Financial Statements: An Introduction PDF

MODULE - 3 Financial Statement 16 FINANCIAL STATEMENTS : AN...

MODULE - 3 Financial Statement 16 FINANCIAL STATEMENTS : AN Notes INTRODUCTION In the previous lessons you have learnt to record the business transactions in various books of accounts and their posting into ledger. You have also learnt about balancing the account and preparing the trial balance. One of the most important purposes of accounting is to ascertain financial results, i.e., profit or loss of the business operations of a business enterprise after a certain period and financial position on a particular date. For this certain financial statements are prepared which are termed as income statement (i.e. Trading and Profit & Loss Account) to know what the business has earned during a particular period and the Position Statement (i.e. Balance Sheet) to know the financial position of the business enterprise on a particular date. In this lesson you will learn about the financial statements that are prepared by a profit organisations. OBJECTIVES After studying this lesson you will be able to : z explain the meaning and the objectives of preparing financial statements; z classify the financial statements into Trading and Profit & Loss Account and Balance Sheet; z distinguish between capital expenditure and revenue expenditure, capital receipts and revenue receipts; z explain the purpose of preparing Trading Account and Profit and Loss Account; z draw the format of Trading Account and Profit and Loss Account and z prepare the Balance Sheet. Accountancy 45  MODULE - 3 Financial Statements : An Introduction Financial Statement 16.1 FINANCIAL STATEMENTS : MEANING AND OBJECTIVES When a student has studied for a year, he/she wants to know how much he/she has learnt during that period. Similarly, every business enterprise wants to know the result of its activities of a particular period which is generally one year and what is its financial position on a particular date which is at the end of this period. For this, it prepares various statements which are called the financial statements. Notes Financial statements are the statements that are prepared at the end of the accounting period, which is generally one year. These include Income Statement i.e. Trading and Profit & Loss Account and Position statement i.e. Balance Sheet. Objectives of preparing Financial Statements Financial statements are prepared to ascertain the profits earned or losses incurred by a business concern during a specified period and also to ascertain its financial position at the end of that specified period. Financial statements are generally of two types (a) Income Statement which comprises of Trading Account and Profit & Loss Account, and (b) Position Statement i.e., the Balance Sheet. Following are the objectives of preparing financial statements: - 1. Ascertaining the results of business operations : Every businessman wants to know the results of the business operations of his enterprise during a particular period in terms of profits earned or losses incurred. Income statement serves this purpose. 2. Ascertaining the financial position : Financial statements show the financial position of the business concern on a particular date which is generally the last date of the accounting period. Position statement i.e. Balance Sheet is prepared for this purpose. 3. Source of information : Financial statements constitute an important source of information regarding finance of a business unit which helps the finance manager to plan the financial activities of the business and making proper utilisation of the funds. 4. Helps in managerial decision making : The Manager can make comparative study of the profitability of the concern by comparing the results of the current year with the results of the previous years and make his/her managerial decisions accordingly. 46 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement 5. An index of solvency of the concern : Financial statements also show the short term as well as long term solvency of the concern. This helps the business enterprise in borrowing money from bank and other financial institutions and/or buying goods on credit. Importance of Financial Statements i. Pertaining to Finance : The term “financial statement” doesn’t make sense at first. Numbers are for counting while statements need words, so how could these Notes two mix together? But when seen as “money statements,” then suddenly it’s a crucially important matter. ii. Facilitate in Decision Making : Not only is it important for you, but for the management and stockholders as well. It’s important for the management because financial statements speak of the company’s success and competence, whereas stockholders refer to financial statements to know whether or not to invest in a company. In other words, financial statements tell whether the company made or lost money. iii. Showing the Operational Performance : Financial statement hold