Financial Statements

UNIT 3 FINANCIAL STATEMENTS

Learning Objectives
After reading this chapter, you will be able to:

 Explain the meaning and objectives of financial statements of a business entity

 Understand the basic concepts of a Profit & Loss account

 Classify income and expense items

 Understand the structure and components of a balance sheet

 Classify the various assets, liabilities and capital accounts in a balance sheet

 Understand the basic principles of assets valuation

 Appreciate the concept of a balance sheet equation

 Appreciate the linkage between profit and loss account and balance sheet

Structure

3.1 Introduction to Financial Statements

3.2 Objectives of Financial Statements

3.3 Income determination: Basic concepts

3.4 Revenue and Expense

3.5 Profit and Loss

3.6 Income Statement

3.7 Preparing a Trading and Profit and Loss Account

3.8 Balance Sheet

3.9 Balance Sheet contents and classification

3.9.1 Dual Aspect Concept
3.9.2 Current Assets
3.9.3 Fixed Assets
3.9.4 Intangible Assets
3.9.5 Long Term Liabilities
3.9.6 Capital or Owner’s Equity
3.10 Relationship between Income Statement and Position Statement

3.11 Summary

3.12 Key Words

3.13 Self-assessment Questions/Exercises

3.14 Further Readings

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Accounting: An
Overview
3.1 INTRODUCTION TO FINANCIAL
STATEMENTS
The process of accounting aims at providing the financial information about
the business entity to the users with the help of financial statements. Financial
statements are the formal end reports that summarise the business operations
and transactions conducted in a financial year. These statements are prepared
as per the accounting principles to generate systematic and consistent results.
They are useful indicators of the financial health of a business entity at a
particular point of time. The various users of financial statements include
owners and external parties such as investors, tax authorities, government,
employees, etc. It is vital to present the financial statements in a proper form
with suitable contents so that the shareholders and other users of financial
statements can easily understand and use them in their economic decisions in
a meaningful way.

There are three main financial statements of a business entity: the Balance
Sheet (position statement) as at the end of accounting period, the Statement
of Profit & Loss (income statement) and the Cash Flow Statement.

3.2 OBJECTIVES OF FINANCIAL

STATEMENTS
The financial statements are prepared with the purpose to determine the
financial standing of a business entity by measuring three main variables:
profitability, liquidity, and solvency.

 Profitability is the ability of a business to make profit. After paying all

the business expenses out of the sales revenue for a particular accounting
period, is the entity still able to make a profit?

 Liquidity is the ability of a business to pay current obligations without

disrupting normal operations. It is the ability to pay regular bills without
having to sell off assets needed to operate the business. In short, being
liquid means having enough cash to pay the bills.

 Solvency is the ability of a business to pay all its debts if the business
were liquidated, or sold out. A solvent business must have more assets
than it has debt.

These variables are shown in the revenue generated by business (profit-and-

loss statement), the movement of cash in various business activities and
balance cash available (cash-flow statement), and the net worth of the
business (balance sheet).

3.3 INCOME DETERMINATION: BASIC

CONCEPTS
To be able to understand the income statement of a business, the basic
concepts of revenue recognition and income measurement must be clearly
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understood. But before that, one must be able to distinguish between capital Financial Statements
and revenue items. The revenue items form part of the income statement
whereas the capital items are shown in the balance sheet. These basic
concepts have been discussed as follows:

3.3.1 EXPENDITURE
Expenditure represents any payment or outlay made for the purposes of
business. The expenditures are incurred with a view to provide benefits to the
business. Such benefit may extend up to one accounting year or more than
one year. If the benefit of expenditure extends up to one accounting period, it
is termed as revenue expenditure. Revenue expenditure is the outflow of
funds to meet the running expenses of a business and it will benefit the
business during the current period only. It is incurred to carry on the normal
course of business or for the repairs and maintenance of the capital assets. In
other words, revenue expenditure is incurred to maintain the earning capacity
of business. For example, salaries, rent, routine repairs of machinery, interest
paid on loan, etc. are all revenue expenditures as they will only benefit the
current accounting period. Also, revenue expenditures are of a recurring
nature. Revenue expenditures form part of the Income Statement and are also
referred to as expenses recognised during an accounting period.

If, however, the benefit of certain expenditure extends for more than one
accounting period, it is termed as capital expenditure. For example,
payment to acquire machinery for use in the business. Machinery acquired in
the current accounting period will give benefits for many accounting periods
to come. Hence, it will be treated as a capital expenditure that affects the
balance sheet by an increase in the fixed assets. In simple words, capital
expenditure is incurred to increase the earning capacity of a business and is of
a non-recurring nature. Common examples of capital expenditure can be
payment to acquire fixed assets and/or to make additions/extensions in the
fixed assets to increase their useful life.

3.3.2 Receipts
A similar distinction of capital and revenue nature is made in case of receipts
of the business. A receipt of money is treated as a capital receipt when the
contribution is made by the owners towards the capital of the business
(example: equity share capital) or, a contribution towards the capital is made
by an outsider to the business (example: debentures, long term loan) or when
a fixed asset is sold. Capital receipts do not usually have any effect on the
profits earned or losses incurred during an accounting year as they are not
shown in the Income Statement (P&L A/c). Capital receipts have an impact
on the balance sheet.

Next, a receipt is considered as a revenue receipt when it is received from

sale of goods or services, fee received for rendering technical services, or any
interest/dividend earned on investments made by business, or any receipt
from business activities done in the normal course during an accounting
period. Revenue receipts are shown in the Income statement. They are set off
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Accounting: An against the expenses in order to ascertain the profit or loss for the accounting
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period.

3.3.3 Revenue Recognition

Now that we have learnt about revenue receipts and expenditure, the next
question that arises is, when should the revenue and expense be recognised in
the books of accounts? Should we record the revenue when the transaction is
made or when the cash is received or paid? The answer lies in the
fundamental accounting concept of accrual basis and the revenue
realisation principle.

The accrual basis of accounting states that revenues should be recorded

when they are earned or accrued, and not when they are received in cash.
Similarly, expenses should be recorded when they are incurred, and not when
they are paid in cash. For example, assume RT Ltd. made a sale of goods on
12-06-2019 to a customer on credit. The cash was received on 25-08-2019.
Hence, under accrual accounting, the revenue from sale will be recorded on
12-06-2019 and not on 25-08-2019.Later, when the cash is received; no
revenue is recorded because it has already been recorded on the day of sale.
In simple terms, accrual basis requires income and expense to be recorded in
the accounting period to which they relate and not on a cash basis. Taking
another example, if any advance salary is paid to the employee, it will be
debited as an expense in the Profit and loss account in the accounting period
to which it belongs and not in the period in which it is paid. However,
advance salary paid will be shown as a current asset in the Balance sheet of
the accounting year in which it is paid.

Realisation principle, on the other hand, is the point of recognising the

revenue. It states that the revenue should be recognized only to the extent to
which it is certainly realizable. Therefore, just receiving an order of goods or
services from the customer won’t make it eligible to be recognized as
revenue. The reasonable certainty of realizing the revenue will come only
when the goods or services ordered are actually supplied to the customer and
an invoice is created for the same. This concept ensures that income unearned
or unrealized will not be considered as revenue. Further, realisation principle
also enables the recognition of costs, incurred in making available such goods
or services, as expense. Thus, the realisation principle facilitates the process
of income measurement by recognising revenues and also the expenses
incurred with respect to such revenues. This also implies, if costs are incurred
in producing the goods, such costs are not considered as expenses unless
sales are made.

3.3.4 Measurement of Income

Income is nothing but the excess of amount the business entity has earned
from its operations over what they have invested into it over its lifetime.
However, as per the going concern concept the business is expected to run
its operations for an indefinite period of time. Therefore, it is impractical to
wait till the winding up of business to measure the net income earned by it
over its lifetime. There comes the concept of accounting period.
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Accountants choose some convenient segment of time, such as a calendar Financial Statements
year or quarter of a year, to collect, summarise and report all information on
material changes in the owners' equity (retained earnings) during that period.
This period is usually one year, which could be a calendar year i.e. 1st
January to 31st December or it could be a fiscal year, like in India it is 1st
April to 31st March. The business organizations have the freedom to choose
their own accounting year. However, generally, as a convention, most
business firms tend to have a uniform accounting period for easier
comparison of results.

The accountants measure the income of an accounting period by recognizing

the revenue and expense of that particular accounting period based on
accounting principles of realisation and accrual. Therefore, accounting period
facilitates a practical system of valuation and measurement. Accounting
periods are bounded by balance sheets at the beginning and at the end of the
period. Operations during the period are summarised by income statements.

3.3.5 Matching Concept

The determination of profit earned or loss incurred by a business during a
particular accounting period requires deduction of the expenses from the
revenue relating to that period. The matching concept emphasises exactly on
this aspect. It is an accounting principle that states that expenses incurred in
an accounting period should be matched with the revenues of that period. It
implies that both the revenues and the expenses incurred to earn these
revenues must be recognised in the same accounting period. Matching
concept ensures that the profit or loss of an accounting period is not over or
under-stated.

