Expenses are typically recorded when they are paid. Failing to record unpaid expenses results in an understatement of that expense and a liability. To avoid understating these expenses and liabilities, an adjustment entry is passed by debiting the expense account and crediting the personal account of the party to whom the amount is to be paid. If outstanding expenses appear on the credit side of the trial balance, they will be shown on the liability side of the balance sheet.

Prepaid Expenses (Assets)

Expenses paid in advance before their use or consumption are termed as prepaid expenses. At the end of the year, the unconsumed part of the payment is treated as an asset since its benefit will be availed of in the future. The adjustment entry for prepaid expenses involves debiting the prepaid expense account and crediting the expense account. If this item appears on the debit side of the trial balance, it will be shown only on the assets side of the balance sheet and will not appear in the Profit & Loss Account.

Accrued Income (Assets)

Accrued income is an amount earned but not received during the accounting period or until the date of preparing final accounts. The first effect of accrued income is to credit the profit and loss account and show the same on the assets side of the balance sheet.

Income Received in Advance (Liability)

Income received but not earned during the accounting period is termed as income received in advance. This represents income for which services are to be rendered in the future. This income is deducted from the concerned income on the credit side of the profit and loss account and is also shown as a liability in the balance sheet.
To see the impact of adjustment entries’ on the final account (financial condition of the business firm) let’s take the same illustration of Ms. Naina again only including the some common adjustments in it. And let us check its impact practically by comparing the transactions of both the illustrations (with or without adjustment entries).

Example

Example: The following figures from the trial balance has been extracted from the books of M/s. Naina Prepare the Trading and Profit & Loss Account for the year ended 31 March 2004.

Adjustment:
1. Stock on 31st March 2004 was valued at Rs. 50,000.
2. Depreciation of building 5%; furniture and machinery is 10% p.a.
3. Trade expenses Rs. 2,500 and wages Rs. 3,500 have not been paid as yet.
4. Allow interest on capital at 5% p.a.
5. Make provision for doubtful debts at 5%.
6. Machinery includes Rs. 2,00,000 of a machinery purchased on 31st December 2003. Wages include Rs. 5,700 spent on the installation of machine.
Ans:

Conclusion

The Trading Account and Profit and Loss Account are intricately linked, with the Gross Profit/Loss playing a crucial role in determining the net profit/loss figure. These accounts provide a comprehensive view of an organization by outlining its revenues and expenses. Typically prepared at the end of the accounting period, the Balance Sheet is a fundamental financial statement that offers a snapshot of the business's financial position, detailing its assets, liabilities, and owner's capital at a specific point in time. While the Balance Sheet alone doesn't provide insights into the operational details, comparing two balance sheets can reveal changes in the business position over time. For a more comprehensive understanding of business operations, additional statements like the Cash Flow Statement and Funds Flow Statement are necessary, topics that will be covered in subsequent units.