the secrets of a company. Aside from stating whether the company earns or loses money, they also provide clues on where the mangement might find more resources to boost its revenue. In addition, financial statements reveal a company’s past performance and potential. Capital Expenditure and Revenue Expenditure, Capital Receipts and Revenue Receipts The preparation of Trading Account and Profit and Loss Account requires the knowledge of revenue expenditure, revenue receipts and capital expenditure and capital receipts. The knowledge shall facilitate the classification of revenue items and put them in the Trading account and Profit and Loss Account on one hand and prepare Balance Sheet based on capital items (expenditure as well as receipts) on the other hand. Capital Expenditure refers to the expenditure incurred for acquiring fixed assets or assets which increase the earning capacity of the business. The benefits of capital expenditure to the firm extend to number of years. Examples of capital expenditure are expenditure incurred for acquiring a fixed asset such as building, plant and machinery etc. Revenue expenditure, on the other hand, is an expenditure incurred in the course of normal business transactions of a concern and its benefits are availed of during the same accounting year. Salaries, carriage etc. are examples of revenue expenditure. Accountancy 47  MODULE - 3 Financial Statements : An Introduction Financial Statement There is another category of expenditure called deferred revenue expenditure. These are the expenses incurred during one accounting year but benefits from the same are available wholly or in part in future periods also. These expenditures are otherwise of a revenue nature. Example of deferred revenue expenditure are heavy expenditure on advertisement say for introducing a new product in the market, expenditure incurred on research and development, etc. Notes Difference between Capital Expenditure and Revenue Expenditure Basis of Capital Revenue Difference Expenditure Expenditure 1. Purpose It is incurred for It is incurred for the acquiring fixed assets. maintenance of fixed assets. 2. Earning It increases the earning It helps in maintaining capacity capacity of the business. the earning capacity of the business intact. 3. Periodicity Its benefits are spread Its benefits accrue only in of benefit over a number of years. one accounting year. 4. Placement in It is an item of Balance It is an item of Trading financial Sheet and is shown as and Profit and Loss statements an item of asset. Account and is shown on the debit side of either of the two. 5. Occurrence of It is non-recurring It is usually a recurring expenditure in nature. expenditure. Capital and Revenue Receipts Capital receipts are receipts which do not arise out of normal course of business. Examples of such receipts are sale of fixed assets, and raising of loans etc. Such receipts are not treated as income of the enterprise. Revenue receipts are receipts which arise during the normal course of business, Sale of goods, rent from tenants, dividend received, etc. are some of the examples of revenue receipts. They are the items of incomes of the business entity. 48 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Distinction between Capital Receipts and Revenue Receipts Basis of Capital Receipt Revenue Receipt Difference Source Receipts that do not arise during Receipts that arise during the the normal course of business. normal course of business. Nature These are of capital nature and These are of revenue nature and hence are not treated as items hence are treated as items of Notes of income of the business. income of the business. Occurrence These are of non-recurring These are recurring in nature. in nature. INTEXT QUESTIONS 16.1 I. Classify the following items of expenditure into capital expenditure revenue expenditure and deferred revenue expenditure (i) Amount spent on purchase of machine. (ii) Expenditure incurred on repairs of building. (iii) Heavy expenditure on advertisement to introduce a new product in the market. (iv) Purchase of motor vehicle for business use. II. One important objective of financial statements is to ascertain the results of business operations. List the other objectives of the financial statements: (a)........................................................................................................... (b)........................................................................................................... (c)........................................................................................................... (d)........................................................................................................... 