1. Stakeholders & their information

Chapter -9

Financial statements - 1

Stakeholders and their Information Requirements

A stakeholder is a person associated with the business. The stakes of various stakeholders can be monetary or non-monetary. The objective of business is to communicate the meaningful information to various stakeholders in the business so that they can make informed decisions. The stakes can be active or passive; or can be direct or indirect. The owner and persons advancing loan to the business would have monetary stake. The government, consumer or a researcher will have non-monetary stake in the business.
The stakeholders are also called users who are normally classified as internal and external depending upon whether they are inside the business or outside the business. All users have different objectives for joining business and consequently different types of information requirements from it.

Classified category of internal and external users specifying their objectives and consequent information requirements.

2. Distinction between Capital & Revenue Expenditure

Distinction between Capital and Revenue

The revenue items form part of the trading and profit and loss account, the capital items help in the preparation of a balance sheet.

Expenditure
The expenditures are incurred with a viewpoint they would give benefits to the business. Whenever payment or incurrence of an outlay are made for a purpose other than the settlement of an existing liability, it is called expenditure. The benefit of expenditure may extend up to one accounting year or more than one year.
If the benefit of expenditure extends up to one accounting period, it is termed as revenue expenditure.

Normally, they are incurred for the day-to-day conduct of the business.

For example can be payment of salaries, rent, etc. The salaries paid in the current period will not benefit the business in the next accounting period, as the workers have put in their efforts in the current accounting period. They will have to be paid the salaries in the next accounting period as well if they are made to work.

If the benefit of expenditure extends more than one accounting period, it is termed as capital expenditure.

For example can be payment to acquire furniture for use in the business. Furniture acquired in the current accounting period will give benefits for many accounting periods to come. The usual examples of capital expenditure can be payment to acquire fixed assets and/or to make additions/ extensions in the fixed assets.

Following points of distinction between capital expenditure and revenue expenditure are worth noting:

  • Capital expenditure increases earning capacity of business whereas revenue expenditure is incurred to maintain the earning capacity.
  • Capital expenditure is incurred to acquire fixed assets for operation of business whereas revenue expenditure is incurred on day-to-day conduct of business.
  • Revenue expenditure is generally recurring expenditure and capital expenditure is non-recurring by nature.
  • Capital expenditure benefits more than one accounting year whereas revenue expenditure normally benefits one accounting year.
  • Capital expenditure (subject to depreciation) is recorded in balance sheet whereas revenue expenditure (subject to adjustment for outstanding and prepaid amount) is transferred to trading and profit and loss account.

Sometimes, it becomes difficult to classify the expenditure into revenue or capital category. In normal usage, the advertising expenditure is termed as revenue expenditure. The heavy expenditure incurred on advertising is likely to benefit the business firm for more than one accounting period. Such revenue expenditures, which are likely to give benefit for more than one accounting period, are termed as deferred revenue expenditure.

The part of the expenditure, which is perceived to have been used or consumed in the current year, is termed as expense of the current year.
Revenue expenditure is treated as an expense for the current year and is shown in trading and profit and loss account. For example, salary paid by the business firm is treated as an expense of the current year. Capital expenditures are charged to income statement and are spread over to more than one accounting period.

Receipts
If the receipts imply an obligation to return the money, these are capital receipts. The example can be an additional capital brought in by the owner or a loan taken from the bank. Both receipts are leading to obligations, the first to the owner (called equity) and the other to the outsiders (called liabilities).
Importance of Distinction between Capital and Revenue
The distinction between capital and revenue items has important implications for the preparation of trading and profit and loss account and the balance sheet as all items of revenue value are to the shown in the trading and profit and loss account and the items of capital nature in the balance sheet.

If any capital expenditure is wrongly shown as revenue expenditure (for example, purchase of furniture shown as purchases), it will result in under statement of profits, and also an under statement of assets. Thus, the financial statements will not reflect the true and fair view of the affairs of the business. Hence, it is necessary to identify the correct nature of each item and treat it accordingly in the book of accounts. It is also important from taxation point of view because capital profits are taxed differently from revenue profits.

3. Financial statements

Financial Statements

Various users have diverse informational requirements. Instead of generating particular information useful for specific users, the business prepares a set of financial statements, which in general satisfies the informational needs of the users.

