Financial Statements are the systematically organized summary of all the ledgers account heads presented in a manner that it gives detailed information about the financial position of an enterprise.
We know that there are various users of an enterprise with different informational requirements. So instead of generating particular information useful for a certain no. of users, the business prepares a complete set of financial statements which satisfies the needs of all the users.
1. Manufacturing entities
2. Non- Manufacturing entities
The financial statements for both the above mentioned entities are same to a major extent. The only difference here is that a manufacturing entity needs to prepare a Trading A/c before it goes forward to prepare the Profit and Loss Account.
Before preparing the final accounts for an entity, an accountant needs to go through other steps as well which are-
a. Recording Journal entries for all the material financial transactions
b. Preparing Ledger accounts or subsidiary books for all the individual accounts
c. Preparing Trial Balance
d. Preparation of the Final Accounts
1. Income Statement: Income statement is prepared to determine the profit earned or loss sustained by the business enterprise during the accounting period. It is a summary of all the revenues and expenses of the business and calculates the net figure of profit or loss.
For non-manufacturing concern, the income statement is sub-divided into two parts:
a.Trading account; and
b.Profit and Loss Account
2.Position Statement: A position statement tells the financial position of the business on as fixed date, which is usually the last day of the year. It comprises of Balance Sheet, which shows the assets and liabilities of a firm as on the closing date of the accounting period.
Note: For better understanding of the financial statements, additional statements like Cash-flow statement, statement showing Earning per share, etc. is also prepared which is not a mandatory practice for non-corporate entities.
To prepare the financial statements properly, it is very important that all the transactions are recorded properly during that particular accounting period. Some of the things to keep into mind while recording the transactions are:
i)A distinction should be made between capital and revenue receipts and payments;
ii)Income and expenses relating to the current period of accounting should be separated from those of another period. Accrual concept should be kept in mind while doing this;
iii)Different incomes and expenses should be accumulated under correct heads;
iv)Personal incomes and expenses should be separated and not recorded with the business incomes and expenses in the books of the entity;
v)Assets should be valued and other provisions should be estimated on the same basis as the prior year, since it ensures consistency;
vi)Every information considered material for the business should be disclosed properly in the financial statements; and
vii)Though the transactions are recorded continuously in the books but at the end of the accounting period, the closing entries should be distinguished from those of the succeeding period
It is to be remembered that out of the total expenditure incurred, some appear in the Profit and Loss account while some in the Balance Sheet
E.g. (i) Out of the total manufacturing cost incurred on manufacturing of goods, the part which attributes to the finished goods is shown in the Balance Sheet as closing stock and the rest of the cost is debited in the Trading and P&L account.
(ii) When an asset is purchased the machine is shown in the Balance Sheet at the book value and the depreciation charged on the machine or the gain/loss on sale of the asset is shown in the P&L account.
(iii) If a machine undergoes repairs & replacement and cleaning, then cleaning expenses will be charged to the P&L account because it is a re venue expense whereas the repairs & replacements will be added to the value of the assets in the Balance sheet
Hence, it is very important to charge accurately determined amount to the Profit and Loss account, otherwise both the statements will show an incorrect position. The principle that governs this is called the Matching Principle.
This Principle demands expenses to be matched with revenue of that period, which implies the following:
(a) If a certain income is entered in the Trading and P&L account, the related expenses also needs to be debited whether or not the expenses have been paid, and vice-versa.
(b) If some expenses have been incurred but the sales against it will be made in the next accounting year, then those expenses will not be debited in the Trading and P&L account. It will be recorded in the Balance Sheet. That is the reason why the opening stock is debited in the Trading account as the revenue from sales is credited in the same account.
(c) At the year end, all the remaining inventory is valued at cost of production or Net Realisable Value, whichever is lesser. The closing stock is credited in the Trading Account with the unused or unsold inventories, the same amount will come as an opening balance in the next accounting period.
(d)If an expense was incurred last year for the revenue related to this year, that expense amount will be debited to the Profit and Loss account after deducting the same from the “prepaid expenses” of the last year from the Balance Sheet.
As discussed earlier, the revenue items form part of the Trading and Profit & Loss account whereas the capital items helps in the preparation of Balance Sheet.
1. Expenditure: Whenever a payment is made for a purpose other than settlement of an existing liability, it is called expenditure. The expenditures are incurred with a motive that it would provide benefits to the business, short term or long term.
If the expenditure incurred is recurring and its benefits extend to an year or less, then it is called a revenue expense.
Normally these expenses are incurred to facilitate the day-to-day operations of the business. E.g. salaries, rent, administrative expenses, etc. The salaries paid for the current year will not give any benefit the next year. To get the work done by the workers in the next period, the entity will have to pay the salaries again.
If the expenditure incurred is non-recurring and its benefits extend to more than an year, then it is called a capital expense.
Normally these expenses are incurred to buy patents, rights or assets, purchase or additions/extensions or installation of assets, etc.
E.g. Purchase of furniture for the business in the current accounting period which will give benefits for many accounting periods to come.
Sometimes, a same kind of expenditure can be either revenue or capital depending upon the situation. E.g. Advertising or marketing expenditure is generally considered a revenue expense as it is done to sell the goods and services produced in that year, but if the advertising expenditure is huge like getting an advertisement on the T.V. or celebrity endorsements, then the expenditure becomes a capital expenditure because it is building the brand image and goodwill of the business which will benefit the entity for a long period of time.
(a) Capital expenditure increases the earning capacity of the business whereas revenue expenditure is incurred to maintain that earning capacity.
(b) Capital expenditure are one-time non-recurring expenses whereas revenue expenditure are operational and are recurring.
(c) Capital expenditure is incurred to acquire fixed assets, copyrights or rights whereas revenue expenditure is incurred on a day-to-day basis.
(d) Capital expenditure benefits the organization for more than a year whereas revenue expenditure benefits for only one accounting period.
(e)Capital expenditure is recorded in the Balance sheet whereas the revenue expenditure is recorded in the Profit and Loss account.
2. Receipts: The similar kind of treatment is given to the receipts of the business.
If the receipts imply that the entity will have to return the money, these are capital receipts.
E.g. Loan taken from the bank, sale of fixed assets, etc.
The thing to note here is that both the above examples are obligations for the business to return, one to the outsider (external liability) and another one to the owner (internal liability).
If the receipt is recurring revenue and it’s a result of the regular trade and operations of the business, then it’s a revenue receipt.
E.g. Sales made by the firm, interest/dividends earned by the entity on its investments, etc.
Exception to the rule: There is an exception to the rule that only such income will be debited in the Trading and Profit & Loss account which yields alternate revenue. There are some cases where the expense doesn’t have any revenue attached to it even then it is debited in the Trading and P&L account and hence it’s a loss for the firm.
E.g. If a fire occurs or theft happens in the business and inventory gets destroyed, then the cost related to that inventory will be debited to the Trading account to the extent which is not covered by insurance), even though it will not yield any revenue for the firm.
We’ll discuss about the Income and Position Statements in detail in the next topic.