16.2 TRADING ACCOUNT Income statement consists of Trading and Profit and Loss Account. Let us, first study the Trading Account. A business firm either purchases goods from others and sells them or manufactures and sells them to earn profit. These are known as trading activities. A statement is prepared to know the results in terms of profit or loss of these activities. This statement is called Trading Account. Accountancy 49  MODULE - 3 Financial Statements : An Introduction Financial Statement Trading Account is prepared to ascertain the results of the trading activities of the business enterprise. It shows whether the selling of goods purchased or manufactured has earned profit or incurred loss for the business unit. Cost of goods sold is subtracted from the net sales of the business of that accounting year. In case the total sales value exceeds the cost of goods sold, the difference is called Gross Profit. On the other hand, if the cost of goods sold exceeds the total net sales, the difference is Gross Loss. All accounts related to cost of goods sold such as opening stock, net purchases i.e. purchase less returns outward, direct expenses such as wages, carriage inward etc. Notes and closing stock with net sales (i.e. Sales minus Sales returns) are posted to the Trading Account. Then this account is balanced. Credit balance shows the gross profit and debit balance shows the gross loss. It is necessary to understand the meaning of cost of goods sold before preparing Trading Account. Cost of goods sold and gross profit A business enterprise either purchases goods or manufactures goods to sell in the market. Cost of goods sold is computed to know the profit earned (Gross Profit) or loss incurred (Gross Loss) from the trading activities of a business unit for a particular period. Cost of goods sold = the amount of goods purchased + expenses incurred in bringing the goods to the place of sale or expenses incurred on manufacturing the goods (called direct expenses). In case there is a stock of goods to be sold in the beginning of the year or at the end of the year, the cost of goods is calculated as follows : Cost of goods sold = Opening stock + Net purchases + All direct expenses – Closing stock Gross Profit = Net sales – Cost of goods sold Illustration 1 Calculate the cost of goods sold from the following information : ` Opening stock 10000 Closing stock 8000 Purchases 80000 Carriage on purchases 2000 Wages 6600 50 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Solution : Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses (Carriage on Purchases + Wages) – Closing Stock = ` [10,000 + 80,000 + 86,00 (i.e. 2,000 + 6,600) – 8,000] = ` 90600 Illustration 2 Notes Calculate cost of goods sold and gross profit from the following information. Sales ` 62500 Sales Returns ` 500 Opening Stock ` 6400 Purchases ` 32000 Direct Expenses ` 4200 Closing Stock ` 7200 Solution : ` Net sales (Sales-Sales Returns i.e. 62500 – 500) 62000 Less : Cost of goods sold Opening Stock 6400 Add Purchases 32000 Add Direct Expenses 4200 Less : Closing Stock (7200) 35400 Gross Profit 26600 Or Gross profit = Net sales – cost of goods sold = 62000 – 35400 = 26600 Illustration 3 From the following information for the year ending 31st March, 2014 furnished by Mr. Vikram, a trader, calculate cost of goods sold and also calculate Gross Profit/Gross Loss of business. Accountancy 51  MODULE - 3 Financial Statements : An Introduction Financial Statement ` Sales 1,20,000 Purchases 80,000 Octroi 1,600 Carriage on purchases 4,500 Notes Purchase Returns 2,400 Opening Stock 27,600 Closing Stock 32,400 Solution : ` Cost of goods sold : Opening stock 27,600 Add Net Purchases (` 80,000 – ` 2,400) 77,600 Add carriage on Purchases 4,500 Add Octroi 1,600 Cost of goods available for sale 1,11,300 Less closing stock 32,400 Cost of goods sold 78,900 Gross Profit : ` Sales 1,20,000 Less : Cost of goods Sold 78,900 Gross Profit 41,100 Need of Trading Account Trading Account serves the following purposes : 1. Knowledge of Gross Profit : Trading Account gives information about Gross Profit. It is the profit earned by a business enterprise from its trading activities. The percentage of gross profit on sales reflects the degree of success of business. 52 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement 2. Knowledge of All Direct Expenses : All direct expenses are debited to trading Account. Direct expenses are the expenses that can be directly attributed to purchase or manufacturing of goods for sale. Percentage of Direct expenses on sales of current year when compared with the same of previous years, helps the manager to exercise control over direct expenses. 