As previously discussed, revenue is recognised when a sale is made or

service is rendered, not when cash is received. Similarly, an expense is
recognised when an asset or service has been used to generate revenue, and
not when the cash is paid. It is worth noting that, only when a cost is
recognised or accrues during an accounting period, it becomes an expense.
Therefore, cost is not a synonym for expense. Only those costs that have
expired during an accounting period are treated as expenses. For example,
each year’s depreciation is an expired cost of an asset which is treated as an
expense during the accounting period in which the asset is used. Similarly in
a trading account, sales revenue is matched with its cost of goods sold to
ascertain the gross profit. This implies, we should only consider the cost of
goods that have been sold during that year, and not the cost of all the goods
purchased or produced during that period. For this purpose, the cost of unsold
goods should be deducted from the cost of the goods produced or purchased.
The balance amount is called as closing inventory or closing stock and
shown in the trading account.

Other examples of expenses include salaries, rent, insurance, interest on loan

etc. These are recognised in the accounting period to which they belong
irrespective of the actual payment.

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Accounting: An
Overview
3.4 REVENUE AND EXPENSE
Let us now learn, what constitutes revenue and expense during an accounting
period. Moreover, we shall also try to answer the following questions. Does a
business only earn revenue from sales? Are there any other sources of income
for a business entity? How are expenses classified in a Trading and P&L
Account? Later we will study how these revenues and expenses are shown in
an Income Statement in order to determine the profit or loss.

3.4.1 Revenue
Revenue is simply described as the income generated by a business from the
sale of goods or provision of services during an accounting period. Revenue
is also commonly referred to as the ‘sales revenue’ or ‘gross revenue’.
However, there are certain activities which are incidental to the main
operations of the business. The revenue that accrues from such non-operating
activities is known as non-operating revenue. Examples include dividend
income from shares held in other companies, interest on investments, rental
income, gain on sale of fixed asset etc.

3.4.2 Expense
Expenses refer to the costs incurred by a business firm to generate revenue
during an accounting period. It is a revenue expenditure incurred for
running the business operations and its benefit is only limited to the current
period. Expenses are generally, of a recurring nature such as salaries, rent,
interest etc. Moreover, capital expenditure such as purchase of a fixed asset is
not treated as an expense as the benefit of a fixed asset continues for more
than one accounting period. As already discussed, a cost becomes an expense
when it is recognised. The recognition of expense occurs at a point where the
corresponding revenue is realised. Let’s take few examples to explain it
better.

i. Rent of the office building due for the current period is an expense of the
current period, even if the actual payment of rent is made during the next
accounting period. Such payments that become due during the current
period but are actually paid in the subsequent accounting period are
called as outstanding expense.

ii. Prepaid rent related to the next accounting period, paid during the
current period is not an expense of the current accounting period. It will
be recognised as an expense in the next accounting period when it
becomes due.

iii. Inventory is treated as an expense in the accounting period during which

it is sold. Thus, the remaining unsold inventory or closing stock is not
treated as an expense because it did not generate revenue during the
current accounting period. It will, however, be treated as an expense in
the year in which such inventory is sold.

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In other words, an expense is that part of the cost that has expired and been Financial Statements
used up by activities directed at generating revenue. Therefore, all expenses
are costs, but all costs are not expenses.

Expenses can be in the form of payments due in respect of routine business

activities (e.g. wages, salaries, rent etc.) or an expired portion of an asset (e.g.
depreciation, amortization), or a decrease in owners’ equity (loss on sale of
an asset, bad debts etc.).There are two important classifications of expenses:

i. Direct and Indirect expenses

ii. Operating and non-operating expenses

Direct and Indirect Expenses

‘Direct’ as the name suggests, are those expenses which are directly related
and allocated to the core business operations. Mainly, these are the expenses
involved in purchases of inventory and manufacturing/production of goods or
services. Direct expenses are a part of the cost of goods sold by a business
entity. They are debited in the trading account. Examples of direct expenses
include carriage inwards, wages of factory workers, fuel charges, electricity
and water charges of the factory, freight inwards, etc. Direct expenses may
differ for different types of companies such as manufacturing, trading,
services, financial etc.

On the other hand, indirect expenses are not directly related and allocated to
the core business operations of a firm such as production. Indirect expenses
are incurred to run the business operations smoothly. They are not directly
involved in the revenue-generating activities. All those expenses recognised
during an accounting period which cannot be classified as direct expense,
will be treated as indirect expense. Indirect expenses are debited in the profit
and loss account. Examples of indirect expenses include rent of building,
salaries to employees, marketing expenses, legal charges, fire insurance
premium, interest on loan, depreciation, printing charges, loss on sale of a
fixed asset, bad debts etc.

Operating and Non-operating expenses

Operating expenses are the expenses incurred for running the business
operations but are not directly related to the core activities of production or
trading. Operating expenses are usually connected with generating sales. The
common examples of operating expenses include administrative expenses,
office expenses, selling and distribution expenses, marketing expenses,
depreciation, bad debts etc.

Non-operating expenses are expenses incurred on non-core activities. These

expenses are not related to production or sales, but are incidental to the
business operations. Few examples of non-operating expenses include:
interest expense, loss on sale of a fixed asset, legal fee, etc.

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Accounting: An Activity 3.1
Overview
1. Fill in the blanks:

a) Income statement is a summary of _________ and ________ for an

accounting period.

b) Income is the excess of ________ over _________.

c) Goods worth Rs.25,000 are sold on 20th March 2020 but the actual
payment is received on 12thApril 2020. The sales revenue will be
recorded in the year ending_________. (Assume that the business entity
follows the financial year 1st April to 31st March)

d) Realisation principle in accounting is the basis of __________

recognition.

e) Prepaid expense is recognised as an expense during the ________

accounting period.

f) Loss on sale of investments is a __________ .

3.4.3 Few Important Concepts

We shall now discuss some important elements of the Income statement in
detail.

I. Cost of Goods Sold

Having studied the types of revenue and expense that form part of the trading
and profit and loss account, now we will read about the expenses that
constitute the cost of goods sold. Cost of Goods Sold (COGS) is the direct
costs incurred in the production of goods or services that are sold during an
accounting period. It includes raw material cost, direct labour cost and direct
factory overheads assigned to the goods which are sold during a particular
accounting period. The excess of sales revenue over cost of goods sold results
in gross profit. Cost of goods sold includes the expenses related to the goods
or inventory which have been converted into sales during an accounting
period. It can be depicted in an equation as follows:

COST OF GOODS SOLD = OPENING STOCK + PURCHASES + DIRECT

EXPENSES – CLOSING STOCK.

Illustration 1
Let us illustrate the idea based on a simple example for a better understanding
of the concept of COGS. A manufacturing concern First Class Ltd. has an
opening stock of inventory worth Rs. 1,20,000 on 1st April 2020. During the
fiscal year from 1st April 2020 to 31st March 2021, they made the following
transactions:

a. They purchased raw material worth Rs. 1,80,000

b. Wages paid to direct labour Rs. 40,000
c. Carriage Inwards Rs. 3,000
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d. Factory fuel and lighting Rs. 10,000 Financial Statements

e. Sales made during the year Rs. 3,30,000

The closing stock of inventory (unsold) on the last day of the fiscal year was
Rs. 65,000.

(Please recollect the golden rule of accounting- that all expenses and losses
are debited and all incomes and gains are credited.)

Thus, the trading account of First Class Ltd. for the fiscal year ending 31st
march 2021 will appear as follows:

Trading Account of First Class Ltd. for the year ended 31st March 2021
Particulars (Debit) Amount Particulars (Credit) Amount
(Rs.) (Rs.)
Opening Stock 1,20,000 Sales Revenue 3,30,000
Purchases 1,80,000 Closing Stock 65,000
Direct Labour 40,000
Carriage Inwards 3,000
Factory Fuel & Lighting 10,000

Gross Profit 42,000

3,95,000 3,95,000

As discussed, the Cost of Goods Sold will be computed as follows:

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses –
Closing Stock
= Rs. 1,20,000 +Rs. 1,80,000 + Rs. (40,000+3,000+10,000) – Rs. 65,000
= Rs. 2,88,000
Subsequently, gross profit is the excess of sales revenue over cost of goods
sold. Hence, is computes as:
Gross Profit = Rs. 3,30,000 – Rs. 2,88,000 = Rs. 42,000

II. Inventory valuation

As discussed, assets are recorded in the balance sheet at the cost price at
which they are purchased. Similarly, inventory is also valued at cost. The
challenge here is that the cost of inventory purchased doesn’t remain constant
over an operating cycle.

Inventory used in the production of finished goods is purchased multiple

times in an operating cycle to ensure a smooth production process. Similarly,
in a trading business, inventory is purchased in multiples batches to ensure
smooth sales. However, the cost of purchasing inventory might fluctuate
during an accounting period resulting in different cost prices. It is because of
this fluctuation in the purchase price of inventory that various methods of
inventory valuation have evolved. Two of the most commonly used methods
are as follows:
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Accounting: An  First in First out (FIFO): This method is based on the assumption those
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materials/inventory purchased first are issued first for production process
or sales. Hence, they are priced at the cost of oldest materials/inventory
listed in the stores ledger until all units of the oldest batch are used up.
Alternatively, sale of goods is made in the order in which they are
purchased. Hence, inventory purchased first, will be sold first.

 Last in First out (LIFO): In contrast to FIFO, LIFO is based on the

assumption those materials/inventory purchased last in order are issued
first for production process or sales. Hence, the inventory issued for the
production process is priced at the cost of materials which were
purchased last in the order until that batch exhausts. The same process
continues when next batch of inventory is issued for production. This
also implies that goods which are purchased last, are sold first and hence
they are valued at the cost of inventory which was purchased last in
order.