The basic objectives of preparing financial statements are :
(a)  To present a true and fair view of the financial performance of the business
(b)  To present a true and fair view of the financial position of the business

For this purpose, the firm usually prepares the following financial statements:
1. Trading and Profit and Loss Account
2. Balance Sheet
Trading and Profit and Loss account, also known as Income statement, shows the financial performance in the form of profit earned or loss sustained by the business. Balance Sheet shows financial position in the form of assets, liabilities and capital. These are prepared on the basis of trial balance and additional information, if any.

Example 1
Observe the following trial balance and signify correctly the various elements of accounts and you will notice that the debit balances represent either assets or expenses/ losses and the credit balance represent either equity/liabilities or revenue/gains.

Trial Balance as on March 31, 2017

The balance sheet and profit and loss account are now called position statement and statement of profit and loss in the company's financial statements. Analysis of

Trial Balance as on March 31, 2017

 

4. Trading & P/L A/c

Trading and Profit  and Loss Account

This account is prepared to determine the profit earned or loss sustained by the business enterprise during the accounting period. In simple words, it is a summary of revenues and expenses of the business and calculates the net figure termed as profit or loss. Trading and Profit and Loss account summarizes the performance for an accounting period. Trading and Profit and Loss account is also an account with Debit and Credit sides.

You can observe that debit balances (representing expenses) and losses are transferred to the debit side of the Trading and a Profit and Loss account and credit balance (representing revenues/gains) are transferred to its credit side.

Relevant Items in Trading and Profit and Loss Account

The different items appearing in the trading and profit and loss account are explained here under:

Items on the debit side

  • Opening stock : This is the stock of goods which has been carried forward from the previous year and remains unchanged during the year and appears in the trial balance
  • Purchases less returns : Goods, which have been bought for resale appears as purchases on the debit side of the trading account. They include both cash as well as credit purchases. Goods which are returned to suppliers are termed as purchases return. It is shown by way of deduction from purchases and the computed amount is known as Net purchases.
  • Wages : Wages are the remuneration paid to workers who are directly engaged in factory for loading, unloading and production of goods and are debited to trading account.
  • Carriage inwards/Freight  inwards: The items  of transport expenses, which are incurred on bringing  materials/goods purchased to the place of business are this types of expenses. These items are paid in respect of purchases made during the year and are debited to the trading account.
  • Fuel/Water/Power/Gas : These items are used in the production process and hence are part of expenses.
  • Packaging material and Packing charges:  Packaging material comes in direct expenses as is part of goods sold. However, the packing used for transporting the goods so it is an indirect expense.
  • Salaries : Salaries are paid to all the staff for the services for running the business. If salaries are paid in kind by providing certain facilities (called perks) to the employees such as rent free accommodation, meals, uniform, medical facilities should also be regarded as salaries and debited to the profit and loss account.
  • Rent paid : The amount of rent paid is shown on the debit side of the profit and loss account. It is all rent paid for the buinding for running a business.
  • Interest paid : Interest paid on loans, bank overdraft, renewal of bills of exchange, etc. is an expense and is debited to profit and loss account.
  • Commission paid: Commission paid or payable on a business transactions undertaken through the agents is an item of expense and is debited to profit and loss account.
  • Repairs : Machinery, furniture, fixtures, fittings, etc. which are repairs, renewals or  replacements for keeping them in working is an expenditure and comes in debited to profit and loss account.
  • Miscellaneous expenses: Certain expenses of small amount clubbed together and are called miscellaneous expenses.  In normal usage these expenses are called Sundry expenses or Trade expenses.

Items on the credit side

Sales less returns: It is shown on the credit side of the trading account. Goods returned by customers are called return inwards and are shown as deduction from total sales and the computed amount is known as net sales.
Other incomes: Examples of such incomes are rent received, dividend received, interest received, discount received, commission received, etc and they are recorded in the profit and loss account.

Closing Entries
The preparation of trading and profit and loss account requires that the balances of accounts of all concerned items are transferred to it for its compilation.
Opening stock account, Purchases account, Wages account, Carriage inwards account and direct expenses account are closed by transferring to the debit side of the trading and profit and loss account. 

This is done by recording the following entry :

 Trading A/c                                      Dr.

To Opening stock A/c

To Purchases A/c

To Wages A/c

To Carriage inwards A/c

To All other direct expenses A/c

The purchases returns or return outwards are closed by transferring its balance to the purchases account. The following entry is recorded for this purpose :

Purchases return A/c                        Dr.     To Purchases A/c

Similarly, the sales returns or returns inwards account is closed by transferring its balance to the sales account as :

Sales A/c                                           Dr.    To Sales return A/c

The sales account is closed by transferring its balance to the credit side of the trading and profit and loss account by recording the following entry:

Sales A/c                                           Dr.    To Trading A/c

Items of expenses, losses, etc. are closed by recording the following entries:

Profit and Loss A/c                           Dr.

