Learning Objective:
This chapter would enable you to understand
- Financial Statement: Meaning and Objectives
- Objectives and Importance
- Trading Account: Meaning
- Features of Trading Account
- Purpose of the Trading Account
- Contents of a Trading Account
- Balancing of Trading Account
- Profit and Loss Account: Meaning
- Features of Profit and Loss Account
- Content of Profit and Loss Account
- Balances of the Profit and Loss Account
- Distinction between Gross Profit and Net Profit
- Operating Profit and Net Profit
- Balance Sheet: Meaning and characteristic
- Distinction between Balance Sheet and Trial Balance
- Grouping and Marshalling (Arrangement) of Assets and Liabilities
- Classification of Assets and Liabilities
- Distinction between Tangible Assets and Intangible Assets
- Distinction between Profit and Loss Account and Balance Sheet
- Methods of Presentation of Financial Statements
Financial Statement: Meaning and Objectives
| Quick Review: Financial Statements are the statements prepared at the end of the accounting period to show financial performance and financial position of the business. A complete set of Financial Statements includes 1. Manufacturing Account by manufacturing enterprise. 2. Trading and Profit and Loss Account; and 3. Balance Sheet. |
Manufacturing Account reflects the cost of goods manufactured (We shall discuss final account of manufacturing entity in the following chapter) while Trading and Profit and Loss Account reflects the profit earned or loss incurred by the enterprise during a specific period (i.e., accounting period) and balance sheet shows the financial position of the enterprise on a given date. As these statements are prepared to show the final results of the business, they are collectively known as Final Accounts or Financial Statements. These Financial Statements are communicated to the users of the accounting information. Thus, Final Accounts mean accounts which are prepared at the final stage and which reflect the profit earned or loss incurred during the accounting period and the financial position of an enterprise as on a given date.
Objectives and Importance
The objectives and importance of the Financial Statements are:
(a) Trading and Profit and Loss Account
- Ascertain Gross Profit or Gross Loss: Trading Account provides information about the gross profit earned or gross loss incurred by the business during the accounting period. It helps in determining whether the sales realisation has adequate profit margin or not.
- Ascertain Net Profit or Net Loss: The Profit and Loss Account provides information about the net profit or net loss earned or suffered by the business during the accounting period.
- Comparison with the Previous Year’s Profit: The profit amount ascertained by the Profit and Loss Account for the accounting period can be compared with that of the previous year’s profit. It helps in ascertaining whether the business is being conducted efficiently or not.
- Details of Indirect Expenses: All the indirect expenses are shown in the Profit and Loss Account. These expenses can be compared over the period and suitable steps may be taken for controlling these expenses.
- Preparing Balance Sheet: A Balance Sheet discloses capital at the end of the year. Net profit earned is added to the opening capital for finding the capital at the end. If there is a loss, then it is deducted from the capital. It is a link between two consecutive Balance Sheets.
- Maintaining Provisions and Reserves: To meet future uncertainties and to strengthen financial position of the firm, Provisions and Reserves are created, out of profits. The amount of provisions and reserves depend upon net profit earned. (vii) Calculation of Ratios: For financial analysis, several ratios are calculated with the help of information/data provided in the Profit and Loss Account. For example, Net Profit Ratio, Operating Ratio, Return on Capital Employed, etc.
(b) Balance Sheet
- Ascertaining Financial Position: Balance Sheet is a part of financial statements that shows the financial position of the business at a particular point of time under various heads. If the assets are more than the outside liabilities, the business is considered to be in sound financial position.
- Comparison with Previous Year: The amounts under various heads of Balance Sheet can be compared with that of previous year and ascertained whether the financial position has improved or worsened as compared to previous year.
- Analysis of Industrial Items: An analysis of individual items of Balance Sheet can be carried out to ascertain whether long-term funds (long-term loans, capital, etc.) have been invested in long-term assets, whether the current assets are realised as stipulated, whether the business has sufficient working capital, whether appropriate credit period is enjoyed, etc.
