FINANCIAL ACCOUNTING: MODULE - 3

PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS

THEORY SHEET

Background:

Sole trader A person trading on his own. He controls, manages and

("self- owns the business.
employed") Legally, the person and the business are one and the same.
All financial risks are taken by the sole trader and all of the
sole trader's assets are at risk.

Partnership A business owned and run by two or more people with a

("self- common view to making a profit.
employed") Profits are usually shared according to a written agreement.

Sole Trader
Obligations to Keep Records
A sole trader needs to keep careful records to:
a) Define personal transactions (e.g. taking goods from inventory for own
use); and
b) Distinguish between and apportion business and private use of assets
(e.g. if working from home or using own car for work purposes).
Liabilities
A sole trader is completely liable for any debts or legal compensation for
which the business becomes liable. Without adequate insurance a sole trader
could lose everything.

Advantages:
a) Almost complete control over how the business is run. A sole trader
can make decisions (as long as they are legal) without interference.
b) Low administrative costs.
c) No legal requirements (apart from keeping records for tax purposes).

Disadvantage:
All personal assets are at risk if the business fails. Personal bankruptcy can
occur.

Partnership:
Obligations
Same as for a sole trader.

Liabilities:

1
Same as for a sole trader.
However, although profits may be shared unequally (by agreement),
liabilities which may arise are shared jointly.

Advantages:
a) Often more money can be raised to start the business and more
expertise and skills can be brought in if more than one person is
involved.
b) No legal requirements other than keeping records for tax purposes.
c) The workload can be shared.

Disadvantages:
a) All personal assets of each partner are at risk if the business fails.
Personal bankruptcy can occur.
b) Decisions are taken jointly. Although the partnership agreement may
specify different levels of decision-making for each partner, the
decision-making process may be hampered (e.g. in stalemate
situations).
c) A partnership is a very risky type of business to get involved in
because of the potential for conflict, and the financial effect which
conflict between partners can have on the business.*

Introduction to Financial Statement: After having checked the accuracy

of the books of accounts through preparation of Trial Balance, businessman
wants to ascertain the profit earned or loss suffered during the year and the
financial position of his business at the end of the year. For this purpose he
prepares ‘Final Accounts’ which are also termed as ‘Financial Statements’.

Meaning: A financial statement is any report summarising the financial

condition or financial results of a business on any date or for any period.

Components of Financial Statements:

Statement of financial position (also called balance sheet): a
statement of assets and liabilities at a given point in time.
Statement of profit or loss: a summary of transactions and events over a
period of time. It includes:
Statement of changes in equity: a statement to explain changes in
equity over a period.
Statement of cash flows: a report on cash flow activities classified
between operating, investing and financing activities.
Accounting policies and explanatory notes: these are usually included
because the financial statements are often too complex to understand
without additional details.

Purpose
To provide information about:

2
 a) Financial position (e.g. solvency) - Statement of financial position
b) Financial performance (e.g. profitability) - Statement of profit or loss
c) Cash flows - Statement of cash flows
d) Financial statements also show the results of management's
stewardship (i.e. management's accountability for the resources
entrusted to it).
e) To meet this objective of stewardship, financial statements provide
information about:*
Assets
Liabilities
Equity
Revenue and expenses
Cash flows

The statement of financial position is a statement, at a particular date, of

the book value or carrying amount (i.e. the amount which is carried in the
books) of all of an entity's:*
a) assets (resources controlled);
b) liabilities (obligations owed); and
c) owners' capital or equity (the difference between assets and liabilities).
The statement is usually presented in a vertical format and all items
recorded have a monetary value attributed to them.

Pro Forma Statement

The following pro forma statement of financial position is suitable for a sole
trader.*
Points to note:
a) It is dated at the point in time at which it is stated.
b) Items are classified in general order of liquidity (i.e. relative ease of
conversion into cash). The accounts can be organised from most liquid
to least liquid or from least liquid to most liquid (as shown in the
following table).
c) The three main elements are:
i) assets, classified as current and non-current;
ii) liabilities, classified as current and non-current; and
iii) capital (also called equity).