To Expenses (individually) A/c

To Losses (individually)  A/c

Items of incomes, gains, etc. are closed by recording the following entry:

 Incomes (individually) A/c                Dr.

Gains  (individually) A/c                   Dr.

To Profit and Loss A/c

The posting for closing the seven accounts of expenses and revenues as they appear in the trial balance are given below:

(i)  For closing the accounts of expenses

Trading A/c                                 Dr.                        83,000

To Purchases A/c                                                     75,000

To Wages A/c                                                            8,000

(ii) Profit and Loss A/c               Dr.                       43,500

To Salaries                                                               25,000

To Rent of building                                                  13,000

To Bad debts                                                              4,500

(i)  For closing the accounts of revenues

Sales A/c                                       Dr.                     1,25,000

To Trading A/c                                                       1,25,000

 (ii) Commission received A/c      Dr.        5,000

To Profit and Loss A/c                                            5,000

The posting done in ledger will appear as follows :

Purchases Account

Wages Account

Salaries Account

Rent of Building Account

Bad Debts Account

Sales Account

Commission Received Account

Concept of Gross Profit and Net Profit

The trading and profit and loss can be seen as combination of two accounts - Trading account and Profit and Loss account. The trading account or the first part ascertains the gross profit and profit and loss account or the second part ascertains net profit.

Trading Account

The trading account ascertains the result from basic operational activities of the business. The basic operational activity involves the manufacturing, purchasing and selling of goods. It is prepared to ascertain whether the selling of goods and/or rendering of services to customers have proved profitable for the business or not. A purchase is one of the main constituents of expenses in business organization. Besides purchases, the remaining expenses are divided into two categories - direct expenses and indirect expenses.

Direct expenses means all expenses directly connected with the manufacture, purchase of goods and bringing them to the point of sale. Direct expenses include carriage inwards, freight inwards, wages, factory lighting, coal, water and feul, royalty on production, etc.

Similarly, sales is the main item of revenue for the business. The excess of sales over purchases and direct expenses is called gross profit.  If the amount of purchases including direct expenses is more than the sales revenue, the resultant figure is gross loss. The gross profit or the gross loss is transferred to profit and loss account. The computation of gross profit can be shown in the form of equation as :

Gross Profit = Sales - (Purchases + Direct Expenses)

The indirect expenses are transferred to the debit side of the second part - profit and loss account. All revenue/gains other than sales are transferred to the credit side of the profit and loss account.

Note - When the total of the credit side of the profit and loss account is more than the total of the debit side, the difference is the net profit for the period of which it is being prepared and if the total of the debit side is more than the total of the credit side, the difference is the net loss incurred by the business firm.

In an equation form, it is shown as follows :

Net Profit = Gross Profit + Other Incomes - Indirect Expenses

Net profit or net loss so computed is transferred to the capital account in the balance sheet by way of the following entry :

(i)  For transfer of net profit

Profit and Loss A/c                           Dr.        To Capital A/c

(ii)  For transfer of net loss

Capital A/c                                       Dr.       To Profit and Loss A/c

Cost of Goods Sold and Closing Stock-Trading Account Revisited

The trading and profit and loss account prepared in the figure presents useful information as to the profitability from the basic operations of the business enterprise. It is reproduced for further perusal.

Trading Account for the year ended March 31, 2017

An illustrative trading account

If there is no opening or closing stock, the total of purchases and direct expenses is taken as Cost of goods sold. The cost of goods sold will be computed using the following formula :

Cost of Goods Sold = Purchases + Direct Expenses

=Rs 75,000 + Rs 8,000

= Rs 83,000

As there is no unsold stock, the presumption here is that all the goods purchased have been sold. But in practice, there is some unsold goods at the end of the accounting period.

let us assume that out of the goods purchased amounting to Rs 75,000 in the current year, the business owner is able to sell goods costing Rs 60,000 only. In such a situation, the business will have an unsold stock of goods costing Rs 15,000 in hand, also called closing stock. The amount of cost of goods sold will be computed as per the following equation:

Cost of Goods Sold = Purchases + Direct Expenses - Closing Stock

= Rs 75,000 + Rs 8,000 - Rs 15,000

It may be noted that closing stock does not normally form part of trial balance, and is brought into books with the help of the following journal entry :

Closing stock A/c                              Dr.