- Calculating Ratios: The Balance Sheet enables calculation of financial position ratios such as Debt-Equity ratio (to determine whether debts are sufficiently covered); current ratio (to determine working capital adequacy), etc. Ratio analysis helps analysing over or under investment in fixed assets, working capital, etc., and in the process helps in taking appropriate decisions.
| 1. Choose the correct Statement Profit and Loss Account and Balance Sheet is prepared for a particular period. Profit and Loss Account and Balance Sheet is prepared on a particular date. Profit and Loss Account is prepared for a particular period and Balance Sheet is prepared on a particular date. None of the above |
Trading Account
| Quick Review: Trading Account can be depict for the following formula Gross Profit / (Gross Loss) = Opining Stock + Net Purchase + Direct Expenses – (Net Sale + Closing Stock) |
Meaning
Preparation of Trading Account is the first stage in the process of the preparation of Final Accounts. Trading Account shows the results of buying and selling of goods and/ or services. It is prepared to calculate Gross Profit or Gross Loss during an accounting year. Its main components are sales, services rendered and cost of such sales or services rendered.
Trading Account is prepared to know gross profit or gross loss during the accounting period. This account is based on matching the selling price of goods and services with the cost of goods sold and services rendered.
Features of Trading Account
- It is the first stage in the preparation of final accounts of a trading concern.
- It records only net sales and direct cost of goods sold.
- The balance of this account discloses the gross profit or gross loss.
- The balance of this account is transferred to the Profit and Loss Account.
Purpose of the Trading Account
The Trading Account is prepared to know gross profit or gross loss during the accounting period. This account is based on matching the sales of goods and services with the cost of goods sold and services rendered.
Contents of a Trading Account
Items shown on the Debit Side of the Trading Account
Trading account is debited with the following items:
- Opening Stock: Itis the closing stock of the previous year, which has beenentered in the opening stock account through an opening entry. Therefore, it is an entry in the Trial Balance. It is usually the first item of the Trading Account. In the first year of a business there will be no opening stock. In the case of a trader, opening stock consists of different types of finished goods.
- Purchases and Purchase Returns: Purchases account will show a debitbalance, showing the gross amount of purchases made of the materials. This refers to the goods purchased, both cash and credit purchases, for resale. It is a possibility that goods dispatched by the seller have not been received by the purchaser but, the title to the goods has passed on to the purchaser. In such case goods should be accounted as purchase giving corresponding credit to the seller. Remember, the purchases of assets which are meant for permanent use in business such as machinery, furniture, etc., are not included in the purchases, it is a capital expenditure.
The Purchase Returns Account will show a credit balance showing the returns of materials to the suppliers.On the debit side of the trading account, the net amount is shown as indicated below (with assumed figures):
| Rs. | ||
| To | Purchases | 10,00,000 |
| Less: Purchase Returns | 1,00,000 | |
| 9,00,000 |
Besides the purchases returns, the following amounts should also be deducted:
- Goods taken by the proprietor for his personal use.
- Goods given as charity.
- Goods given by way of samples.
Let us discuss some issues relating to purchases for more clarity of the subject:
- Goods taken by the owner for personal use are drawings. It is recorded in the books by debiting the Drawings Account and crediting the Purchases Account.
- Goods received on consignment are recorded separately from purchases. They are not included in purchases because these goods are not owned by the firm.
- Purchase of plant, furniture, stationery, etc., are also recorded separately.
- Sometimes it happens that some goods are purchased in the last days of the year and the firm receives them but these are not recorded in the account books. In such a situation, before preparing the Trading Account, such purchases are also recorded in the books. This amount is debited in the Purchases Account and credited in the Seller’s Account.
- If goods purchased are in transit, it is necessary to record them too. This amount is debited to ‘Goods-in-Transit Account’ and credited to Seller’s Account. In the Balance Sheet, ‘Goods-in-Transit Account’ is shown on the assets side and Seller’s Account on liabilities side. The Trading Account remains unaffected by such type of purchases.
- Adjusted Purchases. When the business firms adjust their opening and closingstocks by preparing Purchases Account, the following entries are passed:
(i) For Adjustment of Opening Stock:
Purchases A/c …Dr.
To Opening Stock A/c
(ii) For Adjustment of Closing Stock:
Closing Stock A/c …Dr.
