Module 2: Financial Statements & Business Performance PDF

Module 2 Preparation of Profit and Loss Account, Balance Sheet and Cash Flow Statement © All Rights Reserved. This document has been authored by Prof. Prof. M.S. Narasimhan and is permitted for use only within the course "Financial S...

Module 2 Preparation of Profit and Loss Account, Balance Sheet and Cash Flow Statement © All Rights Reserved. This document has been authored by Prof. Prof. M.S. Narasimhan and is permitted for use only within the course "Financial Statements and Business Performance" delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illu strations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author. Overview In this module, you will be introduced to Profit and Loss Account or Income Statement. Balance Sheet Cash Flow Statement Few adjustments required before preparing the financial statements, namely, the profit and loss account, balance sheet, and cash flow statement. Adjustment Entries Adjustment entries are required to reflect the true and fair view of the financial statements. Adjustment entries are required to account for accrued income and expenses and deferred revenues or expenses. Adjustment entries could be related to income and expenses of Profit and Loss Account and related to the assets and liabilities of the Balance Sheet. Adjustment Entries Related to Income Profit and Loss Account measures the profit or loss of the business i.e., communicates about the performance of the business. Profit = Revenue – Expense All expenses should be matched against revenue to determine the profit earned or loss incurred by the firm in a period. Adjustment entries are required to account for the incomes and expenses not recorded. Adjustment Entries Related to Income Example: Accrued Interest Income Firms have surplus cash which they invest in Government Securities and Fixed Deposit. Government securities and bonds usually pay interest half-yearly. Example: On 30th June and 31st December. The firm’s accounting period ends on 31st March. The interest earned from Jan 1 to March 31 is not received in the bank account. As per the accrual system of accounting, this needs to be accounted for as income belonging to the period, whether it is received or not. Hence, adjustment entry for accrued interest income is required before closing the books of accounts for the year.  Adjustment entry for accrued interest income Date Particulars L.F. Debit Credit (Rs.) (Rs.) Interest Accrued Dr. xxx To Interest Income xxx (Being interest accrued for 3 months from Jan to March) Account Type Rule of Accounting Interest accrued Representative personal Debit the receiver, credit the giver; account represents the loan given by the business to others, hence being an asset and business is owing this amount, it is debited Interest income Nominal account Debit all expenses and losses, credit all incomes and gains Adjustment Entries Related to Income A company is executing a contract like an airport construction or metro rail project that will take a few years to complete. For long-term contracts, income can be recognized based on the progress of the project. Example, if forty per cent of the work is completed in the first year, 40 per cent of the revenue can be recognized in the first year. This method of recognizing the revenue is called the percentage of completion method. Percentage of completion method suggests recognition of revenue in proportion to the contract completed Adjustment Entries Related to Expense Amount paid for expenses in advance In October, the insurance premium is paid for a year in advance. The firm’s accounting period ends on 31st December. As per the accrual accounting system, only three months' expense is to be recognised this year, and the nine months’ premium has to be adjusted. Hence, adjustment entry for prepaid insurance expenses is required before closing the books of accounts for the year.  Adjustment Entry for Prepaid Insurance Year 1 - Taken insurance for one-year, effective Oct, year 1 – Sep of next year. Paid the insurance premium for the full year in October, Rs. 12 lakhs. The books close on Dec 31. Date Particulars L.F. Debit Credit (Rs.) (Rs.) Year 1 Insurance expense Dr. 12,00,000 Oct To cash and bank account 12,00,000 (Being insurance exp paid for the full year from Oct – Sep) Dec Prepaid insurance Dr. 9,00,000 To Insurance expense 9,00,000 (Being insurance exp paid for nine months from Jan to Sep of the next year transferred to prepaid insurance)  Adjustment Entry for Prepaid Insurance Year 1 - Taken insurance for one-year, effective Oct – Sep of next year. Paid the insurance premium for the full year in October, Rs. 12 lakhs. Year 2 – Prepaid insurance adjusted Date Particulars L.F. Debit Credit (Rs.) (Rs.) Next year Insurance expense Dr. 9,00,000 Sep To Prepaid insurance 9,00,000 (Being prepaid insurance adjusted to insurance expense for the year) Adjustment Entries Related to Outstanding/Accrued Expense Outstanding/Accrued Expenses – Electricity Expense The firm’s accounting period is from 1 st January to 31st December. Example: The electricity expense invoice for December was received on 10th January of next year, 10 lakhs. Paid the amount on 15th January. Hence, an adjustment entry is required to account for the electricity consumed for December for the accounting period ending December 31st.  