3. Precaution against Future Losses : Trading Account, if shows gross loss, reasons for this loss can be found out and necessary corrective steps can be taken. Notes FORMAT OF TRADING ACCOUNT Trading Account of.............................. for the year ending ………….. Dr. Cr. Particulars Amount Particulars Amount ` ` Opening Stock Sales Purchases Less: Sales Returns Less Purchase Returns Closing stock Direct Expenses : Gross loss transferred to Carriage Inward Profit & Loss Account Freight Wages Fuel & Power Excise Duty Factory Rent Heating & Lighting Factory Rent & Insurance Work Managers Salary Gross Profit transferred to Profit & Loss Account Important Items of Trading Account Important items of Trading account are : Accountancy 53  MODULE - 3 Financial Statements : An Introduction Financial Statement 1. Stock : Stock refers to the goods lying unsold on a particular date. It can be of two types : (a) Opening stock and (b) Closing stock (a) Opening Stock : Opening stock refers to the value of goods lying unsold at the beginning of the accounting year. It is shown on the debit side of the Trading Account. In the first year of business there is no opening stock. (b) Closing Stock : It is the value of goods lying unsold at the end of the accounting year. It is valued at the cost price or market price whichever is Notes less. It is shown on the credit side of the Trading Account. 2. Purchases : Purchases mean total items purchased for resale during the year. It can be both in cash and on credit. Purchases are shown on the debit side of the Trading Account. These are always shown as net purchases i.e. amount of purchases returned (Purchase returns or return outwards) is deducted from the total amount of purchases made. Goods received on consignment basis are never treated as purchases. Similarly, goods received on ‘sale or return’ basis are never treated as purchases. 3. Sales : Sales refer to the total revenue from sale of goods of the business enterprise for which the Trading Account is being prepared. It includes both cash sales and credit sales. These are recorded on the credit side of the Trading Account. Sales are shown at their net value i.e. sales return or returns inward is deducted from the total sales. Cash sales plus credit sales minus sales returns constitute net sales. Goods sent on ‘sale or approval’ are not part of sales until approval is received. 4. Direct Expenses : Direct expenses are the expenses that can be attributed directly to the purchase of goods or goods manufactured. These are shown on the debit side of the Trading Account. These are shown at the amount as shown in the Trial Balance. For example, wages are recorded on the debit side of Trading Account at the amount shown in the Trial Balance. Important Items of Direct Expenses 1. Wages i.e. wages relate to production. If amount under this head includes wages paid for construction of building or manufacturing of furniture for office it will be subtracted from the amount of wages. 2. Carriage, Cartage and Freight i.e. amount paid for carriage of goods purchased for sale or raw material purchased for manufacturing. 3. Other such direct expenses are customs and import duty, packing materials, gas, electricity water, fuel, oil, gas greese, heating and lighting, factory rent and insurance and many more such items. 54 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement 5. Gross Profit/Gross Loss : It is the excess of net sales revenue over cost of goods sold. Gross Profit is equal to net sales minus cost of goods sold. If total of the credit side exceeds the total of debit side, the excess amount is termed as ‘gross profit’ and is shown on the debit side of Trading Account. On the other hand if debit side is more than the credit side, the difference in amount is called gross loss and is shown on the credit side of the Trading Account. Gross Profit = Net Sales – Cost of Goods Sold Gross Loss = Cost of Goods Sold – Net Sales Notes INTEXT QUESTIONS 16.1 I. Fill in the blanks with suitable word/words : 1. Financial statements are generally of.......……. Types. 2. Income statement comprises of.......….. A/c and......……. A/c. 3. Trading Account is prepared to ascertain the.......……. profit of the business. 4. The percentage of gross profit on sales reflects the degree of.......……. of business. II. Show the result in the following cases (a) Sales – sales return =.............................. (b) Purchases – purchases return =.............................. (c) Total of the credit column of trading account – total of the debit column of trading account =.............................. (d) Cost of goods sold – total sales =.............................. (e) Total of the debt column of trading account - Total of the credit column of trading account =.............................. 16.3 TRANSFER ENTRIES Before preparing Trading Account, closing or transfer journal entries are made in the journal proper of the business enterprise. These journal entries are: (a) For transferring debit balances Trading A/c Dr. To Opening stock To Purchases Accountancy 55  MODULE - 3 Financial Statements : An Introduction Financial Statement To Direct expenses To Sales returns (Transfer of balances of opening Stock, Purchases, direct expenses & Sales Returns) (b) For transferring credit balances Sales A/c Dr. Notes Closing stock A/c Dr. Purchase Returns A/c Dr. To Trading A/c (Transfer of credit balances of Sales, Closing Stock, Purchase return) (c) For transferring gross profit Trading A/c Dr To Profit & Loss A/c (Transferring of gross profit) (d) For transferring gross loss Profit & Loss A/c Dr. To Trading A/c (Transferring of gross loss) Illustration 4 The ledger balances extracted at the close of a trading year on 31st March, 2014 are given as follows Name of the Account Amount (` ) Opening stock 12,000 Purchases 52,000 Sales 74,000 Purchase Returns 2,000 Carriage Inward 800 Wages 4,200 Closing stock 13,500 Pass necessary journal entries in the journal proper. 