Chapter 9 Financial Statements - 1

The primary objective of a financial statement is to provide financial information about the company such that it can help the stakeholders and other users take economic decisions including past performance and current position assessment, predict and judge a company's growth and predict its situation on bankruptcy or any kind of failure.

1) Past Performance and Current Position Assessment
2) Prediction of Net Income and Judging the Growth
3) Prediction of the Bankruptcy of a Business Entity and another Failure
4) Help Stakeholders and other users to make Economic Decisions.

Trading and Profit and Loss account is prepared to determine the profit earned or loss sustained by the business enterprise during the accounting period.

Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to “cost of services”). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer.

After determination of financial results by preparation of Trading and Profit and Loss account, balance sheet is prepared to record capital liabilities and assets of the business.

Balance sheet is a statement containing ledger balances of Real and Personal accounts. Unlike Trading and Profit and Loss accounts, it is not an account.

Characteristics of balance sheet:

(i) It is always prepared on a particular date.
(ii) The total of both the sides must be equal.
(iii) It shows the financial position of the business.
(iv) It is a statement not an account.
(v) It has no debit and credit side.
(vi) Neither ‘To’ nor ‘By’ are used before the names of the account.

When the benefit of expenditure is to be received over a series of accounting years, it is termed as capital expenditure. Account incurred on purchase of fixed assets like land and building, plant and machinery, patents,trademark etc is termed as capital expenditure because the benefit is to be received over a number of years.

On the other hand, when the benefit of expenditure is confined to a short period of time, normally a year, it is termed as revenue expenditure. e.g., rent of building, salaries, insurance premium, wages,audit fees etc.

Operating profit, sometimes called EBIT, is a financial measurement that calculates how much profit a company makes from its core business activities. This figure only includes income from core operations before taxes excluding all income from investments. In this way it is a measure of a firm’s efficiency to control its costs and run its operations effectively.

Financial statements are those statements which are prepared for reporting to the decision-maker on the basis of trial balance containing balances of ledger accounts.

These are prepared to throw light on the financial results of operation of business during the period under consideration and the financial position at the end of the period.

In financial accounting through financial statement profit is measured in two stages, i.e. Gross profit and Net profit.

To ascertain the gross profit, trading account is prepared and to ascertain the net profit, P&L account is prepared. To report on the financial position of a business enterprise, its assets, liabilities and owner's equity balance sheet is prepared. Financial statements are the statements, which present periodic reports on the process of business enterprises and the results achieved during a given period. Financial statements include Trading and Profit and Loss account, balance sheet and other statements and explanatory notes, which form part thereof. Information provided by financial statements is useful to management to plan and control the business operations. Financial statements are also useful to creditors, shareholders and employees of the enterprise.

Information Provided by Financial Statements

Trading and Profit and Loss accounts present a true and fair view of the financial performance of the business in the form of profit or loss during the year. Balance sheet presents a true and fair view of the financial position of the business.

The preparation of Trading and Profit and Loss account requires that the balances of accounts of all concerned items are transferred to it for its compilation.

For transferring the balance of all the ledger accounts to the concerned head is done through closing entries. Here are some examples of closing entries.

(i) Opening stock account, Purchase account, Wages account, Carriage inwards account and direct expenses account are closed by transferring to the debit side of the Trading and Profit and Loss account. This is done by recording the following entry:

Trading A/c                       Dr.
To Opening Stock A/c
To Purchase A/c
To Wages A/c
To Carriage Inwards A/c
To All Other Direct Expenses A/c

(ii) The Purchase return or Return outwards account are closed by transferring its balance to the Purchase account. The following entry is recorded for this purpose:

Purchase Return A/c         Dr.
To Purchase A/c

(iii) Similarly, the sales return or Return inwards account is closed by transferring its balance to the Sales account is

Sales A/c                          Dr.
To Sales Return A/c

(iv) The Sales account is closed by transferring its balance to the credit side of the Trading and Profit and Loss account by recording the following entry.

Sales A/c                          Dr.
To Trading A/c

A balance sheet is the mixed list of the assets, liabilities and proprietorship of business of an individual at a certain date. The preparation of the balance sheet is needed for the following purposes.

(i) To know the financial position : Balance sheet shows the financial position of the firm. It is the list of assets and liabilities of the firm on a specific date generally at the end of the financial year.

(ii) Inform about the Liquidity Position : A balance sheet tells us about current assets and current liabilities. If the current assets are double of current liabilities, it is a symbol of the healthy and sound liquidity position of the firm.

Hence, it can be said that a balance sheet has to be prepared to know the financial position of the business and the nature and values of its assets and liabilities. All the accounts which have not been closed till the preparation of the Profit and Loss account are shown in the balance sheet. Assets and liabilities shown in the balance sheet are marshalled in order of liquidity or in order of permanence.

Grouping In a balance sheet, assets and liabilities should be properly grouped and classified under appropriate headings. The individual balance of each Debtors and Creditors account need not be shown. Debtors and creditors should be shown in total. The grouping together of dissimilar assets will make the balance sheet misleading. Hence, it can be said that grouping means putting together the items of similar nature under a common heading.

Marshalling The term marshalling means the order in which assets and liabilities are stated on the balance sheet as the balance sheet exhibits the financial position of a concern even to a non-technical observer. It is of great importance that the different assets and liabilities should be arranged in the balance sheet on certain principles. The balance sheet is generally marshalled in three ways.

(i) The order of Liquidity or Realisability According to this method, assets are entered up in the balance sheet following the order in which they can be converted into cash and the liabilities in the order in which they can be paid off. The following is a format of a balance sheet based on this order.

(ii) The order of Performance This method is the reverse of the first method. Under this method, the assets are stated according to their permanency, i.e., permanent assets are shown first and less permanent are shown one after another. Similarly, the fixed liabilities are stated first and the floating liabilities follow. The following is a specimen of a balance sheet based on this order.

(iii) Mixed Order of Arrangement This method is the combination of the first two methods. Under this method, the assets are arranged in order realisability and liabilities are arranged in order of performance.

• The first method is adopted by sole proprietors, firms and partnership concerns.
• The second method is adopted by companies and the third method is adopted by banking concerns.

(i) True
(ii) True
(iii) False
(iv) True

(i)  (b)
(ii)  (a)
(iii)  (e)
(iv)  (c)
(v)  (d)

(v) (ii) & (iii)

(iii) Gross Profit, Operating Profit, Net Profit

(iii) Expenses of a purely financial nature

(iii) Operating profit = Net profit + Non-operating Expenses – Non-operating incomes