Adjustment Entry for Outstanding/Accrued Expense Example: Electricity expense invoice for the month of December is received on 10th January of the next year, 10 lakhs. Paid the amount on 15th January. Date Particulars L.F. Debit Credit (Rs.) (Rs.) Current year Electricity expense a/c Dr. 10,00,000 Dec To Outstanding electricity 10,00,000 (Being electricity exp due for the month of Dec)  Adjustment Entry for Outstanding/Accrued Expense Example: Electricity expense invoice for the month of December is received on 10th January of the next year, 10 lakhs. Paid the amount on 15th January. Date Particulars L.F. Debit Credit (Rs.) (Rs.) Current year Electricity expense a/c Dr. 10,00,000 Dec To Outstanding electricity 10,00,000 (Being electricity exp due for the month of Dec) Date Particulars L.F. Debit Credit (Rs.) (Rs.) Next year Outstanding electricity Dr. 10,00,000 Jan To cash and bank a/c 10,00,000 (Being outstanding electricity exp paid) Adjustment Entries Related to Expense Example: Creating provision for Bad debts Warranty Gratuity A provision for these expenses is required to account for the probable liability.  Adjustments related to provision for expenses Example: The estimated amount the customers may go bad or the amount customers may claim as warranty expense is Rs. 20 lakhs. The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Mar Bad debt expense Dr. 20,00,000 To Provision for doubtful debt 10,00,000 (Being provision for bad and doubtful debt created) Date Particulars L.F. Debit (Rs.) Credit (Rs.) Mar Warranty expense Dr. 20,00,000 To Provision for warranty exp 10,00,000 (Being provision for warranty expense created) Adjustment Entries Related to Expense Matching concept requires to account the expenses against the related revenue. Creating provisions for expenses allows accounting of the probable expenses against the related revenue. Hence, these are provisions can be created: - Provision for bad and doubtful debt - Provision for warranty expense  Adjustments related to provision for expenses Example: Year 1 - The estimated amount customers may claim as warranty expense is Rs. 20 lakhs. Year 2 - The service person replaced a component worth of Rupees 5000 against customer’s warranty claim. The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 1 Warranty expense Dr. 20,00,000 March To Provision for warranty exp 10,00,000 (Being provision for warranty expense created) Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 2 Provision for warranty expense Dr. 5,000 To Stores (inventory) account 5,000 (Being issued materials for replacement against warranty claim)  Adjustments related to provision for expenses Example: Year 1 - The estimated amount customers may claim as warranty expense is Rs. 20 lakhs. Year 2 - The service person replaced a component worth of Rupees 5000 against customer’s warranty claim. The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 1 Warranty expense Dr. 20,00,000 March To Provision for warranty exp 10,00,000 (Being provision for warranty expense created) Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 2 Provision for warranty expense Dr. 5,000 To Stores (inventory) account Material is a real account; 5,000 (Being issued materials for replacement against warranty claim) Debit what comes in and Credit what goes out  Adjustments related to provision for expenses Example: Year 1 - The estimated amount customers may claim as warranty expense is Rs. 20 lakhs. Year 2 - The service person replaced a component worth of Rupees 5000 against customer’s warranty claim. The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 1 Warranty expense Dr. 20,00,000 Dec To Provision for warranty exp 10,00,000 (Being provision for warranty expense created) Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 2 Provision for warranty expense Dr. 5,000 To Stores (inventory) account No impact on next year’s P&L; The 5,000balance for (Being issued materials for replacement against provision for warranty and stores gets reduced warranty claim) (both balance sheet items; liability and asset, respectively) Adjustment Entries Related to Expense Gratuity - The company has to estimate the gratuity amount payable as the employee completes the service every year and make a provision for the same. Example: The estimated amount of gratuity for last drawn salary of Rs. 5000 per day is Rs. 22,50,000. Matching concept requires the company to estimate the gratuity amount payable every year and charge suitable provision for gratuity against the employee services.  