STATEMENT OF FINANCIAL POSITION AS AT ………….

PARTICULARS CURRENT PREVIOUS
YEAR YEAR
EQUITY AND LIABILITIES:

Equity and Reserves

Non-current Liabilities:

3
Current Liabilities:

TOTAL

ASSETS

Non-current Assets:

Current Assets

TOTAL

Liabilities:
A liability is a financial obligation, or the cash outlay which must be made at
a specific time to satisfy the contractual terms of such an obligation.
a) Liabilities imply legal responsibilities to other parties.
b) Liabilities are categorised by time as "current" and "noncurrent" (i.e.
short and long term).

Non-current Liabilities
Entities are frequently financed by credit obtained from sources other than
the owners (e.g. interest-bearing loans). For example, a five-year loan
received in 2015 which is due to be totally repaid in 2020 will be a non-
current liability in 2015–2018 statements of financial position. (It will be
reclassified as current in the year 2019 statement of financial position.)

Current Liabilities:
Current liabilities are amounts owed by the business falling due for payment
within one year of the end of the reporting period. For example, amounts
due to suppliers for goods purchased on credit are trade payables.

Asset— an economic resource controlled by an entity which is expected to

have future economic benefits and is the result of a past financial
transaction.

Non-current Assets:
They are also called fixed assets. Non-current assets are:
a) tangible (i.e. physical objects such as buildings, equipment, vehicles);
or
b) intangible (i.e. without physical substance, but possessing rights to
monetary values, such as trademarks).
Typically cost will be the monetary purchase price.
With few exceptions, such as land, assets become less valuable over time.
Wearing out of a tangible asset is called depreciation (called amortisation for
an intangible asset).

4
Investments:
Usually shares in other entities.
May be classified as non-current (if held on a continuing basis) or current.
Listed investments are those quoted on a recognised stock exchange.

Current Assets:
These are assets which will be converted into cash in the ordinary course of
business.
Therefore, it is expected that they will be held for less than one year.
They are usually listed in the statement of financial position in the order in
which they can be turned into cash most easily (i.e. increasing or decreasing
liquidity order).
With respect to conversion into cash:
a) inventory takes the longest time;
b) receivables are fairly liquid and take less time; and
c) cash is cash.

Inventory:
The type of inventory held by a business will depend on the type of business.
Type of Types of Inventory
Business
Retailer Goods for resale
Manufacturer Raw materials, Work in progress (WIP) such as half finished
cars on a production line, Finished goods (e.g. cars
completed but not yet distributed to garage outlets)
Service WIP (e.g. labour and overheads for accounting services not
industry (e.g. yet billed to clients).
accountancy)
Inventory should be measured at the lower of:
a) cost (i.e. its purchase price or manufacturing cost); AND
b) Net realisable value (estimated selling price less any further costs
incurred).
Statement of Profit or Loss:
This statement comprises:
a) a trading account summarising trading transactions
(Revenue – Cost of sales = Gross profit); and
b) a profit and loss account (also called income and expenditure account)
for all other items of income and expenditure legitimately earned as a
result of business activities.
It shows the profit or loss for the period after taking account of all items of
expenditure.

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED ……….

5
PARTICULARS CURREN PREVIOU
T YEAR S YEAR
Revenue (Sales – Sales Returns) XXX
Less: Cost of Sales:
Opening Inventory XXX
Add: Purchases XXX
Less: Closing Inventory (XXX)
XXX
Add: Other Direct Expenses XXX
XXX
GROSS PROFIT XXX
Add: Other Income XXX

Less: Expenses: XXX

PROFIT OR LOSS FOR THE PERIOD XXX

Revenue—income is derived from the main trading activities.