Let us understand this with the help of an illustration:

Illustration 2
Date Particulars No. of units Cost per unit Amount (Rs.)
(Rs.)
January 1 Opening 500 3 1500
Inventory
January 10 Purchases 1000 4 4000
January 12 Purchases 2000 6 12000
January 18 Purchases 4000 4 16000
January 24 Purchases 2000 7 14000
9500 47500
January 11 Sales 1000
January 13 Sales 500
January 17 Sales 1200
January 21 Sales 2000
January 29 Sales 1300
6000
Under the First-in First-out method, inventory valuation will be done as
follows:

First in First out Method

Date Quantity Quantity Rate Amount Total
sold Break-up Amount
January 11 1000 500 3 1500
500 4 2000
January 13 500 500 4 2000
January 17 1200 1200 6 7200
January 21 2000 800 6 4800
1200 4 4800
January 29 1300 1300 4 5200
TOTAL 6000 27500
SALES
CLOSING 3500 1500 4 6000
INVENTORY
2000 7 14000
3500 20000
TOTAL 9500 47500
Therefore, valuation under FIFO will be:
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Cost of goods sold 27500 Financial Statements

Closing inventory 20000

Total 47500
Now, under the Last-in First-out method, inventory valuation will be done as
follows:

Last In First Out Method

Date Quantity Quantity Rate Amount Total
sold Break-up Amount
January 11 1000 1000 4 4000
January 13 500 500 6 3000
January 17 1200 500 6 3000
700 6 4200
January 21 2000 2000 4 8000
January 29 1300 1300 7 9100
TOTAL 6000 31,300
SALES
CLOSING 3500 700 7 4900
INVENTORY
2000 4 8000
300 6 1800
500 3 1500 16,200
TOTAL 9500 47,500
Therefore, valuation under LIFO will be:
Cost of goods sold 31,300
Closing inventory 16,200
Total 47,500

Based on the illustration above, we can see how the valuation of inventory
and cost of goods sold is affected by the change in valuation method.

III. Closing Stock

Closing stock is the amount of inventory lying unsold at the end of an
accounting period. It can be in the form of raw material, work-in-progress or
finished goods. The closing stock at the end of an accounting period is
carried forward to the next accounting period. The calculation of closing
stock is done as follows:

CLOSING STOCK = OPENING STOCK + PURCHASES – COST OF

GOODS SOLD

Every business entity calculates its unsold goods at the end of the period and
puts a value against it. Various methods are used for calculating the value of
closing stock. Two of them namely, LIFO and FIFO have been discussed in
the previous point. Closing stock is a real account and therefore, it appears on
the assets side of the balance sheet.

IV. Depreciation

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Accounting: An As already discussed, fixed assets are the ones having a useful life of more
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than one year. They provide benefits to the business in the long run and thus,
are bound to suffer some wear and tear with the passage of time.
Depreciation is the gradual decline in the value of a fixed asset over its useful
life due to use, wear and tear or obsolescence. Thus, every year the
proportionate decrease in the value of the fixed asset is charged as
depreciation in the Profit and Loss (P&L) Account. It is the expired cost of a
fixed asset which is recorded as an expense during an accounting period.

Fixed assets generate revenues for the business for multiple accounting
periods. However, with each passing year, the earning capacity of the fixed
asset declines because of physical wear and tear. This is why, every year the
depreciation on fixed asset is written off against the revenues generated
during that period. It is a non-cash expense.

Now the question arises that how the depreciation of each year should be
calculated? There are various methods to calculate depreciation. The two
most commonly used methods are:

i. Straight line method

ii. Written down value method

Any of the two methods of depreciation can be used by the business entity.
However, it is important to follow the same method of depreciation every
year.

Now we shall discuss the basic terminology of depreciation:

• Original cost of the asset: This is the cost at which the fixed asset has
been purchased and made available for use in the business.
• Salvage value: It is the expected recovery or scrap value of the asset at
the end of its useful life.
• Useful life: The time period (in years) for which the asset is expected to
be used for the operations of business.
• Depreciable cost: It is the net cost after deducting the salvage value
from the original cost of the asset. This is the cost of asset to be
depreciated during its useful life. Some portion of depreciable cost will
expire and treated as an expense each year until the useful life of asset.
That expired cost is known as depreciation.
• Book Value: The original cost of the asset less its depreciation to date
(accumulated depreciation) is known as the book value of the asset. This
is also referred to as the written down value.

V. Bad Debts
Bad debts are the accounts receivable which could not be collected by the
business firm after making all reasonable efforts. We know that sales of
80 goods and services are made on both cash and credit basis by a business
entity. Also, as per the revenue recognition concept, revenue is recognised Financial Statements
when the sale is made and not when the cash is received. Now consider a
credit sale to customers of Rs. 1000. The following entries will be made in
the books of accounts:

Debtor A/c Dr. Rs.1000

To Sales A/c Rs. 1000

Thus, the sales revenue increases by Rs. 1000 and debtors also increase by
Rs. 1000. Debtors are shown as a current asset in the balance sheet as the
payment for credit sales is expected to be received within few weeks or
months. Now assume that the debtors defaulted on their payments and went
bad. The business entity will have to make the following journal entry in the
books:

Bad Debts A/c Dr. Rs.1000

To Debtors A/c Rs.1000

The debtors will be reduced by Rs. 1000 and an expense in the Profit and
Loss A/c is created in the name of Bad debts. Bad debts lead to reduction in
the amount of profits as it is recorded as an expense in the Profit and Loss
Account. Similarly, a loss in collection of a bad or doubtful debt is also
recorded as an expense in the Profit and Loss Account as well as deduced
from the accounts receivables balance is the Balance Sheet.

VI. Provision for doubtful and bad debts

The accounting principle of ‘prudence’ states that expected losses must be
provided for and expected profits must not be accounted until realised.

We know that a business entity makes both credit and cash sales during an
accounting period. However, all credit sales may not be realized in the same
year in which the sales are made. Some realizations may happen in the
succeeding year. The entity, therefore, has to make provision at the end of the
accounting year, for likely bad debts, which may happen during the course of
the next year.

VII. Income Tax/Provision for Tax

Income tax is a charge on income earned by the business, which has to be
statutorily submitted to the government’s income tax department every year.
Thus, it is recorded as an expense in the Profit and Loss A/c every year. The
amount of tax liability is computed as per the law. We have Income Tax Act,
1961 in India which governs the computation and collection of income tax.
However, the tax liability is determined on the basis of books profits
calculated as per law and not on the basis of net profit reported by business.
A business firm estimates its tax liability usually in advance and a provision
is created for the same. Provision for tax is recorded as an expense in the
profit and loss account as it is created for current year’s tax obligation. Also,
provision for tax is shown as a current liability in the balance sheet. So, when
the actual tax is paid, it is set off against the provision of tax.
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Accounting: An
Overview
3.5 PROFIT AND LOSS
So far, we have learnt about the various revenue and expenses arising during
the course of business operations and shown in the Trading & Profit and Loss
Account. Broadly, we understand that profit is the excess of revenue over the
expenses recognised during a fiscal year (or accounting period). Conversely,
loss is the excess of expenses over revenues realised during a fiscal year.
However, the significance of dividing income statement into trading and
profit and loss account lies in the presentation of gross profit and net profit
respectively. Besides, business entities are also interested in ascertaining the
profit arising solely from business operations, referred to as operating profit.

3.5.1 Gross Profit

The excess of sales revenue over the cost of goods sold is called gross profit.
Whereas, gross loss is the excess of cost of goods sold over revenue earned
from sales. It only deducts the direct expenses related to the production of
goods. Hence, it is the net result of a trading account. Gross profit, taken as a
percentage of sales is a significant financial ratio used in financial analysis by
managers for decision making purposes. This percentage indicates the
average mark-up obtained on products sold.

Thus,

GROSS PROFIT = SALES – COST OF GOODS SOLD

GROSS PROFIT RATIO =

Gross Profit or Loss is transferred to the Profit and Loss Account.

3.5.2 Operating Profit

Operating profit is derived from gross profit. It reflects the remaining income
after deducting all the operating expenses. In addition to COGS, these
expenses include rent, insurance, salaries, administrative expenses, selling
and distribution expenses, as well as amortization and depreciation of assets.
All those expenses that are necessary to run the core business operations must
be taken into account to arrive at the operating profit. It is the profit from
core business operations before deducting interest and tax expense. It is also
referred to as EBIT i.e. earnings before interest and tax. Therefore,

OPERATING PROFIT = GROSS PROFIT – OPERATING EXPENSES

including DEPRECIATION/AMORTIZATION

The idea is to separate the income earned from production and sales from the
other non-core activities of business.