Adjustments related to provision for expenses Example: The estimated amount of gratuity for last drawn salary of Rs. 5000 per day is Rs. 22,50,000 The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 1 Gratuity expense Dr. March To Provision for gratuity (Being provision for gratuity made)  Adjustments related to provision for expenses Example: The estimated amount of gratuity for last drawn salary of Rs. 5000 per day is Rs. 22,50,000 The adjustment entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year 1 Gratuity expense Dr. March To Provision for gratuity (Being provision for gratuity made) Provision for gratuity is Gratuity expense is reported as an reported as a liability in the expense in the profit and loss balance sheet. account.  Adjustments related to provision for expenses Example: The company pays the gratuity to the employee. The accounting entry for the above is Date Particulars L.F. Debit (Rs.) Credit (Rs.) Year Provision for gratuity Dr. To Cash and bank account (Being gratuity paid to the employee) Adjustment Entries Related to Assets Example- Entry when materials are purchased Inventory a/c To Suppliers a/c When materials are sold Customers a/c To Salesconsumption Adjustment entry is required to match the inventory a/c expense with the related sales. Adjustment Entries Related to Assets Cost of goods consumed = Opening stock + Purchases – Closing stock Consider the below information: Opening stock = 10 lakhs Purchases = 400 lakhs Stock remaining at the end of the year = 30 lakhs Materials consumed = 10+400-30 = 380 lakhs Adjustment Entries Related to Assets Entry when materials are purchased Inventory a/c To Suppliers a/c When materials are sold Customers a/c To Sales a/c to match the cost with the sales Adjustment entry for inventory consumption Cost of materials consumed a/c Dr. 380 To Materials inventory 380 Adjustment Entries Related to Assets When a business buys a machine costing Rs. 100 lakhs Machine account Dr. Rs. 100 lakhs To Cash and Bank account Rs. 100 lakhs At the end of the year, adjustment is required to record the reduction in the value of the asset due to its use over the year. Depreciation account Dr. Rs. 10 lakhs To Machine account Rs. 10 lakhs Machine Value at the beginning Depreciation Accumulated Value at the end of of the year (in lakhs) (b) depreciation the year (a) (c ) (a – c) Year 1 100 10 10 90 Year 2 100 10 20 80 Adjustment Entries Related to Liabilities Adjustments related to Liability side of the Balance Sheet Outstanding expenses - Outstanding salary - Provision for gratuity Adjustment Entries When Financial Assets are Revalued A company invested Rs. 100 lakhs in the shares of State Bank of India. The market value of SBI shares on the balance sheet date is Rs. 108 lakhs. There is a gain in the market value of the shares by Rs. 8 lakhs Adjustment Required for Revaluation of Financial Assets As per the Accounting Standards, the financial assets (investments) need to be revalued at fair values depending on the nature of the investment. The change in the value of long-term investments (available for sale securities) is accounted through Fair Value through Comprehensive Income (FVTOCI). Adjustment Entries When Financial Assets are Revalued A company made a long-term investment of Rs. 100 lakhs in the shares of State Bank of India. Investment in SBI shares Dr. 100 lakhs To cash and bank 100 lakhs (Being invested in shares of SBI) The market value of SBI shares on the balance sheet date is Rs. 108 lakhs. Investment in SBI shares Dr. 8 lakhs To Other comprehensive income 8 lakhs (Being shares in SBI revalued to their fair value) Other comprehensive income will be recognized as part of Other equity Adjustment Required for Revaluation of Financial Assets The change in the value of long-term investments (available for sale securities) is accounted through Fair Value through Comprehensive Income (FVTOCI) The change in the value of short-term investments (investments held for trading) is accounted through Fair Value through Profit and Loss (FVTPL)  Income Statement It is also called as Profit and Loss Statement or Profit and Loss Account. It reports all the revenues and expenses of the business. It considers the summary of