Financial Statements refers to Accounts statements which are finally prepared showing the profit earned or loss suffered (called Profit & Loss A/c) by the firm and the financial state of affairs of the firm at the end of the concerned period (called as Balance Sheet).
Financial Statements are systematically organized summary of all the account heads presented in a manner to give complete information about the financial position and the performance of the enterprise.
Performance of the enterprise is judged on the basis of the income earned or accrued during the year in the form of profit after the adjustments of expenses related to the enterprise and to the income earned or accrued.
Preparation of Financial Statements
The principal function of financial statement of accounts (i.e. Trading Account, Profit and Loss Account and the Balance Sheet) are to exhibit truly and fairly the profitability and the financial position of the business to which they relate.
Basic Principles of preparation of Financial Statements
A distinction be made between capital and revenue, both income and expenditure. Income and expenses relating to a period of account should be separated from those of another period.
All personal Income & expenses must be separated from Business Income & Expenses.
Different items of income and expenditure should be accumulated under significant heads, and to disclose the sources from which capital has been procured and the nature of liabilities, which are outstanding for payment.
Asset should be valued in the same basis as that of previous year. Provision for Income accrued but not received, and for Expenses incurred but not paid, should be made (on actual or estimation), on the same basis as that of previous year.
Every information, considered material for judging the profitability or financial position, must be disclosed. Items (damaged, obsolete etc) which are to be sold below cost, should be shown separately, at their approximate realisable value..
Trading Account is prepared to ascertain the Gross Profit. Gross Profit is the difference between Sales and Cost of goods sold (also called operational Profit).
Cost of Goods sold is computed as [(Opening Stock) + Net Purchases (i.e Purchases – Purchase Returns) – (Closing Stock)]. To it are added direct costs (like Freight / Carriage Inward and other direct expenses attributable to purchase and cost of bringing the goods into stock.
Trading Account is the details of computation of Gross Profit. After arriving at Gross Profit, Financing charges, administrative and selling expenses are charged, to determine the net profit.
However, now a days, many organisations do not prepare Trading Account. They prepare directly Profit & Loss Account, combing all income & expenses into one account
Method of Computation of Gross Profit
Gross Profit : Gross Profit is the excess of net sales (that is, gross sales minus returns from customers) over the Cost of Goods Sold.
Cost of Goods Sold : Cost of goods sold involves an adjustment for stocks on hand. Thus, if in the first year of its existence, a business purchases goods (net, that is after deducting returns to suppliers) to the extent of Rs.1,00,000 and if, at the end of the year, goods worth rs.15,000 are still unsold, the cost of goods sold will be Rs.85,000.
Treatment of Closing Inventory
Usually, no ledger account is maintained to show the value of closing stock lying in godown. So, the Closing Inventory do not appear in Trial Balance. So, to correctly ascertain the gross profit (to compute the cost of goods sold), the following entry is made
Closing Inventory A/c Dr
To Trading Account Cr
Alternatively, Closing Stock may be adjusted with Purchases. In that case, following entry may be passed
Closing Inventory A/c Dr
To Purchases Account Cr
Closing Stock will appear in Trial balance, will not be shown in P L statement, but will appear in Balance Sheet only.
Format of Trading Accounts
Trading Account for the period from xxxxxxx to xxxxxxx
|To Opening Stock||xxx||By Sales||xxx|
|Add: Purchases||xx||Less: Return||xx||xxx|
|xxx||By Closing Stock||xxx|
|To Carriage Inward||xxx|
|To Gas, water, fuel etc.||xxx|
|To Packaging Charges||xxx|
|To Other factory expenses||xxx|
|To Gross Profit. (Bal. fig.)||xxx|
Profit and Loss Account
Profit and Loss Account is prepared to ascertain net profit. Net profit is calculated by deducting other expenses (like general, administrative or selling and distribution expenses) from gross profit.
The Profit and Loss Account starts with the credit from the Trading Account in respect of Gross Profit (or debit if there is Gross Loss).
Thereafter, all those expenses or losses which have not been debited to the Trading Account are debited to the Profit and Loss Account.
If there is any income besides the Gross Profit, it will also be transferred to the credit of the Profit and Loss Account.
Format of Profit & Loss Account
Profit & Loss Account for the period from xxxxxxx to xxxxxxx
|To Salaries To Interest Paid To General Expenses To Depreciation To Legal Expenses To Net Profit||xxx xxx xxx xxx xxx xxx||By Gross Profit b/f (Trading A/c) By Interest Earned By Profit on Sale of Fixed Assets||xxx xxx xxx|
A Balance Sheet shows the financial position of a business by detailing the assets and liabilities, standing as on a specified date, grouped, properly classified and arranged in a specific manner.