3.5.3 Net Profit Before Tax

Net profit before tax is the surplus of all business income over all expenses
including interest but excluding tax. This is the profit available to the
business entity as a result of both operating and non-operating activities. This
82
profit is usually referred to as PBT (Profit Before Tax) or EBT (Earnings Financial Statements
Before Tax).
NET PROFIT = GROSS PROFIT + OTHER BUSINESS INCOMES –
INDIRECT EXPENSES (excluding Tax)

3.5.4 Net Profit

Net profit is simply, the amount which is available to the business for
appropriation. It is the net income from both operating and non-operating
business activities after reducing both direct and indirect expenses. It is either
distributed as dividends to shareholders (owners) or retained in the business
as retained earnings, thereby increasing the owners' equity in the business.
Alternatively, it is called as PAT (Profit After Tax) or EAT (Earnings After
Tax).
After dividend distribution (if any), the remaining surplus is added to the
retained earnings. Retained earnings accumulated over the years is shown in
the Balance Sheet under the head Reserves and Surplus.
Net profit impacts the decision of various users of financial statements such
as management, investors, creditors, competitors etc. For example, creditors
refer to the net income of a company to gauge the repayment capability
before sanctioning a loan.
Activity 3.2
1. Classify each item listed in Column A under appropriate classification in
item B, assuming that the information relates to a small manufacturing
company.
A B
Raw material Operating revenue
Interest received on investments Non-operating revenue
Dividends received from shares Cost of goods sold
Wages to workers Selling and distribution expenses
Carriage outwards Administrative expenses
Carriage inwards Non-operating expense
Salary to office staff None of the above
Rent of office
Power and Fuel
Selling agents’ commission
Audit fee
Legal fee
Advertising
Municipal taxes
Interest expense on loan
Provision for Income Tax
Profit on sale of furniture
Sales revenue
Sales discount
Purchase returns
2. Fill in the blanks
a) The maximum amount of capital that can be raised by a company is
called __________.
b) All fixed assets except _________ are subject to depreciation. 83
Accounting: An c) The gross profit is transferred to_________.
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d) All indirect expenses are _________ in the profit and loss account.
e) Goodwill is _______ asset.
f) Advance income received is shown on the _________ side of Balance
Sheet.
g) Depreciation is the net cost after deducting ____________ from the
original cost of the asset.
h) Under the _______ method of valuing inventory, closing stock is
valued at the oldest price.

3.6 INCOME STATEMENT

The balance sheet represents the summary of the assets, liabilities and net
worth of the business at the end of an accounting period. In a way, it
summarises the net effect of business operations and transactions made
during the accounting period. However, it does not disclose anything about
the business operations. What was the sales volume and revenue? How much
direct and indirect expenses were incurred? What was the amount of
operating and non-operating income? How many purchases of raw materials
were made? All these answers are in fact, addressed by the income statement
of the business. Income statement is also commonly referred to as Profit and
Loss Account. It discloses the business’s revenue, costs of goods sold, gross
profit/loss, selling and administrative expenses, other non-operating expenses
and income, taxes paid, and net profit/loss in a coherent and logical manner.
The profit or loss is determined by taking all income and subtracting all
expenses from both operating and non-operating activities pertaining to an
accounting period. For a systematic determination of gross profit or loss and
net profit or loss, income statement is divided in two sections namely:
Trading Account and Profit and Loss Account.

3.7 PREPARING A TRADING AND PROFIT

AND LOSS ACCOUNT
Having understood the basic concepts of income and expense as well as
revenue recognition, we shall now prepare a trading and profit and loss
account. It is also commonly referred to as Profit and Loss Account (P&L) or
Income Statement or statement of operations. It is a final account that shows
the summary of all revenue and expense recognised during the accounting
period, the net effect of which is reflected in the profit earned or loss
incurred. Thus,

REVENUE – EXPENSE = PROFIT/LOSS

Some fundamental rules must be clear while preparing a trading and profit
and loss account:

84
i. The P&L account has two sides – debit and credit. We must debit all Financial Statements
expenses and losses; and credit all income and gains. Debit balances are
shown on the left-hand side and credit balances on the right-hand side.

ii. The incomes and expenses must relate to the current accounting period.

iii. The balances of expenses, incomes, losses and gains are taken from the
trial balance. However, there might be some omissions or corrections in
the trial balance which need to be adjusted in the P&L account if they
relate to current year.

iv. Trading account represents the gross profits/loss from the core business
operations.

v. Profit and Loss account represents the net income/loss from all the
operating and non-operating activities of the business entity.

Illustration 3
Let us illustrate the preparation of profit and loss prepared from a trial
balance with the help of an example. The trial balance of XYZ Ltd. as on 31st
March 2021 is given as follows:

TRIAL BALANCEXYZ Ltd.as on 31/03/2021

Particulars Dr. (Rs.) Cr. (Rs.)
Capital 20,000
Debtors 5,400
Machinery 7,000
Creditors 2,800
Wages 10,000
Purchases 19,000
Opening stock 4,000
Cash at Bank 3,000
Carriage inwards 300
Salaries to office staff 500
Rent of building 800
Sales revenue 29,000
Drawings 1,800
51,800 51,800
Additional information to the trial balance has been provided as follows:
i) Closing Stock is valued at Rs. 1,200.
ii) Outstanding Rent of the building is Rs. 200.
iii) Depreciation is charged on machinery at 10% p.a.
iv) Prepaid wages amount to Rs. 400.

As we learnt, the P&L account takes the balances of revenues and expenses
from the trial balance and adjustments are made for any additional
information. Let’s start with the preparation of trading account. Trading
account records the sales revenue and cost of goods sold for the accounting
period, the net effect of which is represented in the gross profit or gross loss.
The gross profit or loss of the trading account is then transferred to the profit
and loss account against which all indirect expenses are set off as well as any
other non-operating income is added. All expenses are shown on the debit 85
Accounting: An side and incomes on the credit side. Hence, the income statement of XYZ
Overview
Ltd. will appear as follows.

Trading and P&L Account XYZ Ltd. for the year ending 31st March 2021

Particulars (Dr.) Amount Particulars (Cr.) Amount

To Opening Stock 4,000 By Sales 29,000
To Purchases 19,000 By Closing stock 1,200
To Wages 10,000 9,600
Less: Prepaid wages (400)
To carriage inwards 300
By Gross Loss c/d 2,700
32,900 32,900
To Gross Loss b/d 2,700 By Net Loss 4,900
To Salaries to office staff 500
To Rent of building 900
Add: Outstanding rent 200 1,000
To Depreciation on machinery 700
4,900 4,900

Activity 3.3
1. State True or False:

i) In trading and profit and loss account, opening stock appears on the
debit side because it forms the part of the cost of sales for the current
accounting year.
ii) Rent, rates and taxes is an example of direct expenses.
iii) If the total of the credit side of the profit and loss account is more
than the total of the debit side, the difference is the net loss.
iv) Discount received is an example of indirect income.
v) As per the double-entry system of accounting, when expense
increases, it is debited.
vi) Interest income from investments is a non-operating income for a
manufacturing company.
2. Indicate whether each of the following items would appear on the
income statement (IS) or the balance sheet (BS) or both. Also specify the
head under which it will be classified.

Items IS or BS or Head of
Both classification
Sale of services revenue
Office expenses
Marketing expense
Factory Fuel and water charges
Advance salary paid
Income received in Advance
Closing Stock
Outstanding rent
Office equipment
86
Accounts receivable Financial Statements
Provision for Taxes
Profit on sale of Investments
Preliminary expenses of company
(not written off)

SUMMARISING THE INCOME STATEMENT: P&L ACCOUNT

Profit and Loss account is one of the three final accounts generated by the
business at the end of an accounting period. It shows the gross and net profits
or losses generated by the business in an accounting period. Therefore, it’s a
measure of management's ability to generate income from assets. P&L
account is divided into two sections. Trading account reflects the earnings
from core business operations in the gross profit or gross loss. Whereas, the
profit and loss account summarises all the operating and non-operating
revenues and expenses in the net profit or loss. The revenues and expenses
recorded in a profit and loss account belong to the current accounting period.
P&L account is also commonly referred to as the statement of profit and loss,
income statement, statement of operations etc. Its preparation is based on the
accounting principles of revenue recognition, matching and accruals. The net
profit or loss sustained by the business as calculated by the P&L account
increases or decreases the retained earnings in the balance sheet respectively.

3.8 BALANCE SHEET

The ‘balance sheet’ as the name suggests, is the summary of the balances of
the various assets, liabilities and capital accounts of a business entity as on a
particular date. In simple terms, it is the summary of things owned by the
entity as well as the claims against those things represented in monetary
terms as on a specific date. It contains information about both the resources
and obligations of an entity. Thus, it depicts the financial position of a
business at a given point of time which is usually the close of an accounting
period. It also depicts net worth which is just one part of the balance sheet
which is also the total shareholders’ funds. Balance sheet depicts financial
position as on a particular date.

In brief, the various aspects of a balance sheet can be put as follows:

i. A Balance Sheet is a financial statement prepared from the point of view

of a business entity, firm or company, and not from the point of view of
its owners, investors, directors, creditors etc.

ii. A Balance Sheet is a statement and not an account.

iii. It is a statement showing the financial position of the business entity on a

specific date.

iv. It is a historical report showing the cumulative effect of past transactions.

v. A Balance Sheet always relates to a particular point of time or date and
not a period.
87
Accounting: An vi. A Balance Sheet depicts the resources owned (assets) on one side and
Overview
obligations (liabilities) of a business entity on the other side.

vii. All items on a Balance Sheet are represented in terms of monetary value.

viii. The total of both sides on a balance sheet are always equal.

Let us understand the concept of a balance sheet with the help of an example.