To Purchases A/c
| Attention Required: On account of these adjustments, there will be no opening stock in the Trial Balance. The amount in the ‘Adjusted Purchases Account’ is shown on the debit side of the Trading Account and the amount of closing stock on the assets side of the Balance Sheet. Adjusted Purchases = Net Purchases + Opening Stock – Closing Stock |
3. Direct Expenses: Direct Expenses are those expenses which are incurred on thegoods purchased till they are brought to the place of business for sale. Examples of such expenses are freight inwards, insurance, customs (import) duty, clearing charges, octroi duty, cartage, etc.
Let us discuss Direct Expenses individually.
- Carriage or Freight or Cartage Inwards: It is the cost of bringing materialsto the firm’s godown and making them available for use. If any freight or carriage is paid on any asset, like machinery, it is added to the cost of the asset and not debited to the Trading Account.
- Wages: Wages paid to workers in godownare debited to the Trading Account, if any amount is outstanding it must be brought into the books so that the full wages for the period are charged to the trading account. If any amount is spent on the making of an asset, the amount is added to the cost of the asset, and debit to the Trading Account is reduced to that extent.
But the difficulty arises when wages are clubbed with salaries (an indirect expense) and the Trial Balance includes a single amount for ‘Wages and Salaries’. In such a situation it is assumed that the item includes the salaries of the supervisory staff in the factory itself. Therefore, the amount is shown in the Trading Account. But, if the item in the Trial Balance is shown as ‘Salaries and Wages’, it is shown in the Profit and Loss Account. It is assumed that the item includes the wages of office staff only.
- Power and Fuel: The cost of coal used in the boiler or electricity consumed in running the machines is included under this head of accounts. Expenses incurred including not paid, i.e., outstanding expenses are debited to the Trading Account.
- Factory Lighting: Electricity consumed for providing light for running the factory is debited to the Trading Account. If there is a common meter for the office and the factory, the total bill should be appropriately divided between the two-only the portion relating to the factory is debited to the Trading Account; the other portion will be debited to the Profit and Loss Account.
- Factory Rent and Rates: The rent paid for the factory premises as well as the municipal taxes (which are called rates) or charges for water, etc., are debited to the Trading Account. If the office and the factory are in the same premises, the total rent and rates have to be suitably apportioned.
- Duty on Purchases: Any duty paid in connection with the purchases of goods is debited to the Trading Account.
- Royalties are the payments which are made for acquiring the right to use patents. It is treated as a direct expense if it is based on the number of unit produced.
- Consumable Stores: These are incurred to keep the machine in right condition and include engine oil, cotton waste, soft soap, oil grease and waste, consumed in a factory.
Stores consumed during the year = Opening Balance in Stores + Purchases of Stores during the year – Closing Balance of Stores.
Items shown on the Credit Side of the Trading Account
- Sales and Sales Returns: The sales account always has a credit balance, indicating the total sales made during the year. The sales returns account has always a debit balance, showing the total of the amount of goods returned by customers. The net of the two amounts is called ‘net sales’ and is entered on the credit side of the Trading Account.
- GST: It must be borne in mind that the GST charged is not a part of the sales revenue. GST charged is to be deposited with the Government. However, if sales are inclusive of GST, the tax amount must be deducted from the sales amount.
- Closing Stock: Closing Stock refers to the stock of unsold goods at the end of the current accounting period. Usually there is no account to show the value of goods lying in the godown at the end of the year. However, to correctly ascertain the gross profit, the closing stock must be taken and valued.
The following entry is recorded to incorporate the closing stock in the books:
Closing Stock A/c …Dr.
To Trading A/c
As a result the closing stock appears both on the credit side of the Trading Account and on the asset side of the Balance Sheet.
Note: In this case the closing stockappears outside the trial balance.
It is also possible to pass the following entry:
Closing Stock A/c …Dr.
To Purchases A/c
The effect of this entry is to reduce the debit in the Purchases Account, the Stock Account is then not entered in the Trading Account. It will then appear in the Trial Balance and the closing stock will be shown on the asset side of the Balance Sheet.
| Attention Required: According to the convention of conservatism, stock is valued at its cost or its market price, i.e., net realisable value, whichever is lower. |
Let us take an example. Suppose, an article worth Rs. 100 is purchased. If this article is not sold out up to the end of the year, its value will be taken as Rs. 100 at the time of valuation of the closing stock, notwithstanding the fact that its sales price is more than Rs. 100 at the end of the year. But if at that time the sales price of this article is Rs. 95 only, in such a situation, its value will be taken as Rs. 95 only. But remember, obsolete articles are not included in the closing stock.