Fixed assets are shown at historical cost depreciated up-to-date. It does not reflect the true value of these assets. Intangible assets are shown in the Balance Sheet at book values which may bear no relationship to market values.
Sometimes, Balance Sheet contains some assets such as preliminary expenses, debenture discount, etc, which do not reflect any value. The inclusion of these assets unduly inflates the total value of assets, and confuses ordinary persons who do not understand the technical implication of such figures.
The Balance Sheet does not reflect the value of factors like managerial skill. Value of many current assets are based on some estimates, so it cannot reflect the true financial position of the business.
Formats of Balance Sheet : A Balance Sheet may be prepared in 2 formats. Horizontal (Traditional) format and Vertical format.
- Horizontal Format : The horizontal formats distinctly shows all elements of Assets & Liabilities, without considering the time factor.
- Vertical Format : Vertical Format lays on stress on time factor. Current Assets & Current Liabilities are grouped separately and the Working Capital is computed from total of Current Assets & Current Liabilities
Order of Items in Balance Sheet : As per normal practice, the Items in Liabilities & Assets side appear in following orders:
- Liabilities : Items of Liabilities are according to the order of payments. So, these are arranged in sequence of Capital, Reserves, Long Term Liabilities, Short Term / Current Liabilities
- Assets : Asserts are normally arranged as per permanence. So, the order preferred is Goodwill, Patents, Land, Building, Furniture, Machinery, Investments, Semi Finished Stock, Raw Materials, Finished Goods, Trade Receivables, Cash at bank, Cash in Hand.
However, some prefer just the reverse order.
Balance Sheet in Horizontal Format
In Balance Sheet in horizontal format, the left hand side lists liabilities of the business as on the last day of the accounting period as well as details of its capital and on the right hand side are listed various assets of the enterprise.
Balance Sheet as on ….
Liabilities Rs. Assets Rs.
Capital xxx Land and Building xxx
Reserve and Surplus xxx Plant and Machinery xxx
Outstanding Expenses xxx Furniture and Fixtures xxx
Loans xxx Other Investments xxx
Trade Creditors xxx Government Securities xxx
Bills Payable xxx Sundry Debtors xxx
Bills Receivables xxx
Cash at Bank xxx
Cash in Hand xxx
Total xxx xxx
Balance Sheet in Vertical Format
The Balance Sheet in Vertical Format displays the net worth of the business to the owner, showing the details fixed assets, current assets and working capital.
Balance Sheet As on ….
Rs. Rs. Rs.
Plant and Machinery 3,00,000
Delivery Van 2,00,000 12,00,000
Bills Receivable 50,000
Cash at Bank 30,000
Cash in Hand 20,000 5,00,000
Creditors – 1,00,000
Bills Payable – 50,000
Outstanding Expenses 50,000 2,00,000
Working Capital: 3,00,000
NET ASSETS EMPLOYED 15,00,000
Add: Net Profit 1,30,000 15,00,000
Profit and Loss Account vs Balance Sheet
Profit and Loss Account provides a ‘historical’ review of the accounts of the past transactions while the Balance Sheet gives a ‘static’ picture of the financial position as on the last day of the accounting period.
Profit and Loss Account itself is an account whereas a Balance Sheet is a statement of Assets and Liabilities.
- Profit and Loss Account is a link in the Balance Sheet at the beginning and end the of the Financial Accounting Period.
- The Profit and Loss Account and the Balance Sheet are the two technical instruments used in reporting the division of costs incurred between the present and future accounting periods.
- The Profit and Loss Account shows the division of costs assigned to current period, while the Balance Sheet exhibits the costs incurred which may reasonably be applicable to future years. The Balance Sheet thus serves as a means of carrying forward unexpired acquisition costs of assets.
- So, Balance Sheet can be described as a summary of residual transactions that results from the Profit and Loss Account transactions.
- Profit and Loss Account shows the profit earned or losses incurred for the accounting period whereas the Balance Sheet shows the financial position of the business.
- Profit and Loss Account is prepared for the accounting period ended whereas a Balance Sheet is prepared as at the last day of the accounting period.
- The accounts that are transferred to the Profit and Loss Account are closed and no balance is carried to next accounting period. But the accounts that are transferred to the Balance Sheet carry the balances as opening balances for the next period.
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