Mr. Raghav is the owner of a start-up firm RT Ltd. On 1st April 2020, the
position of his business firm RT Ltd is as follows: He has invested his
personal savings worth Rs. 10,00,000 cash into the firm as Capital to start the
business. He also took a loan from bank of an amount equal to Rs. 3,50,000
for buying Office Premises for his business firm. Further, he purchased some
Machinery worth Rs. 2,00,000 and a Motor car worth Rs. 3,00,000 for the
operations of the firm. To start the business operations, he brought in
Inventory worth Rs. 2,50,000 and kept an amount of Rs. 20,000 as Cash and
also deposited an amount of Rs. 50,000 in a bank account for the purpose of
business. Apart from this, Mr. Raghav invested the remaining amount of Rs.
1,80,000 in government bonds on behalf of his firm RT Ltd.

Now let us generate a balance sheet for RT Ltd. as on 1st April 2020 on the
basis of given information. We will classify the above information into the
resources owned by RT Ltd. and the claims against those resources. The
commonly accepted format of Balance Sheet in India shows Liabilities on the
left-hand side and Assets on the right-hand side.

As already discussed, a balance sheet is always prepared from the point of

view of a business entity and not the owner. Hence, the balance sheet or the
position statement of RT Ltd. as on 1st April 2020 would be presented as
follows:

Balance Sheet of RT Ltd.as on 1st April 2020

Liabilities (obligations Amount (in Rs.) Assets (resources Amount (in
of the firm) owned by the firm) Rs.)
Capital Rs. 10,00,000 Machinery Rs. 2,00,000
Loan from Bank Rs. 3,50,000 Building (Office Rs. 3,50,000
Premise)
Motor Car Rs. 3,00,000
Investment in Bonds Rs. 1,80,000
Inventory Rs. 2,50,000
Cash Rs. 20,000
Bank Account Rs. 50,000
Total: Rs. 13,50,000 Total: Rs. 3,50,000

Here, we can see that the total value of resources owned by RT Ltd. which
includes building, machinery, car, cash, investments and inventory is worth
Rs. 13,50,000. In accounting, these resources owned by the business are
referred to as assets. Further we observe that the claims against these
resources in the form of bank loan stands at Rs. 3,50,000. Such claims
against business entity’s assets are referred to as liabilities. Now, the net
worth of RT Ltd. will be calculated by deducting the claims against its worth
from its total worth of resources which is an amount equal to Rs. 10,00,000
88 (*13,50,000 minus 3,50,000).
Thus, the net worth of an entity represents the claims of its owner(s) which is Financial Statements
also referred to as owner's equity. We also learnt that the items of monetary
value possessed by an entity are referred to as assets. Whereas, the amount
owed by an entity which represents claims against its assets by outsiders are
called as liabilities. Thus, we can say that the position statement is a
summary of the assets, liabilities and net worth of an entity at a specific point
of time.

3.8.1 Dual Aspect Concept

Let us take a step further in the previous example: suppose Mr. Raghav
purchased some goods (raw material) worth Rs. 10,000 in cash. This
transaction will have a dual impact on the balance sheet of RT Ltd. First, the
inventory will increase by Rs. 10,000 and second, the cash balance will
decrease by Rs. 10,000. Similarly, if the goods were purchased by Mr.
Raghav on credit for Rs. 10,000, the inventory (asset) will go up by Rs.
10,000 whereas, the creditors will also increase by Rs. 10,000. This brings us
to a fundamental accounting concept known as dual-aspect in accounting.
This concept explains that each transaction made by a business entity impacts
the business in two different aspects which are equal and opposite in nature.
It means that every business transaction will affect at least two accounts
which implies that for every debit there is an equivalent credit and vice versa.
For example, if your company borrows money from the bank, the company’s
asset Cash is increased (debited) and the company’s liability Notes Payable is
also increased (credited). It is because of this feature that both sides (assets
and liabilities) of the balance sheet will always be equal. This concept forms
the basis of double-entry accounting and is used by all accounting
frameworks for generating accurate and reliable financial statements. The
dual aspect concept is also explained in the fundamental accounting equation:

ASSETS = LIABILITIES + OWNERS EQUITY

The above accounting equation indicates that an entity’s assets have to be

equal to the sum of its liabilities and owner’s equity. This equation is
considered to be the foundation of double entry system of accounting. It
ensures that every entry made on the debit side has a corresponding entry
made on the credit side and vice versa. Hence, the double entry made will
automatically balance the accounting equation. To sum it up,

 An increase in assets is followed by an increase in liabilities and/or

equity and vice versa.

 A decrease in assets is followed by a decrease in liabilities and/or equity

and vice versa.

 An increase in an asset is followed by a decrease in another asset and

vice versa.

 An increase in a liability is followed by a decrease in another liability

and vice versa.

Let’s consider the following series of examples to explain this concept

further: 89
Accounting: An Mr. Raghav further invested cash worth of Rs. 4,00,000 into his business RT
Overview
Ltd. The effect of this transaction will be as follows:

 Capital will increase by Rs. 4,00,000.(Liabilities side)

 Cash will also increase by Rs. 4,00,000.(Assets side)

Also, Mr. Raghav repaid the loan in cash, he took from bank for his
office building worth Rs. 3,50,000. This transaction will have the
following effect:

 Loan from Bank will reduce by Rs. 3,50,000. (Liabilities side)

 Cash will also reduce by Rs. 3,50,000. (Assets side)

Lastly, Mr. Raghav sold the investments he made in government bonds for
Rs. 2,00,000 cash. In this transaction, RT Ltd. made a profit of Rs. 20,000 (as
the gold bonds were purchased for Rs. 1,80,000 initially). The effect of this
transaction will be shown as follows:

 Investment in Government Bonds will reduce by Rs. 1,80,000. (Assets

side)

 Cash will increase by Rs. 2,00,000. (Assets side)

 Profits of Rs. 20,000 will be shown by an increase in Capital. (Liabilities

side)

Hence, a balance sheet will always balance its two sides. The effect on one
account will be compensated by an equal and opposite effect on another
account.

Activity 3.4
1. State whether the following statement is True or False:
i) An increase in asset always results in increase in owner's equity.

ii) If you own a house worth Rs. 4,00,000 and a home loan of Rs.
2,50,000, then your equity is Rs. 1,50,000.

iii) Losses result in increase in owner's equity.

iv) An increase in assets could be equalled by increase in liabilities.

v) Assets are the economic resources that are expected to produce

future benefits

vi) During an accounting period, the assets increased by Rs. 4,000 and the
equity increased by Rs. 1,000. For the accounting equation to balance,
the liabilities must increase by Rs. 5,000.

2. For the transactions given below, circle the correct effect on the
accounting equation of the business entity:

(i) The owner invests personal cash in the business.

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 Assets Increase Decrease No Effect Financial Statements

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(ii) The business entity purchases raw materials on credit.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(iii) The business entity repays a long-term loan to the bank.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(iv) The owner withdraws some cash from the business for personal use.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

3.9 BALANCE SHEET CONTENTS &

CLASSIFICATIONS
Having understood the basic concepts and functioning of a balance sheet, let
us now study the contents of a balance sheet. We have seen that every
transaction affects the financial statements of a business but it is not feasible
to draw up the financial statements after every transaction. Thus, financial
statements such as balance sheet, P&L and cash flow statement are prepared
at the end of a specified period, usually, a year. This specified period is
referred to as an accounting period or a financial year.

As already discussed, the balance sheet prepared at the end of the accounting
period reflects upon the position of the entity’s assets, liabilities and capital
accounts on that specific date. The balance sheet is further sub-grouped in
order to facilitate a more meaningful and convenient analysis as shown in the
following illustration:

91
Accounting: An Balance Sheet of RT Ltd.as on 31st March 2019
Overview
(Rupees in thousands)

Liabilities Amount Assets Amount

(in Rs.) (in Rs.)
Capital Goodwill 700
Equity Shares of Rs. 10 2000 Fixed Assets
each
12% Preference Shares of 500 Land and Buildings 2800
Rs. 100 each
Reserves & Surplus 1000 Plant and Machinery 1500
2000
Less: Depreciation
(-) 500
Capital Reserve 500
Current Assets
Long term Liabilities Cash 200
8% Debentures 1000 Axis Bank Account 300
Secured Loan from Bank 2000 Marketable Securities 200
Bills Receivable 1200
Current Liabilities Closing Stock (Inventory) 1100
Bills Payable 1800 Prepaid Expense 500
Income Tax Provision 400
Bank Overdraft 800 Other Assets
Deferred Expenditure 1500
10000 10000
To be able to read and analyse a balance sheet, you must understand its
different elements and what they signify about the financial health of the
business. An accurate understanding of the balance sheet enables an analyst
to evaluate the liquidity, solvency, and overall financial health of a business.

A balance sheet represents the assets, liabilities and capital of the business in
such a way that the accounting equation always balances i.e. ASSETS must
always be equal to the sum of LIABILITIES and OWNERS’ EQUITY. Let
us talk about these balance sheet elements in detail.

Assets are resources of economic value that a business entity owns with the
expectation that they will provide future economic benefit to the business.
They are generally divided into two categories: current assets and non-current
assets. The liquidity of the asset determines into which category it falls.
Liquidity is the ease with which an asset can be converted or realized into
cash. Those assets that can be converted into cash within 12 months are
considered as current assets. For example, inventory, short term investments,
bills receivable, cash and bank balance, etc. Non-current assets, on the other
hand, are the assets which generally cannot be converted to cash within 12
months and are normally used to run the business. These include fixed assets,
such as equipment used in the running of the business, furniture and fixtures
and also any real estate the business owns. Non-current assets also include
long term investments made by business and intangible assets such as
goodwill etc.
Liabilities are obligations the business owes to outsiders. They are also
divided into current liabilities and non-current liabilities. Current liabilities
92 are obligations that are scheduled to be paid within a span of 12 months.
Most common current liabilities include accounts payable, business line of Financial Statements
credit, current instalment of a long-term debt, provisions etc. Non-current
liabilities are long-term liabilities that are usually paid in more than one year.
Usually, such long-term liabilities include debentures and bonds, borrowings
from financial institutions and banks. The borrowings can either be secured
or unsecured.