56 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Solution : Journal Date Particulars LF Dr Cr 2014 Amount Amount ` ` March 31 Trading A/c Dr 69,000 To Opening stock A/c 12,000 Notes To Purchases A/c 52,000 To Wages A/c 4,200 To Carriage Inward A/c 800 (Transfer of debit balances to trading Account) March 31 Sales A/c Dr 74,000 Purchase Returns A/c Dr 2,000 Closing stock A/c Dr 13,500 To Trading A/c 89,500 (Transfer of credit items to trading account) March 31 Trading A/c Dr 20,500 To Profit & Loss A/c 20,500 (Transfer of gross profit to Profit & Loss Account) Illustration 5 Following balances have been extracted from the ledger of Rohit & Sons at the close of the year 2014. ` Stock (1.1.2014) 21,000 Purchases 1,40,000 Sales 2,24,000 Purchases Returns 8,000 Accountancy 57  MODULE - 3 Financial Statements : An Introduction Financial Statement Sales Returns 12,000 Wages 15,000 Factory Power 12,000 Stock (31.12.2014) 26,500 Make closing journal entries in the journal proper. Notes Solution : Journal Date Particulars LF Dr Cr 2014 Amount Amount Dec. 31 Trading A/c Dr 2,00,000 To Opening stock A/c 21,000 To Purchases A/c 1,40,000 To Sales Returns A/c 12,000 To wages A/c 15,000 To Factory power A/c 12,000 (Closing entry of debit items transferred to Trading A/c) Sales A/c Dr 2,24,000 Closing stock A/c Dr 26,500 Purchase Returns A/c Dr 8,000 To Trading A/c 2,58,500 (Transfer of credit balances to Trading A/c) Trading A/c Dr 58,500 To Profit & Loss A/c 5,8500 (Transfer of Gross Profit) 58 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement INTEXT QUESTIONS 16.3 Write the “debit” if the items given below are to be placed in debit side of the Trading A/c and “Credit” if they are placed in the credit side of the Trading Account. (i) Closing stock (ii) Carriage inward Notes (iii) Sales (iv) Custom duty 16.4 PROFIT & LOSS ACCOUNT As stated earlier, income statement consists of two accounts : Trading Account and Profit & Loss Account. You have seen that Trading account is prepared to ascertain the gross profit or gross loss of the trading activities of the business. But these are not the final results of business operations of an enterprise. Apart from direct expenses, there are indirect expenses also. These may be conveniently divided into office and administrative expenses, selling and distribution expenses, financial expenses, depreciation and maintenance charges etc. Similarly, there can be income from sources other than sales revenue. These may be interest on investments, discount received from creditors, commission received, etc. Another account is prepared in which all indirect expenses and revenues from sources other than sales are presented. This account when balanced shows net profit (or net loss). This account is termed as Profit and Loss Account. The profit shown by this account is called ‘net profit’ and if it shows loss it is known as ‘net loss’. FORMAT OF PROFIT AND LOSS ACCOUNT Profit and Loss A/c of M/s................….. for the year ended............... Dr. Cr. Particulars Amount Particulars Amount ` ` Gross loss b/d; if any — Gross Profit b/d — Salaries — Discount Received — Rent, Rates & taxes — Commission Received — Insurance Premium — Dividend Received — Accountancy 59  MODULE - 3 Financial Statements : An Introduction Financial Statement Advertising — Interest on Investment — Commission paid — Rent Received — Discount Allowed — Net Loss transferred Repairs & Renewals — to capital account; if any — Bad Debts — Notes Establishment charges — Travelling Expenses — Bank Charges — Sales Tax/Value added Tax — Depreciation on fixed assets — Net Profit transferred to Capital Account — Some important items of Profit and Loss Account As stated earlier indirect expense are shown on the debit side of Profit and Loss A/c. These can be classified under the following heads : Debit Items 1. Selling and Distribution Expenses : To materialise sales, the expenses incurred are called selling and distribution expenses. Examples are : Carriage on sales/carriage outwards, advertisement, selling expenses, travelling expenses and salesman commission, depreciation of delivery van, salary of driver of the delivery van, etc. 2. Office and Administration Expenses : These are the expenses incurred on establishment and maintenance of office. Some of the expenses that may be under this head are: rent, rates and taxes, postage, printing and stationery, insurance, legal charges, audit fees, office salaries, etc. 3. Financial Expenses : Finances are to be arranged