Revenue reflects all sales made to customers in the year, regardless of
whether or not they have been paid for.
A sale is usually recognised as taking place when goods are despatched (or
services provided) to a customer.
Sales made to customers on credit which have not been settled for cash at
the end of the reporting period are shown in the statement of financial
position as trade receivables (i.e. an asset).
Cost of sales—the cost of goods actually sold. The cost of goods available
for sale during the period (i.e. opening inventory and purchases) less the
cost of goods not sold (closing inventory).
This is the cost of goods actually sold. It includes all the costs connected with
the purchase and manufacture of goods. Costs incurred are matched with
revenues earned.
Other income— income other than that derived from trading activities (e.g.
Interest/ dividends /rental income).
Expenses—costs incurred incidental to the direct costs of goods sold.
Expenses may be classified "by function" (as shown here) or "by nature".
Gross profit—this is calculated in the trading account and is the excess of
sales over the cost of goods sold during the period.
Gross profit margin, a common measure of a company's profitability, is
calculated as:
Gross Profit/ Net Sales * 100%
Profit or loss—this is calculated in the profit and loss account and is what
remains after all other costs incurred in the period have been deducted from
the gross profit. The statement of profit or loss is a formal presentation of
the trading and profit and loss accounts.
Treatment of some important adjustments:

6
Outstanding Expenses or Expenses due but Add to the relevant expenses
not paid and show it under current
liability in the Balance Sheet.

7
Prepaid Expenses or Unexpired Expenses Deduct it from the relevant
or Expenses paid in advance expenses and show it under
current assets in the Balance
Sheet.
Depreciation or Amortisation Deduct it from the relevant
asset and show it under
expenses in the Income
Statement.
Accrued Income or Income Receivable Add it to the relevant income
and show it under current asset
in the Balance Sheet.
Unearned Income or Income Received in Deduct it from the relevant
Advance income and show it under
current liability in the Balance
Sheet.
Interest on Capital Add it to Capital and charge it
to income statement in case of
a sole trader.
Add it to Capital and debit it to
profit and loss appropriation
account in case of partnership
firm.
Interest on Drawings Deduct it from capital and show
it under other income in case of
a sole trader.
Deduct it from capital and
credit it to profit and loss
appropriation account in case
of partnership firm.
Interest on loan taken Charge it to Income Statement
as an expense and show it
under Current liability in the
Balance Sheet.
Interest on loan given Show it under other income in
the income statement and
under current asset in the
Balance Sheet.
Bad Debts Charge it to Income Statement
as an expense and deduct it
from trade receivables in the
Balance Sheet.
Provision for bad debts Charge it to Income Statement
as an expense and deduct it
from trade receivables in the
Balance Sheet.

8
Provision for discount on trade receivables Charge it to Income Statement
as an expense and deduct it
from trade receivables in the
Balance Sheet.
Provision for discount on trade payables Show it under other income in
the income statement and
deduct it from trade payables
in the Balance Sheet.
Loss of goods by fire (uninsured) Deduct it from Purchases and
charge it under expenses in the
income statement.
Loss of other assets (Uninsured) Deduct it from the relevant
asset and charge it to income
statement.
Loss of goods by fire (insured and the claim Deduct it from Purchases and
accepted by the insurance company in full) show it under current assets in
the balance sheet.
Loss of Fixed Assets (insured and the claim Deduct it from the relevant
accepted by the insurance company in full) asset and show it under current
asset the claim receivable from
the insurance company.
Loss of goods by fire (insured and the claim Deduct the entire loss from
accepted by the insurance company in Purchases, charge the portion
part) not accepted by the Insurance
Company in the Income
Statement and show the
amount accepted by the
insurance company under
current assets in the balance
sheet.
Loss of other assets by fire (insured and Deduct the entire loss from the
the claim accepted by the insurance relevant asset, charge the
company in part) portion not accepted by the
Insurance Company in the
Income Statement and show
the amount accepted by the
insurance company under
current assets in the balance
sheet.
Charity in the form of goods/ Goods given Deduct it from Purchases and
away as free samples charge it under expenses in the
income statement.
Drawings in goods Deduct it from purchases and
deduct it from capital.
Drawings in cash Deduct it from cash and deduct

9
 it from capital.
Implied interest (on loan given) Show it under other income in
the income statement and
under current asset in the
Balance Sheet.
Implied interest (on loan taken) Charge it to Income Statement
as an expense and show it
under Current liability in the
Balance Sheet.
Unsold inventory lying with the Consignee Same treatment as closing
inventory
Contingent liability Show it in the notes to
accounts.

10