Owners’ Equity represents the owners’ residual interest in the assets of a

company, net of its liabilities i.e. OWNERS’ EQUITY = ASSETS –
LIABILITIES. It is also referred to as net worth of the business. In other
words, owner’s equity is everything that is left from the assets after paying all
the liabilities. It consists of the capital contributed by owners and retained
earnings of the business. We will discuss the constitution of retained
earnings later in this chapter. Hence, the amount of equity is increased by
profits earned during the year, or by the issuance of new equity. On the other
hand, equity is decreased by financial losses, dividend payments, etc.

Assets, liabilities and capital accounts are sub-categorised in a balance sheet

on the basis of their liquidity and to present a more meaningful and useful
view of the financial position of business. Whatever system of classification
is used should be applied on a consistent basis, so that balance sheet
information is comparable over multiple reporting periods. Common
classifications used in a balance sheet are discussed as follows:

3.9.1 Current Assets

A current asset is an item on an entity's balance sheet that is either cash, cash
equivalent, or an asset which can be normally converted into cash within the
operating cycle of business, or within one year. whichever is shorter. An
operating cycle is the duration of time it takes for a business to convert its
inventory into cash. It includes the time taken in acquiring inventory,
converting inventory to sales and then recovering cash from trade
receivables. The operating cycle starts with cash and ends with the collection
of cash. Length of an entity’s operating cycle is an indicator of its liquidity
position and asset-utilization. Common examples of current assets are listed
below in order of their relative liquidity:

 Cash and cash equivalents

 Short term investments (ex: Marketable Securities)
 Accounts Receivable
 Inventory
 Prepaid Expenses

Cash and cash equivalents

Cash refers to the currency, cheques or any other document that circulates as
cash. It includes the cash kept in the cash chest of business and also the
deposits made in current accounts with banks. Further, cash equivalents are
the highly liquid investments that are readily convertible into cash and are
subject to insignificant risk of change in price. Examples include Cash and
Paper Money, Treasury bills, Money Market funds, etc. Cash and cash
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Accounting: An equivalents are the most liquid form of current assets available for a firm's
Overview
day-to-day operations.

Short-term investments
It is advisable to invest excess cash held by a firm to generate additional
income. It may be invested in financial instruments that can be quickly
converted into cash like equity shares, debentures and government securities.
These assets are readily marketable and could be sold whenever cash is
required. They are classified as current assets as these investments tend to
mature within a year or less.

Accounts Receivable
Usually, a business entity sells its goods and services both in cash as well as
on credit. Accounts receivable refers to the balance of money due to a
business entity for the sales made on credit to its customers. It is also denoted
as sundry debtors in the balance sheet. It represents the amount arising out
of normal business transactions such as credit sales and the credit period
usually ranges from few days to months. In most situations these accounts are
unsecured and have only the personal security of the customer. In some
cases, customers default and the payment may not be realised. These defaults
in payment by debtors are called bad debts. Bad debts are recorded as an
expense in the Profit and Loss account.

Inventory
Inventory generally consists of raw materials required to manufacture the
products, unfinished goods at various stages of completion i.e., work in
progress and finished goods i.e., goods ready for sale. Apart from these, there
may be inventory of stores and supplies. Thus, we have raw material
inventory, work in progress inventory, finished goods inventory and stores
and supplies inventory. It is also commonly referred to as stock-in-trade. It
may be noted that the type of inventory may vary depending on the nature of
business. For example, a manufacturing firm will have a combination of raw
material, unfinished goods and finished goods as inventory, but for a trading
firm, inventory will usually include finished goods available for sale.
As a general principle, inventory is valued at cost. It implies that all normal
costs incurred to make the goods available at the place where it can be sold or
used are treated as costs of inventory.
Prepaid Expenses
Prepaid expenses are items which are usually paid in advance such as rent,
taxes, insurance etc. For example, if rent for two months of the office
building is paid in advance, then the business acquires a right to occupy the
building for two months. This right to occupy is an asset but will expire
within a fairly short period of time, therefore it is a current asset. Therefore, it
is shown on the asset side of the balance sheet.
Since these expenses are paid in advance, they become due in the next
accounting period. Hence, they are not debited in the Profit and loss account
of the current period.
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3.9.2 Fixed Assets Financial Statements

Fixed assets are tangible, long-term assets used in the business that are of a
relatively fixed nature. These include building and land, furniture, equipment,
machinery etc. Fixed assets are not expected to be consumed or converted
into cash within a year, instead they are used in running business operations
to generate income. The useful life of fixed assets is more than one year and
they are capable of repeated use. Valuation of the fixed assets is usually made
on the basis of original cost. However, the assets have a limited useful life
and their value decreases over time due to use, wear and tear or obsolescence.
Thus, valuation of the asset is reduced proportionate to the expired life of the
asset. Such decrease in cost is referred to as depreciation in accounting. The
conceptual basis could be clarified with an example.

Suppose a manufacturing business firm buys machinery at a cost of Rs.

10,00,000. It is assumed that the machinery will have a useful life of 10 years
after which it will be discarded as scrap. Therefore, the depreciation on
machinery will be spread out across its useful life of 10 years. The method of
calculating depreciation may vary. Two most commonly used methods are:
straight line and written down value.

Under straight line method, depreciation is evenly distributed across the

useful life of asset. Hence, after the end of each year the machinery will
depreciate by Rs. 1,00,000 (i.e. Rs. 10,00,000/10). And at the end of 10th
year, the book value of machinery will depreciate to 0. Now let’s assume, at
the end of its useful life of 10 years, the machinery would be sold as scrap for
approximately Rs. 50,000. Therefore, the depreciation for each year will be
calculated as follows: Rs. (10,00,000 50,000)/10 = Rs. 95,000.

Under the written down value method, depreciation is calculated each year as
a fixed percentage of the written down value of the asset. The written down
value is the remaining value of the asset at the end of each year after reducing
accumulated depreciation from original cost. For example, machinery
purchased for Rs. 10,00,000, has a useful life of 10 years and the depreciation
will be provided @10% p.a. at written down value. The depreciation will be
calculated as follows:

Cost of Machinery at the beginning of 1st year Rs. 10,00,000

Depreciation at the end of 1st year Rs. 10,00,000 * 10% i.e. Rs. 1,00,000

Cost of Machinery at the beginning of 2nd year Rs. 9,00,000

Depreciation at the end of 2nd year Rs. 9,00,000 * 10% i.e. Rs. 90,000

Cost of Machinery at the end of 2nd year Rs. 8,10,000

The process of providing depreciation for each year will continue like this till
the end of useful life of the asset. The value of fixed assets net of
depreciation is referred to as net book value.
Hence, under the written down value method, the amount of depreciation will
reduce with each passing year as the value of the fixed asset keeps decreasing
95
Accounting: An over its useful life. Whereas, under straight line method, equal amount of
Overview
depreciation is allocated to each useful year.

Fixed assets normally include assets such as land, building, plant, machinery
and motor vehicles. All these items, with the exception of land, are
depreciated. Land is not subject to depreciation and hence shown separately
from other fixed assets.

3.9.3 Intangible Assets

Intangible assets are the resources or things of value that have no physical
appearance and are valuable to the business in the long run. They cannot be
touched or seen but represent an intrinsic value without any material being.
Some common examples of intangible assets include goodwill, customer
relationships, intellectual property such as trademarks, patents, copyrights
etc. However, they are only recorded in the accounting books when they are
purchased from outside. They are shown in the assets side of the balance
sheet and have a useful life of more than one year. As they provide value to
the business in the long run, the cost of their acquisition expires over such
useful life. Hence, they are amortized over their useful life. Amortization is
similar to depreciation, with the intent of gradually reducing the book value
of the asset to zero by accounting for the gradual consumption of the asset.

Some intangible assets might have an indefinite life too, such as goodwill.
Goodwill arises when a business firm acquires another business firm and the
cost of its purchase is higher than the fair market value of the business. It
happens because the acquired business firm has established a popular brand
name, or solid customer base, good customer relations, etc. Hence, the excess
purchase price paid over the fair market value of the acquired business firm is
termed as goodwill. When the intangible asset has an indeterminate life, it is
not amortized but is periodically tested to see if the recorded cost of the asset
has been impaired.

Fictitious Assets
As the name suggests, fictitious assets are not actually assets. Yet they appear
in the asset side simply because of a debit balance in a particular account has
not been completely written off. For example, preliminary expenditure of the
company, promotional capital expenditure etc.

3.9.4 Current Liabilities

Current liabilities are the short-term financial obligations of a business entity
which are due for payment within the operating cycle of the business or
within one year, whichever is less. These are usually incurred when the raw
materials or services are purchased on credit. Current liabilities are settled
either by using current assets or by the creation of other current liabilities.
The ratio of current assets to current liabilities is known as current ratio/
liquid ratio and it helps in determining whether a business entity is able to
pay all its short-term debts. Common examples of current liabilities include
of sundry creditors, bills payable, bank overdraft, outstanding expenses,

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income received in advance, provision for income-tax etc. Let us discuss Financial Statements
some important current liabilities of a business entity.