for carrying on business. Expenses that are incurred in this connection are called financial expenses. Some of the financial expenses are: interest on loan, interest on capital, discount on bills, etc. 4. Depreciation and Maintenance Charges : The total value of a fixed asset like machinery, building, furniture, etc. is not charged to profit and loss account in the year in which it is purchased. Such assets help running business for a number of 60 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement years to come. Therefore, only a part of the value of such assets is treated as an expense and is charged to Profit and Loss A/c as depreciation. Depreciation means decline in the value of fixed asset due to wear and tear, lapse of time, obsolescence, etc. Expense incurred on repairs and renewals and maintenance of assets are expenses other than depreciation under this category. 5. Other Expenses : These are the expenses which are not included under the above mentioned heads of expenses for example, losses and expenses due to fire, theft etc. Notes Credit Items On the credit side of Profit and Loss Account, items of revenue and incomes are written. The first item on this side of Profit and Loss Account is the gross profit transferred from trading account. Other items of the credit side are : Interest on investment, interest on fixed deposits etc. rent received, commission received, discount received, dividend on shares received etc. Need of preparing Profit and Loss Account Need of preparing profit and loss account by a business concern may be stated as follows : (i) To know the net profit or net loss of a business for an accounting year. (ii) Net profit of one year can be compared with net profits of previous year or years. It helps in ascertaining whether the business is being conducted efficiently or not. (iii) Different expenses which are taken to Profit & Loss A/c in one year can be compared with the amounts incurred in previous year or years. This helps in ascertaining the need of applying control over such expenses. INTEXT QUESTIONS 16.4 I. Following are the items of expenditure and income to be taken to Profit and Loss Account. Write ‘E’ for expenses and ‘I’ for income against each item. (i) Interest on Fixed Deposit (ii) Advertisement (iii) Insurance Premium (iv) Discount allowed by creditors (v) Carriage on sales Accountancy 61  MODULE - 3 Financial Statements : An Introduction Financial Statement II. State whether the following statements are ‘true or false’. Write true for true statements and ‘false’ for false statements. (i) Profit and Loss Account is prepared to ascertain the Gross Profit of a business unit. (ii) Items of income are written on the credit side of Profit and Loss Account. (iii) Net Profit calculated by preparing Profit and Loss Account is transferred to Notes Trading Account. (iv) Profit and Loss Account is prepared for an accounting year. 16.5 TRANSFERRING ENTRIES OF PROFIT AND LOSS ACCOUNT Before preparing Profit and Loss Account as per the format given in the previous section, closing entries are made in the journal proper of the enterprise. Following journal entries are made : (i) For transferring the indirect expense accounts : Profit & Loss A/c Dr. To Salaries A/c To Insurance Premium A/c To Bad Debts A/c To Discount Allowed A/c (Transfer of indirect expenses) (ii) For transfer of items of incomes and gain Interest on investment A/c Dr. Rent Received A/c Dr. Discount Received A/c Dr To Profit & Loss A/c (Transfer of items of income) (iii) For transferring Net Profit : Profit & Loss A/c Dr. To Capital A/c (Transferring of Net Profit to Capital A/c) 62 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement (iv) For transferring Net Loss Capital A/c Dr. To Profit & Loss A/c (Transfer of Net Loss to Capital Account) Illustration 6 The following balances were extracted from the books of Maya Gupta & Sons at the Notes end of March 31, 2014. Make necessary closing entries as on that date: Items Dr. Cr. Balance Balance (` ) (` ) Gross Profit 65,000 Salaries 11,500 Audit fees 400 Insurance Premium 800 Interest received 1,600 Discount (Cr) 460 Advertisement 1,200 Bad Debts 150 Discount Allowed 340 Depreciation 460 Rent from tenants — 1,800 Solution : Journal Entries (i) Trading A/c Dr. 65,000 To P&L A/c 65,000 (Gross profit transfered to P&L A/c) (ii) Profit & Loss A/c Dr. 14850 To Salaries A/c 11500 To Audit Fees A/c 400 Accountancy 63  MODULE - 3 Financial Statements : An Introduction Financial Statement To Insurance Premium A/c 800 To Advertisement A/c 1200 To Bad Debts A/c 150 To Discount Allowed A/c 340 To Depreciation A/c 460 (Transfer of items of expenses to profit & Loss A/c) Notes (iii) Interest A/c Dr. 1600 Discount Received A/c Dr. 460 Rent A/c Dr. 1800 To Profit & Loss A/c 3860 (Transfer of items of income to Profit & Loss A/c) (iv) Profit & Loss A/c Dr. 54010 To Capital A/c 54010 (Transfer of Net Profit to Capital Account) Illustration 7 The following ledger