PAGE 43

CHAPTER 11

FINANCIAL STATEMENTS

FINANCIAL STATEMENTS/FINAL ACCOUNTS

Financial statements are the systematically organized summary of all the ledger accounts presented in such a manner that it gives detailed information about the financial position and the performance of the enterprise. As seen above, through categorization of Financial Statements into Income & Position Statement, the profit is measured at two levels:

(a) Gross Profit

(b) Net Profit

The profit of the enterprise is obtained through the preparation of Income Statement i.e., Trading and Profit & Loss A/c

The financial position of the business enterprise is judged by measuring the assets, liabilities and capital of the enterprise and the same is communicated to the users of financial statements. Financial position of the enterprise can be known through the preparation of the Position Statement i.e., Balance Sheet.

Diagram: Financial Statements

The diagram on the page shows:

                    FINANCIAL STATEMENTS
                           │
             ┌─────────────┴─────────────┐
             │                           │
       INCOME STATEMENT            POSITION STATEMENT
             │                           │
       ┌─────┴─────┐                     │
       │           │                     │
 TRADING ACCOUNT  PROFIT & LOSS     BALANCE SHEET
       │           │                     │
 GROSS PROFIT    NET PROFIT       POSITION OF ASSETS
                                  & LIABILITIES

Page number: 43

---

PAGE 44

PREPARATION OF FINAL ACCOUNTS

The principal function of final accounts (Trading Account, Profit & Loss Account and the Balance Sheet) is to exhibit truly and fairly the profitability and the financial position of the business to which they relate. In order that these may be properly drawn up, it is essential that a proper record of transactions entered into by the business during a particular accounting period should be maintained.

The BASIC PRINCIPLES in regard to accumulation of accounting period data are:

(i) a distinction should be made between capital and revenue receipts and payments;

(ii) also, income and expenses relating to a period of account should be separated from those of another period.

(iii) different items of income and expenditure should be accumulated under significant heads so as to disclose the sources from which capital has been procured and the nature of liabilities, which are outstanding for payment.

Having regard to these basic principles, the various matters to which attention should be paid for determining the different aspects of transactions, a record of which should be kept, and the different heads of account under which various items of income and expenditure should be accumulated, are stated below:

(a) Distinction between personal and business income: -

Since the final statements of account are intended to show the profitability of the business and not that of its owner, it is essential that all personal income and expenditure should be separated from business income and expenditure.

(b) Distinction between capital and revenue expenditure: -

A distinction should be made between capital and revenue, both receipts and expenditure. Different types of income and expenditure should be classified under separate heads. Assets should be included in the Balance Sheet by following accounting principles and accounting standards. Likewise, a provision for income and expenses which have accrued but not paid, should be made by estimation or otherwise on the same basis as in the previous year.

Page number: 44

---

PAGE 45

(c) All material information to be disclosed: -

Every information, considered material for judging the profitability of the business or its financial position, should be disclosed.

For example, when the labour charges have increased on account of bonus having been paid to workmen, the amount of bonus paid should be disclosed.

Similarly, if some of the items of inventory are not readily saleable, these should be valued at their approximate net realisable value and the basis of valuation and value of such inventory should be shown separately.

(d) Record only current period transactions: -

Though the record of transactions should be maintained continuously, at the end of each accounting period, the transactions of the closing accounting period should be cut off from those of the succeeding period.

(e) Only transactions completed before close of accounts should be given effect: -

It should be seen that only the effect of transactions, which were concluded before the close of period of account, has been adjusted in the accounts of the year.

For example, when a sale of goods is to take place only after the goods have been inspected by the purchaser and the inspection had not been made before the close of the year, it would be incorrect to treat the goods as a sale in the accounts of the year.

Inter-relationship of the two statements

One of the points to be remembered is that of total expenditure incurred some type of expenditure appears in the Profit and Loss Account and some in the Balance Sheet. Consider few examples,

1. Salaries paid is shown on the Dr. side of Profit and Loss Account but outstanding salaries is shown on liabilities side of Balance Sheet and is added to Salaries.

Page number: 45

---

PAGE 46

2. When a machine is purchased, that part of it which is attributable to the year considered as depreciation is debited to the Profit and Loss Account and the balance is shown in the Balance Sheet as an asset.

Illustration 1

The PDF shows the following Profit & Loss A/c:

And the corresponding Balance Sheet:

Illustration 2

The PDF then shows:

Profit & Loss A/c

Balance Sheet

These illustrations show that the two statements, the Profit and Loss Account and the Balance Sheet, are thoroughly inter-related. The assets shown in the Balance Sheet are mostly only the remainder of the expenditure incurred after a suitable amount has been charged to the Profit and Loss Account or the Trading Account.

For preparing the two statements properly, it is of the greatest importance that the amounts to be charged to the Profit and Loss Account should be properly determined as otherwise both statements will show an incorrect position.

The principle that governs this is called the Matching Principle.

Matching Principle

This principle demands that expenses incurred to earn the revenue should be properly matched. This means the following:

Page number: 46

---

PAGE 47

(a)

If a certain revenue and income is entered in the Trading / Profit and Loss Account all the expenses relating to it, whether or not payment has been actually made, should be debited to the Trading / Profit and Loss Account. This is why at the end of the year an entry is passed to bring into account the outstanding expenses.

That is also the reason why the opening inventory of goods is debited to the Trading Account since the relevant sale is credited in the same account.

(b)

If some expense has been incurred but against it sale will take place in the next year or income will be received next year, the expense should not be debited to the current year’s Profit and Loss Account but should be carried forward as an asset and shown in the Balance Sheet.

It will be debited to the Profit and Loss Account only when the relevant income will also be credited.

The same reason applies to depreciation of assets also. The part of the cost which is used to earn current year revenue is debited in same year.

(c)

If an income or revenue is received in the current year but the work against it has to be done and the cost in respect of it has to be incurred next year, i.e. income received in advance the income or the revenue is considered to be of next year.

It should be shown in the Balance Sheet on the liabilities side as “income received in advance” and should be credited to the Profit and Loss Account of the next year.

E.g. Newspapers or magazines usually receive subscriptions in advance for a year. The part of subscription that covers copies to be supplied in the next year is treated as income received in advance.

An exception

There appears to be one exception to the rule that only such costs as have yielded or is expected to yield revenue should only be debited to Profit and Loss Account.

For example, if a fire has occurred and has damaged the firm's property the loss must be debited to the Profit and Loss Account to the extent it is not covered by insurance.

A loss, resulting from the fall of selling price below the cost or from some debts turning bad, must similarly be debited to the Profit and Loss Account.

If this is not done the profit will be over-stated.

YouTube Link for Lecture:

Channel Name:

Lateef’s Commerce Academy

Page number: 47

Visual elements included

This PDF contains important visual material on pages 43 and 46.

Page 43: The Financial Statements flow diagram showing:

Financial Statements → Income Statement / Position Statement → Trading Account / Profit & Loss Account / Balance Sheet → Gross Profit / Net Profit / Position of Assets & Liabilities.

Page 46: Two worked visual illustrations showing how outstanding salaries affect both the Profit & Loss Account and Balance Sheet, and how depreciation is split between the Profit & Loss Account and the Balance Sheet. The figures shown are ₹25,000 + ₹1,500 = ₹26,500 for salaries and ₹5,00,000 − ₹50,000 = ₹4,50,000 for fixed assets after depreciation.