Accounts Payable
Accounts payable represent the sum of money owed by a business entity to
its suppliers or creditors, usually for the goods or services supplied on credit.
These are the monetary obligations of an organisation arising in a short run.
Generally, such claims are unsecured.

When the business entity gives a written promise to pay money to a creditor
for the purchase of goods or services used in the business or the money
borrowed, then the written promise is called as bills payable or notes payable.

Outstanding Expenses
Outstanding refers to ‘due but not paid’. These expenses become due during
the current accounting and hence, are shown as an expense in the Profit and
Loss account. However, as the actual cash payment of these expenses are yet
to be done, they are also shown as a current liability in the balance sheet.

For example, the rent of building becomes due for the month of March 2021
but is paid in May 2021. Assuming the accounting period ended on 31st
March 2021, the rent of building for the month of March 2021 will be shown
as an outstanding rent in the balance sheet as on 31st March 2021.

Income Received in Advance

It is the amount received in the current accounting period but which is due to
be received in the next accounting period. Since it is not recognised as
income in the current accounting period, it is treated as a current liability in
the balance sheet until it becomes due.

Provision For Taxes

Every business entity is liable to pay taxes to the government on its earnings.
However, taxes are not necessarily paid on the end date of an accounting
period. The due date for payment of taxes usually lies in the next financial
year. Hence, a business entity creates a provision for current financial year’s
taxes to be paid. The provision is reduced when the actual payment of taxes is
done out of it.

It is shown as an expense in the P&L account and as a current liability in the

balance sheet until the taxes are paid.

3.9.5 Long Term Liabilities (Non-Current Liabilities)

Long term liabilities are the financial obligations of the firm which are not
paid off in the current operating cycle or current accounting period. These
liabilities do not become due for payment within one year. The financial
obligation in case of long-term debt lasts for more than a year. They are
classified as secured loans or unsecured loans. When a long-term loan is
obtained against the security (collateral) of fixed assets owned by the entity,
it is called as secured loan. On the other hand, an unsecured loan is not
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Accounting: An secured by any collateral. Usually, long-term liabilities include debentures
Overview
and bonds, borrowings from financial institutions and banks, etc.

CONTINGENT LIABILITIES
The literal meaning of the term ‘contingent’ is ‘subject to chance’.
Contingent liabilities are those liabilities that may arise depending on an
uncertain future event. Until then, both the occurrence and amount of the
liability are uncertain. If the event happens, there is a liability, otherwise
there is no liability at all. Therefore, they are not recorded in the balance
sheet but are required to be disclosed as footnotes to the balance sheet to
provide a fair view about the affairs of the business to the users.

Contingent liability can be defined as, a possible obligation that arises from
past events and the existence of which will be confirmed only by occurrence
or non-occurrence of one or more uncertain future events not wholly within
the control of the enterprise.

A good example of contingent liability is a legal suit contested against the

business entity for financial claim. If the case is decided against the entity,
the liability arises and in the case of favourable decision, no liability will
arise. Hence, it is shown as a contingent liability in the foot-notes of the
balance sheet.

3.9.6 Capital or Owners’ Equity

Ordinarily in a sole proprietorship firm, the owners’ equity constitutes the
capital contributed by the owner into the business. However, in case of a
company the owner's equity section of the balance sheet is divided into two
parts: (1) the share capital representing contributed capital and (2) reserves
and surplus representing retained earnings. The share capital is the capital
contribution by the shareholders or owners. In case of a company, share
capital is the joint stock predetermined at the time of registration which is
known as the authorised capital. It may consist of either equity share capital
or preference share capital (having preferential right to fixed dividend and
repayment of capital at the time of liquidation), or both. The share capital is
divided into equal units or shares. The authorised capital need not all be
raised at one time. That part of authorised capital which is issued for
subscription by the company is referred to as the issued capital.

Equity Share Capital and Preference Share Capital

Equity share capital is also called as the residual capital as the equity
shareholders have the residual claims against assets of the company at the
time of liquidation, after all the claims of creditors and preference
shareholders have been met. Ordinary shares or equity shares have no
preferential rights with respect to either repayment of capital or distribution
of profits. However, equity shareholders possess the voting rights in the
decision making of the company. The dividend distribution to equity
shareholders depends upon the profits earned by the company during a
particular accounting period Equity shares are not redeemable.

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Preference shares, on the other hand, are so called because they have some Financial Statements
preferences over the equity shares. These preferences relate to repayment of
capital and payment of dividend. In the event of liquidation of the company,
remaining assets after the payments to creditors, are first distributed to
preference shareholders and lastly to equity shareholders. Similarly, in the
event of dividend distribution, the preference shareholders are paid first at a
pre-fixed dividend rate. Preference shares could also be made redeemable
after a specified period.

Reserves and Surplus

Reserves and surplus are the accumulated earnings of a business entity
retained over a period of time and not distributed amongst shareholders as
dividends. In other words, when a firm starts its operations, it has no retained
earnings. Reserves and surplus normally arise out of profitable operations.
Loss incurred by a firm reduces its reserves and surplus. Let’s say, if a
business firm earns a profit of Rs. 1,00,000 in the first year and decides to
distribute Rs. 40,000 as dividends, the reserves and surplus at the end of the
year will be Rs. 60,000. Now, in its second year of operation, if the firm
makes a loss of Rs. 25,000 then the retained earnings at the end of the 2nd
year will be Rs. 35,000. Retained earnings (or reserves and surplus) are in the
nature of earned capital for the firm.

In some cases, some part of reserves and surplus can be allocated for specific
purposes. These are called as specific reserves. Specific reserves can neither
be distributed nor be used for any purpose other than specified. Only non-
earmarked or free reserves are available for distribution as dividends.

Activity 3.5
1. Fill in the blanks

a) Balance sheet items are classified and listed according to their

relative __________.
b) The accounting concept that requires financial statements to reflect
the assumption that the business will continue operating indefinitely,
is called the __________.
c) Individuals or organizations entitled to receive payments from a
company are called ________.
d) The residual interest in the assets of an entity that remains after
deducting its liabilities is called ___________.
e) Expiration of cost of intangible assets is referred to as __________.
f) Contingent liabilities are shown in the ___________ of Balance
sheet.

2. State three different kinds of transactions that result in decrease in capital

or owner’s equity.

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Accounting: An SUMMARISING THE POSITION STATEMENT (BALANCE SHEET)
Overview
After learning about balance sheet, we observe that it is one of the most
crucial financial statements as it reflects the financial position of the business
and aids decision making process of stakeholders. It is a periodic summary of
assets, liabilities and owners' capital as of a particular point in time. This
statement in itself does not reveal anything about the details of operations of
the business. However, a comparison of two balance sheets could reveal the
changes in financial position of the business. A holistic understanding of the
operations of the business would require an analysis of two other statements-
Income Statement (Profit and Loss) and Cash Flow Statement. We shall read
about income statement in the next section.

3.10 RELATIONSHIP BETWEEN INCOME

STATEMENT AND POSITION STATEMENT
The income statement mainly determines four elements namely revenue,
expense, income (profit) or loss. Profit is reported when revenue exceeds
expenses. Whereas, when expenses exceed revenue, loss is booked. It should
be noted that the revenue and expenses must relate to a specific accounting
period to determine the profit or loss of that particular period. Now, let us
recall the fundamental balance sheet equation discussed in the previous
section:

ASSETS = LIABILTIES + OWNERS’ EQUITY

Here, owners’ equity signifies the net worth of the business, and constitutes
of the capital contributed by the owners and earnings retained in the business
at the end of each accounting period. Hence,

OWNERS’ EQUITY = SHARE CAPITAL + RETAINED EARNINGS

The retained earnings shown in the equation above is nothing but the profits
earned by the business. These are the profits accumulated by business over
the years. Hence, each year’s profit is clubbed into retained earnings and
shown in the balance sheet as a part of owners’ equity. Similarly, if a
business incurs loss in an accounting period, retained earnings will be
negatively impacted in that year. Thus, we find that profit and loss account is
an integral part of any balance sheet in that it is an expansion of one of the
terms of the balance sheet.

3.11 SUMMARY
The process of accounting aims at providing the financial information about
the business entity to the users with the help of financial statements. Financial
statements are the formal end reports that summarise the business operations
and transactions conducted in a financial year. These statements are prepared
as per the accounting principles to generate systematic and consistent results.
They are useful indicators of the financial health of a business entity at a
particular point of time. It is vital to present the financial statements in a
100 proper form with suitable contents so that the shareholders and other users of
financial statements can easily understand and use them in their economic Financial Statements
decisions in a meaningful way.

There are three main financial statements of a business entity: the Balance
Sheet (position statement) as at the end of accounting period, the Statement
of Profit & Loss (income statement) and the Cash Flow Statement.

The profit and loss account summarises the revenues and expenses of an
accounting period and shows the net profit/loss generated by the company.
The net profit after payment of dividends shows the amount of retained
earnings and hence links the profit and loss account with balance sheet.

Balance sheet is a periodic summary of the position of business. It is the

statement of assets, liabilities and owner’s capital at a particular point of
time. This statement in itself does not reveal much about the operations of the
business, but comparison of balance sheets over a period of time could reveal
changes in business position. Realistic understanding of business operations
require reading and linking of all the three financial statements mentioned
above.