all the nominal accounts. The preparation of income statement needs summarized value of sales, purchases and other incomes and expenses. Subsidiary books Provide summarized information on sales and other accounts. Example: Sales Book Gives the details of all the credit sales during a period  Subsidiary Books Sales Book Figures in rupees Invoice Invoice Name of Gross Other Discount Tax Net Amount Date Number Customer Amount charges (freight etc.) 2024 I-405 Mahesh & 250 15 20 10 255 Jan 1 Co. Jan 5 I-406 Ramesh & 250 15 20 16 261 Sons Jan 10 I-407 Naresh 260 10 15 14 269 Jan 20 I-408 Ketan & Co. 170 10 25 10 165 Total 930 50 80 50 950 Preparation of Income Statement  Income Statement Amount For the period ended …. Amount (Rs.) (Rs.) Revenue from sale of sugar 950 Revenue from sale of molasses 50 Total income 1,000 Expenses Raw materials consumed 600 Salaries and wages 80 Electricity and water charges 30 Other operating expenses 10 Selling and distribution expenses 40 General administration expenses 30 Depreciation 40 Interest expense 70 Let us take an example to understand the preparation of Profit and loss appropriation account  Profit and Loss Appropriation Account Particulars Amount (Rs.) Amount (Rs.) Opening balance 40 Add: Profit for the year 70 Profit available for distribution 110 Dividends issued 30 Transferred to General Reserves 60 90 Balance carried forward to Balance sheet 20 Balance Sheet Balance Sheet reports the financial position of the business. It can also be considered as the Statement of Wealth  Fixed Assets Tangible assets Intangible assets Example: Example: Land Software Building Patents Machines Trademarks Vehicles Furniture  Fixed Assets Tangible assets Intangible assets Example: Currently, accounting rules Example: require fixed assets to be Land reported as non-current assets Software Building Patents Machines Trademarks Vehicles Furniture Preparation of Balance Sheet or Statement of Wealth  Balance Sheet A Statement of Wealth Figures in rupees Equity & Liabilities Amount Equity Share Capital 3,50,000 Sources of Retained earnings 65,500 capital Long term borrowings 80,000 Trade payables 75,000 Total equity and liabilities 5,70,500 Assets Property, plant and equipment 330,000 Application of Inventories 60,000 capital Trade receivables 1,35,500 Cash & cash equivalents 45,000 Total assets 5,70,500  Balance Sheet Income Statement Reports the income and expenses. Reports the assets and liabilities. Summary of all the nominal Summary of all the real and personal accounts. accounts.  Cash Flow Statement Summarises all the cash and bank transactions Reports all the cash transactions under three heads - - Cash flow from operating activities - Cash flow from operating activities - Cash flow from investing activities  Cash Flow Statement Cash flow from operating activities Amount Cash received from customers xxx Payment to suppliers of goods and services (xxx) Payments for expenses (xxx) Paid for advertisement expenses (xxx) Selling and distribution expenses (xxx) Taxes paid (xxx) Cash flow from operating activities xxx  Cash Flow Statement Cash flow from investing activities Amount Purchased machinery (xxx) Purchased furniture (xxx) Paid for software (xxx) Cash received from sale of equipment xxx Interest received xxx Dividend received xxx Cash flow from investing activities xxx  Cash Flow Statement Cash flow from financing activities Amount Cash received from issue of shares xxx Repaid loan (xxx) Cash paid for share buy-back (xxx) Interest paid (xxx) Dividend paid (xxx) Cash flow from financing activities xxx Cash Flow Statement Cash Flow Statement can be prepared using Direct Method or Indirect Method. Cash Flow Statement Cash flow from operating activities Amount Cash received from customers xxx Payment to suppliers of goods and services (xxx) Direct Method Payments for expenses (xxx) Taxes paid (xxx) Cash flow from operating activities (a) xxx Cash flow from investing activities Purchased machinery (xxx) Cash received from sale of equipment xxx Interest received xxx Dividend received xxx Cash flow from investing activities (b) xxx Cash flow from financing activities Cash received from issue of shares xxx Repaid loan (xxx) Interest paid (xxx) Cash flow from financing activities (c ) xxx Net cash flow for the year (a+b+c) xxx Add: Opening cash balance xxx Closing cash balance xxx Partnership Accounting Partnership Accounting Partners’ Capital Accounts records the capital invested by the partners. Partners’ Current Accounts records other transactions related to drawings, remuneration, interest on capital, drawings etc. Partnership Accounting Estimation of Goodwill The partners decide to revalue their business at the time of entry or exit of any partner and value the goodwill. Based on the historical profits, a multiplier is used on the average profits to estimate the firm's goodwill.  