balances were extracted from the books of Rabina & Brothers at the end of accounting year 31st March, 2014. Make journal entries to transfer these balances to prepare Profit & Loss A/c for the year ending 31st March, 2014. ` Gross Profit 65800 Salaries 8400 Rent paid 2400 Discount allowed 500 Interest on investments 3100 Advertisement 1800 Trading expenses 1600 Bad Debts 500 Depreciation 600 Insurance Premium 800 Commission received 2700 64 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Solution : Trading A/c Dr. 65,800 To P & L A/c 65,800 (Gross profit transferring to P&L A/c) Journal Date Particulars LF Dr Cr 2014 Amount Amount Notes March 31 Profit & Loss A/c Dr 16600 To Salaries A/c 8400 To Rent A/c 2400 To Discount allowed A/c 500 To Advertisement A/c 1800 To Trading expenses A/c 1600 To Bad Debts A/c 500 To Depreciation A/c 600 To Insurance Premium A/c 800 (Transfer of indirect expenses to profit & Loss A/c) March 31 Commision A/c Dr 2700 Interest A/c Dr 3100 To Profit & Loss A/c 5800 (Transfer of incomes other than sales to Profit & Loss A/c) March 31 Profit & Loss A/c Dr 55000 To Capital A/c 55000 (Transfer of net profit to capital A/c) Operating Profit Operating profit is the excess of gross profit over operating expenses. Gross Profit is the excess of net sales revenue over cost of goods sold. Operating expenses includes office and administration expenses, selling and distribution expenses, cash discount allowed, interest on bills payable and other short term debt, bad debts and so on. Net sales means cash sales + credit sales - sales returns. Accountancy 65  MODULE - 3 Financial Statements : An Introduction Financial Statement Operating Profit = Net Sales - Operating Cost = Net Sales - (Cost of goods sold + administration and office exp. + Selling and Distribution expenses) Operating Profit = Net Profit + Non-operating exp. - Non-Operating Income Illustration 8 Compute Operating profit from the following particular. Notes ` ` Gross Profit 44,000 Interest on loan 2200 Carriage outward 480 Interest on investment 280 Advertising 1200 Printing and Stationery 360 Salaries 17,800 Loss on Sale of furniture 3,500 Rent & Taxes 6,200 General expenses 140 Lighting 1,500 Donation 510 Insurance charge 240 Rent Received 600 Bad Debts 150 Loss by fire 2,000 Audit fees 200 Gain on sale of machine 5,000 Solution Computation of Operating Profit ` ` Gross Profit 44,000 Less : Selling and Distribution expenses : Carriage outward 480 Advertising 1,200 Bad Debts 150 1,830 Less : Office and Administrative Expenses Salaries 17,800 Rent & Taxes 6,200 Lighting 1,500 Insurance 240 Audit fees 200 Printing & Stationery 360 General expense 140 26,440 (28,270) Operating Profit 15,730 66 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Position Statement/Balance Sheet Position Statement or Balance Sheet is another financial statement that a business enterprise prepares. Balance Sheet is a statement prepared on a particular date, generally at the end of accounting year to ascertain the financial position of the business entity. It consists of assets on the one hand and liabilities on the other. In the words of Francis R Steal, “Balance Sheet is a screen picture of the financial position of a going business at a certain moment.” In the words of Freeman, “A Balance Sheet is an item wise list of assets, liabilities and Notes proprietorship of a business at a certain date.” Financial position of a business is the list of assets owned by the business and the claims of various parties against these assets. The statement prepared to show the financial position is termed as Balance Sheet. In the next lesson we shall discuss Balance Sheet in detail. INTEXT QUESTIONS 16.5 I. Write ‘debit’ if Profit and Loss Account is to be debited and ‘credit’ if profit and loss account is to be credited of the following items : (a) Legal charges (b) Net Loss (c) Rent Received (d) Discount Allowed (e) Salaries II. (a) Name the financial statement which is prepared in addition to income statement. (b) Why it is prepared? (c) When it is prepared? (d) Name its two elements. III. (a) Operating Profit = Net Sales - _______________ (b) Operating Profit = Net Profit + Non-Operating Expenses - __________ (c) If Net Sales = ` 2,00,000 and Operating cost = ` 1,50,000 than calculate Operating profit. WHAT YOU HAVE LEARNT z Financial statements are of two types : (a) Income Statement i.e. Trading Account and Profit and Loss Account. Accountancy 67  MODULE - 3 Financial Statements : An Introduction Financial Statement (b) Position Statement i.e. Balance Sheet. z Trading Account is prepared to ascertain the results of the trading activities of the business. z Trading Account may show profit (i.e. the excess of sales to cost of goods sold or excess of credit side over debit side), which is termed as Gross Profit. Trading Account may show loss (i.e. Cost of goods sold exceeds sales or total of Notes debit side exceeds total of credit side). This is called Gross Loss. z Profit and Loss Account is prepared to find out Net Profit/Net Loss. Net Profit = Gross Profit + other incomes – Indirect expenses. It may also show a net loss. All indirect expenses are shown on the debit side of Profit & Loss Account. All incomes and gains are shown on the credit side of Profit & Loss Account. z Balance Sheet is prepared to ascertain the financial position of a firm on a particular date. TERMINAL EXERCISE 1. State the meaning of financial statements. 