3.12 KEY WORDS

Asset: Any tangible or intangible resource of monetary value that provides
economic benefits to a business entity.

Liability: An amount owed by the business entity (the debtor) to an outsider

to the business (the creditor). It can be long-term (non-current) or short-term
(current).

Current Asset: A current asset is an asset which can be normally converted

into cash within the operating cycle of business, or within one year.
whichever is shorter.

Current Liabilities: Current liabilities are the short-term financial

obligations of a business entity which are due for payment within the
operating cycle of the business or within one year, whichever is less.

Intangible Assets: Intangible assets are the resources or things of value that
have no physical appearance but are valuable to the business in the long run.
Example: goodwill, patents, franchises, copyrights etc.

Contingent Liability: A contingent liability is a potential liability that may

occur in the future, such as pending lawsuits or honouring product warranties.
It becomes a liability only on the happening of an uncertain future event.

Fixed Assets: These are tangible long-term assets having a useful life of
more than one year. They include land, building, plant, machinery, motor
vehicles, furniture and fixtures, etc.

Owner's Equity: It is the owner's claim against the assets of a business

entity. It could be expressed as total assets of an entity less claims of
outsiders or liabilities, includes both contributed capital and retained
earnings.
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Accounting: An Balance Sheet: It is the summary of the balances of the various assets,
Overview
liabilities and capital accounts of a business entity at the end of a particular
accounting period.

Revenue: It is the income generated by a business from both the core

(example: sale of goods or services) and non-core business operations
(example: profit on sale of a fixed asset).

Expense: Expenses refer to the costs incurred by a business firm to generate

revenue during an accounting period.

Realisation: Recognition of the revenue in accounting based on the

assumption that increase in owners' equity arises at the point of sale or
provision of goods or services.

Matching: An accounting principle that states that expenses incurred in an

accounting period should be matched with the revenues of that period.

Accrual: Income measured on the realisation of revenue independent of the

timing of cash receipt and payment.

Cost of goods sold: Direct costs incurred in the production of goods or

services that are sold during an accounting period.

Depreciation: It is the expired cost of a fixed asset due to physical wear and
tear which is recorded as an expense during an accounting period.

Profit/Loss: Revenue minus expenses for a given accounting period.

However, excess of expenses over revenue is termed as loss.

Profit and Loss Account: The final summary of all revenues, gains,
expenses and losses recognised during an accounting period reflected in the
net profit or loss for that period.

3.13 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1. Differentiate between expenditure and an expense. Give suitable
examples.

2. Explain the revenue recognition concept with the help of an example.

3. Write short notes on the following:

a) Operating profit
b) Earnings before interest and tax
c) Contingent liability
d) Retained earnings
e) Depreciation

4. "Fixed assets are physical assets that provide operating capacity for a
number of accounting periods". Explain with the help of suitable
102 examples. Do all fixed assets depreciate?
5. What are bad debts? What is the way to deal with the problem of Financial Statements
expected bad debts in accounting?

6. Given below is the summarised Profit and Loss Account of Athena Ltd.
for three consecutive accounting periods. You are required to fill in the
missing information:

PARTICULARS YEAR 1 YEAR 2 YEAR 3

Sales 10,000 5,000
Cost of goods sold 5,500 2,500 3,000
Gross Profit 2,700
Office and administrative expenses 600 400
Selling and distribution expenses 500 600
Operating Profit 3,500 1,000
Other incomes 2,300 500
Depreciation 300 500
Interest expense 200 100
Net profit before tax 5000 3,000 1,200
Income Tax 200
Net profit after tax 4700 1,050

7. Following are the balances extracted from the books of Pratap Clothing
House on 31st March, 2020 after the income statement for that year had
been prepared and all the relevant adjustments had been made.

Particulars Amount (in

Rs.)
Land and Buildings 1,20,000
Cash in Hand 25,000
Closing inventory 32,000
Plant and Machinery 48,000
Motor car 61,000
Investments 44,000
Accounts Receivable 5,000
Share Capital: 1200 8% Preference Shares of Rs. 100 each 1,20,000
9000 Equity Shares of Rs. 10 each 90,000
9% Debentures 50,000
Provision for Depreciation on Motor Car 3,200
Provision for Depreciation on Plant and Machinery 2,400
Retained Earnings (as on 1st April 2019) 42,000
Accounts Payable 7,500
Bank Overdraft 2,600

You are required to ascertain the net profit of the current period ending
31st March 2020 and prepare a Balance sheet of Pratap Clothing House
as on 31st March 2020. Also classify the balance sheet items under
relevant heads. 103
Accounting: An 8. The following balances are taken from the books of Athena Ltd. As on
Overview
31st March 2021. You are required to prepare a Balance sheet and Profit
and Loss account based on this information.
Depreciation 5,000
Wages 25,000
Purchases of raw material 50,000
Sales 1,00,000
Rent of Building 3,000
Purchase returns 5,000
Sales returns 1,000
Interest expense 2,000
Fire Insurance 2,000
Miscellaneous expenses 5,000
Interest received on deposits 2,000
Cash 15,000
Bank deposits 20,000
Closing stock of inventory 10,000
Buildings 90,000
Land 10,000
Advance tax paid 5,000
Accounts receivable 20,000
Accounts payable 19,500
Long term loan from bank 50,000
Share Capital 75,000
Reserves and Surplus (Net profit) ?
Tax payable @ 20% ?
Also, find the net profit of Athena Ltd for the year ending 31st March 2021
and compute the amount of tax payable @ 20% on profits before tax.

ANSWERS TO ACTIVITIES
Activity 3.4
1. (i) F; (ii) T; (iii) F; (iv) T; (v) T; (vi) F

2. Assets Liabilities Owner’s equity

(i) Increase – No effect – Increase
(ii) Increase – Increase – No effect
(iii) Decrease – Decrease – No effect
(iv) Decrease – No effect – Decrease
Activity 3.5
1. a) liquidity
b) going-concern concept
c) creditors
d) owner’s Equity
e) amortization
f) foot-notes
2. Following transactions would result in the decrease of owner’s equity:
a) Drawings of cash from the business
104
 b) Net loss incurred during an accounting period Financial Statements

c) Loss of a fixed asset because of fire.

Activity 3.1
1. a) Revenue, expenses
b) Revenue, expenses
c) 31st March 2020
d) Revenue
e) next
f) indirect/non-operating expense

Activity 3.2
1.
A B
Raw material Cost of goods sold
Interest received on investments Non-operating revenue
Dividends received from shares Non-operating revenue
Wages to workers Cost of goods sold
Carriage outwards Selling and distribution expenses
Carriage inwards Cost of goods sold
Salary to office staff Administrative expenses
Rent of office Administrative expenses
Power and Fuel Cost of goods sold
Selling agents’ commission Selling and distribution expenses
Audit fee Administrative expenses
Legal fee Non-operating expense
Advertising Selling and distribution expenses
Municipal taxes Non-operating expense
Interest expense on loan Non-operating expense
Provision for Income Tax Non-operating expense
Profit on sale of furniture Non-operating revenue
Sales revenue Operating revenue
Sales discount Selling and distribution expense
Purchase returns Cost of goods sold
2. a) authorised capital
b) land
c) profit and loss account
d) debited
e) an intangible
f) liability
g) salvage value
h) Last in first out (LIFO)
Activity 3.3
1. (i) T; (ii) F; (iii) F; (iv) T; (v) T; (vi) T

105
Accounting: An 2.
Overview
Items IS or BS or Head of classification/account
Both
Sale of services revenue IS Trading account
Office expenses IS P&L Account
Marketing expense IS P&L Account
Factory Fuel and water IS Trading account
charges
Advance salary paid BS Current Assets
Income received in BS Current liability
Advance
Closing Stock Both Trading Account; Current Assets

Outstanding rent Both P&L Account; Current liability

Office equipment BS Fixed Asset
Accounts receivable BS Current Asset
Provision for Taxes Both P&L Account; Current liability
Profit on sale of IS P&L Account
Investments
Preliminary expenses of BS Fictitious Asset
company

3.14 FURTHER READINGS

 Horngren, C.T. and Harrison, W.T., 2017, Financial Accounting,
Prentice Hall: New Delhi (Chapter 1)

 Fraser, L.M. and Ormiston, A., 2013, Understanding Financial

Statements, Prentice Hall: New Delhi (Chapter 2)

 Bhattacharya, S.K. and Dearden, J., 1984, Accounting For Management:

Text and Cases, Vani: New Delhi. (Chapter 3, 10 and 11)

 Hingorani, N.L. and Ramanathan, A.R., 1986, Management Accounting,

Sultan Chand: New Delhi. (Chapter 3).

 Hortagren, C.T., Sundem, G.L. and Jhon, A.E., 2002, Introduction to

Financial Accounting,Prentice Hall:New Delhi (Chapters 2-4)

 Khan M.Y. and Jain P.K., 2013, Cost Accounting and Financial
Management, Tata McGraw Hill (Chapter 3)

 Glautier M.W.E., Underdown, B. and Clark, A.C., 1979, Basic

Accounting Practice, Arnold Hieneman: New Delhi. (Chapters 2-4)

 Meigs, W.B. and Meigs, R.F., 1987, Accounting: The Basis For Business
Decisions (7th Ed.), McGraw-Hill: New York. (Chapters 3 and 4.)

 Raithatha Bapat, Financial Accounting a Managerial Perspective,

McGraw Hill, 2017.

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