To Trading A/c

It opens a new account of asset, i.e. closing stock Rs 15,000 which is transferred to the balance sheet. The closing stock shall be an opening stock for the next year and shall be sold during the year. In most cases, therefore, the business shall have opening stock as well as closing stock every year, and the cost of goods sold should be worked as per the following equation:

Cost of Goods Sold = Opening Stock + Purchases Direct Expenses-Closing Stock

Operating Profit (EBIT)

It is earned through the normal operations and activities of the business. Operating profit is the excess of operating revenue over operating expenses.
While calculating operating profit, the incomes and expenses of a purely financial nature are not taken into account. Thus, operating profit is profit before interest and tax (EBIT). Similarly, abnormal items such as loss by fire, etc. are also not taken into account. It is calculated as follows:

Operating profit = Net Profit + Non Operating Expenses - Non Operating Incomes

5. Balance Sheet

Balance Sheet

Balance Sheet is the financial statement of a company which includes assets, liabilities, equity capital, total debt, etc. at a point in time. Balance sheet includes assets on one side, and liabilities on the other. For the balance sheet to reflect the true picture, both heads (liabilities & assets) should tally (Assets = Liabilities + Equity).

Balance sheet is more like a snapshot of the financial position of a company at a specified time, usually calculated after every quarter, six months or one year. Balance Sheet has two main heads –assets and liabilities.

Preparing Balance Sheet
It is prepared at the end of the accounting period after the trading and profit and loss account have been prepared. It is called balance sheet because it is a statement of balances of ledger accounts that have not been transferred to trading and profit and loss account and are to be carried forward to the next year with the help of an opening entry made in the journal at the beginning of the next year all the account of assets, liabilities and capital are shown in the balance sheet. Accounts of capital and liabilities are shown on the left-hand side, known as Liabilities. Assets and other debit balances are shown on the right-hand side, known as Assets.
The horizontal format in which the balance sheet is prepared is shown in the figure

Format of a balance sheet

Relevant Items in the Balance Sheet
Current Assets: Current assets are those which are either in the form of cash or a can be converted into cash within a year. The examples of such assets are cash in hand/bank, bills receivable, stock of raw materials, semi-finished goods and finished goods, sundry debtors, short term investments, prepaid expenses, etc.
Current Liabilities: Current liabilities are those liabilities which are expected to be paid within a year and which are usually to be paid out of current assets. The examples of such liabilities are bank overdraft, bills payable, sundry creditors, short-term loans, outstanding expenses, etc.
Fixed Assets: Fixed assets are those assets, which are held on a long-term basis in the business. Such assets are not acquired for the purpose of resale, e.g. land, building, plant and machinery, furniture and fixtures, etc. Sometimes the term 'Fixed Block' or 'Block Capital' is also used for them.
Intangible Assets: These are such assets which cannot be seen or touched. Goodwill, Patents, Trademarks are some of the examples of intangible assets.
Investments: Investments represent the funds invested in government securities, shares of a company, etc. They are shown at cost price. If, on the date of preparation the balance sheet, the market price of investments is lower than the cost price, a footnote to that effect may be appended to the balance sheet.
Long-term Liabilities: All liabilities other than the current liabilities are known as long-term liabilities. Such liabilities are usually payable after one year of the date of the balance sheet. The important items of long term liabilities are long-term loans from bank and other financial institutions.
Capital: It is the excess of assets over liabilities due to outsiders. It represents the amount originally contributed by the proprietor/ partners as increased by profits and interest on capital and decreased by losses drawings and interest on drawings.
Drawings: Amount withdrawn by the proprietor is termed as drawings and has the effect of reducing the balance on his capital account. Therefore, the drawings account is closed by transferring its balance to his capital account. However it is shown by way of deduction from capital in the balance sheet.

Grouping of Assets and Liabilities
The term grouping means putting together items of similar nature under a common heading. For example, the balance of accounts of cash, bank, debtors, etc. can be grouped and shown under the heading of 'current assets' and the balances of all fixed assets and long-term investment under the heading of 'non-current assets'.

6. Opening Entries

Opening Entry

The balances of various accounts in balance sheet are carried forward from one accounting period to another accounting period. In fact, the balance sheet of an accounting period becomes the opening trial balance of the next accounting period. Next year an opening entry is made which opens these accounts contained in the balance sheet.

Related Unit Name