2. Explain in brief the various objectives of finanacial statements. 3. Explain in brief the following terms with two examples of each : (a) Revenue expenditure. (b) Revenue Receipts (c) Capital expenditure (d) Capital Receipts 4. Distinguish between capital expenditure and Revenue expenditure on the basis of: (a) Earning capacity (b) Placement in financial statements (c) Occurrence of expenditure 5. Distinguish between capital receipts and revenue receipts. 6. How is cost of goods sold calculated? 68 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement 7. What is Trading Account? Why is it prepared? 8. How is Gross Profit calculated? 9. What is meant by Profit and Loss Account? Why is it prepared? 10. When does Profit and Loss Account show Net Profit? 11. What are direct expenses? Give two examples of such expenses. 12. State the meaning of Balance Sheet. Notes 13. From the following balances of Sabana calculate Gross Profit or Gross Loss by subtracting cost of goods sold from sales for the year ended 31st December, 2014 ` Stock (1.1.2014) 26500 Purchases 64600 Sales 86800 Purchases Returns 2600 Sales Returns 1800 Freight inward 750 Wages 1850 Closing Stock 31100 14. From the following balances extracted from the books of Seth Brothers. Pass journal entries to prepare a Trading Account and Profit and Loss Account for the year ended 31st March, 2014. ` ` Stock (1.4.2013) 20000 Electric Power 5000 Purchases 95000 Wages 14000 Return Inwards 2000 Selling Commission 5500 Carriage Inwards 1850 Repair & Renewals 2000 Carriage Outwards 1200 General Expenses 8000 Custom duty 3000 Insurance 2200 Return outwards 5000 Stock (31.3.2014) 45000 Sales 165000 Discount Received 1500 Accountancy 69  MODULE - 3 Financial Statements : An Introduction Financial Statement 15. The balances from the books of Parimal Ghosh are given below. Pass journal entries to prepare Trading and Profit & Loss Account for the year ended 31st March, 2014 ` ` Stock as on 1.4.2013 9480 Purchase Returns 1800 Purchases 50800 Advertising 1500 Notes Wages 1200 Commission (Cr.) 3200 Salaries 3400 Rent from tenant 2800 Octroi 1320 Sales 72000 Rent & Taxes 850 Stock (31.3.2014) 10700 Bad Debts 250 Discount (Dr.) 360 Interest on capital 760 16. From the following information calculate cost of goods sold for the year ending 31st March, 2014 ` ` Opening Stock 14800 Factory expenses 7200 Purchases 65700 Closing stock 28400 Returns outward 1700 Wages 12500 Carriage Inward 2400 Custom Duty 3200 Rent paid 4500 Establishment expenses 650 17. From the following balances extracted from the books of Jai Bhagwan & Sons as on 31st March, 2014. Pass journal entries to prepare Trading A/c and Profits & Loss A/c ` ` Opening Stock 16000 Rent 3600 Purchases 76000 Office expenses 1600 Machinery 28000 Carriage Inward 1200 70 Accountancy  Financial Statements : An Introduction MODULE - 3 Financial Statement Debtors 21600 Sales Returns 5400 Drawings 7200 Credit Balance Wages 1500 Capital 70000 Bank 12000 Creditors 14000 Depreciaiton 2800 Sales 108000 Closing stock 24000 Purchase Returns 2600 Notes ANSWERS TO INTEXT QUESTIONS 16.1 I. (i) Capital (ii) Revenue (iii) Deferred Revenue (iv) Capital II. (a) Ascertaining the financial position (b) Source of information (c) Helps in managerial decision making (d) An index of the solvency of the concern. 16.2 I. 1. Two 2. Trading and Profit & Loss 3. Gross Profit 4. Success II. (a) Net sales (b) Net purchases (c) Gross profit (d) Gross Loss (e) Gross Loss 16.3 (i) Credit (ii) Debit (iii) Credit (iv) Debit 16.4 I. (i) I (ii) E (iii) E (iv) I (v) E II. (i) F (ii) T (iii) F (iv) T 16.5 I. (a) debit (b) debit (c) Credit (d) debit (e) debit II. (a) Balance sheet (b) to show the financial position of the concern (c) At the end of an accounting year (d) assets; liabilities III. (a) Operating Cost (b) Non-operating income (c) ` 50,000 Accountancy 71  MODULE - 3 Financial Statements : An Introduction Financial Statement ANSWERS TO TERMINAL EXERCISE 13. Gross Profit : ` 25000 14. Gross Profit : ` 74150 Net Profit : ` 56750 15. Gross Profit : ` 21700 Net Profit : ` 20580 Notes 16. Cost of goods sold : ` 75700 17. Gross Profit : ` 21000 Net Profit : ` 13000 ACTIVITY Procure trial balance of at least four business concerns and classify the items into : (a) Revenue expenditure (b) Revenue receipts (c) Capital expenditure (d) Capital Receipts Name of Item of Revenue Revenue Capital Capital organisation expenditure expenditure receipts expenditure Receipts 72 Accountancy