101 Managerial Accounting

Unit II – Basic Concepts – 9 Marks

Meaning of Financial Statements

Financial statements are formal records of the financial activities and position of a business,
organization, or individual. They provide an overview of the financial performance and financial position
over a specific period. The key types of financial statements include:

1. Income Statement (Profit and Loss Statement): This shows a company’s revenues, costs, and
expenses over a specific period, ultimately reflecting its net profit or loss.

2. Balance Sheet: This snapshot of a company’s financial position shows its assets, liabilities, and
shareholders' equity at a specific point in time. It follows the fundamental accounting equation:

Assets = Liabilities + Equity

3. Cash Flow Statement: This outlines the cash inflows and outflows from operating, investing, and
financing activities, helping to assess the company’s liquidity and overall cash health.

4. Statement of Changes in Equity: This provides details about the changes in equity during a
reporting period, showing how profits, dividends, and other adjustments affect the company’s
retained earnings and stockholders' equity.

These statements are used by stakeholders such as investors, creditors, and management to make
informed decisions about the financial health and performance of a company.

Importance and Objectives of Financial Statements

Importance of Financial Statements

The purpose of financial statements is to allow businesses to understand their financial standing. This
provides a summary of previous financial data which can help businesses to make informed decisions.
This data can also inform other individuals or companies which may potentially have a stake in the
business.

1. Investors:
• Evaluate investment opportunities: Assess a company's profitability, growth potential, and risk.
• Make informed buy/sell decisions: Analyze past performance to predict future trends.
2. Creditors:
• Assess creditworthiness: Determine the company's ability to repay loans.
• Set lending terms: Decide on interest rates and loan amounts based on risk.
3. Management:
 • Monitor business performance: Track profitability, identify areas for improvement, and make
strategic decisions.
• Plan for the future: Develop budgets, forecast cash flow, and make investment plans.
4. Government:
• Collect taxes: Determine the company's tax liability.
• Regulate businesses: Ensure compliance with accounting standards and financial reporting
regulations.

Objectives of Financial Statements

Stakeholders of a company heavily rely on financial statements to understand its functioning. They
portray the true state of affairs of the company. Here are some objectives of financial statements:
• These statements show an accurate state of a company’s economic assets and liabilities. External
stakeholders like investors and authorities generally do not possess this information otherwise.
• They help in predicting the extent of a company’s capacity to earn profits. Shareholders and
investors can use this data to make their financial decisions.
• These statements depict the effectiveness of a company’s management. How well a company is
performing depends on its profitability, which these statements show.
• They even help readers of these statements know the accounting policies used in them. This
helps in understanding statements more comprehensively.
• These statements also provide information relating to the company’s cash flows. Investors and
creditors can use this data to predict the company’s liquidity and cash requirements.
• Finally, they explain the social impact of businesses. This is because it shows how the company’s
external factors affect its functioning.

Preparation of Final Accounts of sole proprietary firm

The preparation of final accounts for a sole proprietary firm involves the creation of key financial
statements that summarize the firm’s financial performance and position over a specific period, typically
at the end of the financial year. These include:

1. Trading Account
2. Profit and Loss Account
3. Balance Sheet
4. Closing Entries
5. Manufacturing Account
6. Limitations of Financial Statement

Steps for Preparation of Final Accounts:

1. Trading Account:
The purpose of the trading account is to determine the gross profit or gross loss of the business. It
records all revenues related to the core business activities (sales) and the costs directly associated with
producing the goods sold (cost of goods sold).

Formula for Gross Profit/Loss: Gross Profit/Loss=Sales−Cost of Goods Sold (COGS)

Structure of Trading Account:

Particulars Debit (Dr.) Credit (Cr.)

Opening Stock Opening Stock
Purchases Purchases
Wages Wages
Direct Expenses Direct Expenses
Closing Stock Closing Stock
Sales Sales
Gross Profit Gross Profit

• Sales: Revenue from selling goods or services.

• Purchases: Cost of goods bought for resale.
• Direct Expenses: Expenses directly related to the production of goods, like wages, raw material
costs, etc.
• Stock (Opening/Closing): The value of inventory at the beginning and end of the period.

2. Profit and Loss Account:

The purpose of the profit and loss account is to determine the net profit or net loss of the business by
accounting for operating expenses (indirect costs) such as administrative expenses, selling expenses, and
non-operating income and expenses.

Formula for Net Profit/Loss: Net Profit/Loss=Gross Profit−Operating Expenses

Structure of Profit and Loss Account:

Particulars Debit (Dr.) Credit (Cr.)

Gross Profit Gross Profit
Operating Expenses
- Salaries and Wages Salaries/Wages
- Rent and Rates Rent
- Insurance Insurance
- Depreciation Depreciation
- Other Expenses Other Expenses
 Other Income
- Interest on Capital Interest on Capital

- Commission and Discounts

Net Profit or Net Loss Net Profit/Loss

• Other Income: Income not directly related to business operations (like interest or dividends).
• Operating Expenses: Costs incurred to run the business (salaries, rent, utilities, etc.).

3. Balance Sheet:

The balance sheet provides a snapshot of the firm's financial position at a specific point in time, showing
the assets, liabilities, and equity.

Accounting Equation:

Assets = Liabilities + Owner’s Equity

Structure of Balance Sheet:

Particulars Debit (Dr.) Credit (Cr.)

Assets
- Fixed Assets (Tangible) Fixed Assets
- Current Assets
- Cash/Bank Cash/Bank
- Debtors Debtors
Liabilities
- Creditors Creditors
- Bills Payable Bills Payable
Capital Capital
Net Profit (Transferred
from Profit and Loss Net Profit
Account)

• Fixed Assets: Long-term assets, such as property, equipment, etc.

• Current Assets: Assets that are expected to be converted to cash or consumed within one year
(e.g., inventory, accounts receivable).
• Liabilities: Debts or obligations owed by the business.
• Capital: The owner’s equity in the business, which is calculated as:
Capital=Opening Capital+Net Profit−Drawings
Key Adjustments in Final Accounts:

1. Depreciation: Reduction in the value of fixed assets, usually calculated at a fixed percentage.
2. Outstanding Expenses: Expenses incurred but not yet paid (e.g., wages, utilities).
3. Prepaid Expenses: Expenses paid in advance for future periods.
4. Accrued Income: Income earned but not yet received.
5. Provision for Taxation: Amount set aside for taxes.

Example:

Let’s assume the following simplified details for a sole proprietary firm:

• Sales: ₹500,000
• Purchases: ₹300,000
• Opening Stock: ₹50,000
• Closing Stock: ₹40,000
• Direct Expenses (Wages, etc.): ₹20,000
• Operating Expenses: ₹60,000
• Interest on Capital: ₹10,000
• Owner’s Drawings: ₹30,000
The preparation steps would include:

• Trading Account:
o Calculate Gross Profit = Sales - (Purchases + Opening Stock - Closing Stock + Direct
Expenses)
• Profit and Loss Account:
o Deduct operating expenses from gross profit and account for other income.
• Balance Sheet:
o Adjust capital with net profit and account for liabilities and assets.

This way, final accounts offer a comprehensive picture of the firm’s financial performance and position.