Partnership Accounting Example: Admission of a new partner The partners agreed to use a multiplier of 3 to value the goodwill. In the first year, the firm earned a revenue of Rs. 300 lakhs and incurred an expense of Rs. 250 lakhs. The profit of the first year is Rs. 50 lakhs. Applying 3 as a multiplier, the goodwill of the business at the end of year 1 is Rs. 50 lakhs X 3 = Rs. 150 lakhs.  Partnership Accounting Example: Admission of a new partner The accounting entry is Goodwill A/c Dr. Rs. 150 lakhs Ram’s Capital Account Rs. 60 lakhs Krishna’s capital account Rs. 90 lakhs Rahul contributed Rs. 50 lakhs  Partnership Accounting Example: Admission of a new partner Statement showing the distribution of profits and goodwill post the admission of new partner Partner Capital Profit share Goodwill Total New profit- contributed of first year sharing ratio Ram 20 20 60 100 33.33% Krishna 30 30 90 150 50% Rahul 50 50 16.67% Total 300 Partnership Accounting Retirement of a Partner - When an old partner decides to retire from the partnership firm. Partnership Accounting Example: Retirement of a partner The goodwill needs to be revalued again at the time of retirement of a partner The journal entry is Goodwill A/c Debit All Partner’s Capital Account Credit  After three years, Mr. Ram wants to retire from the partnership business Ram Krishna Rahul Partnership Accounting Example: Retirement of a partner The partners agreed that the value of the goodwill is 5 times the average profit of three years. Year Profit earned (in Rs. Value of Goodwill at the end of 5 years lakhs) 1 50 = 90 x 5 = Rs. 450 lakhs 2 80 3 140 Total 270 Average 90 Partnership Accounting Example: Retirement of a partner The partners agreed that the value of the goodwill is 5 times the average profit of three years. Year Profit earned (in Rs. Value of Goodwill at the end of 5 years lakhs) = 90 x 5 = Rs. 450 lakhs 1 50 2 80 Value of Goodwill at the end of 1 year 3 140 = Rs. 150 lakhs Total 270 Average 90 Partnership Accounting Example: Retirement of a partner The partners agreed that the value of the goodwill is 5 times the average profit of three years. Year Profit earned (in Rs. Value of Goodwill at the end of 5 years lakhs) = 90 x 5 = Rs. 450 lakhs 1 50 2 80 Value of Goodwill at the end of 1 year 3 140 = Rs. 150 lakhs Total 270 Average 90 Increase in Goodwill = 450 -150 = Rs. 300 lakhs Partnership Accounting Example: Retirement of a partner Statement showing the distribution of the remaining goodwill on the retirement of a partner Partner Existing profit- sharing ratio Share in the increase in goodwill Ram 33.33% 300 x 33.33% = 100 Krishna 50% 300 x 50% = 150 Rahul 16.67% 300 x 16.67% = 50 Total 100% 300 Partnership Accounting Example: Retirement of a partner Goodwill is distributed to partner’s capital account Goodwill A/c Debit Rs. 300 lakhs Ram’s Capital Account Rs. 100 lakhs Krishna’s capital account Rs. 150 lakhs Rahul’s capital account Rs. 50 lakhs Corporate Accounting Company Accounts  Forms of business organisations Sole - proprietorship Partnership Company Capital is contributed Capital is contributed Capital is contributed by the owner by the partners by the shareholders represented by share Profit is received by the Profit is distributed capital account owner among the partners Profit earned is accumulated under retained earnings Corporate Accounting Company Accounts deals with transactions related to issue of shares by the company, the shares subscribed, allotted or refunded by the company. Cash and bank a/c. Dr. To Share capital (Issue of shares) Other transactions specific to the company form of business Summary  Adjustments required before preparation of financial statements Expenses Assets Liabilities and Equity Revenues Adjustment related to Adjustment related Adjustment amount received in Adjustments related to to prepaid/accrued related to outstanding expenses, advance/accrued expenses etc. prepaid/accrued unearned revenues, revenue etc. expenses and advances, dividends accrued declared etc. revenues etc. Summary Preparation of Financial Statements – Recap Certain adjustments related to accruals/deferrals are required before preparation of the financial statements. Adjustment entries are required to reflect the true and fair view of the financial position of the business. The law (e.g. Companies Act) prescribes the format of the preparation of financial statements. Following a standard format makes the comparison of companies' financials easy. Cash flow statement can be prepared using the Direct and Indirect method.