In case of a trading business, the closing stock consists of different types of finished goods. In case of a manufacturing concern, the closing stock consists of raw materials, work-in-progress and finished goods.
Closing Stock means only raw material or unsold finished goods or those things which are traded by the firm. Therefore, the balances of items like stationery and other sundry goods of office use are not included in the closing stock but are shown separately.
Balancing of Trading Account
Gross Profit or Gross Loss: After recording the above items in the respective sidesof the Trading Account, the balance is calculated to ascertain Gross Profit or Gross Loss. If the total of the credit side is more than that of the debit side, the excess is Gross Profit.
If the total of the debit side is more than that of the credit side, the excess is Gross Loss.
Gross Profit is transferred to the credit side of the Profit and Loss Account and Gross Loss is transferred to the debit side of the Profit and Loss Account.
Preparation of Trading Account
The Trading Account is prepared for ascertaining the gross profit or gross loss. Preparation of a Trading Account requires recording entries to transfer the balances of accounts of all the concerned items to the Trading Account. These entries are called ‘Closing Entries’ as after recording the entries these accounts are closed. Following closing entries are passed to give effect of such transfer of balances:
| (i) | For the Items of Debit Side | (ii) | For the Items of Credit Side | ||
| Trading A/c To Opening Stock A/c To Purchases A/c (Net) To Direct Expenses A/c | —Dr. | Sales A/c Closing Stock A/c To Trading A/c | —Dr. | ||
| (iii) | For Gross Profit | (iv) | For Gross Loss | ||
| Trading A/c To Profit and Loss A/c | —Dr. | Profit and Loss A/c To Trading A/c | —Dr. |
Format of a Trading Account
Trading Account
for the year ended …
| Particular | Rs. | Particular | Rs. |
| To Opening Stock To Purchases Less: Return Outwards___ To Direct Expenses To Wages and Salaries To Fright Inwards To Octroi To Direct Tax (e.g. Custom Duty on Imported Goods) To *Gross Profit( Transferred to P&L A/c) | … … … … … | By Sales A/c Less: Return Inward ___ By Closing Stock By Abnormal Loss of Stock By *Gross Loss (Transferred to P&L A/c) | … … … … |
| — | — |
*Either Gross Profit or Gross Loss shall appear.
2. State whether the following statement is true or false.
- In trading account we only take direct incomes and direct expenses.
- Adjusted Purchase = Opining Stock + Purchases – Classing Stock
- Goods taken by the owner should be deducted from the purchase account
- Closing stock represent the goods held in godwon.
- Opining stock is not shown in the trading account if adjusted purchase is shown there.
- Carriage inward and outward are direct expenses.
- ‘Salary and wages’ and ‘wages and salary’ are same in meaning.
- Consumable stores are part of closing stock.
- Closing stock is shown at their market price if it is less than their original price.
- Gross profit is shown in the credit side of the trading account.
Illustration 1. Prepare a Trading Account for the year ended 31st March, 2010 from the following balances as on 31st March, 2010:
| Rs. | Rs. | ||
| Stock on 1st April, 2009 | 10,000 | Purchases | 1,00,000 |
| Wages | 5,000 | Carriage Inwards | 1,000 |
| Sales (Inclusive of Sales Tax) | 1,70,000 | Returns Inwards | 5,000 |
| Returns Outwards | 8,000 | Sales Tax Paid | 15,000 |
| Freight | 500 | Octroi Duty | 2,500 |
Closing Stock as on 31st March, 2010 was valued at Rs. 20,000.
Solution:
| Dr. | TRADING ACCOUNT for the year ended 31st March, 2010 | Cr. | |||
|---|---|---|---|---|---|
| Particulars | Rs. | Particulars | Rs. | ||
| To | Opening Stock | 10,000 | By | Sales A/c | 1,70,000 |
| To | Purchases A/c | 1,00,000 | Less: Sales Tax | 15,000 | |
| Less: Returns Outwards | 8,000 | Net Sales | 1,55,000 | ||
| To | Wages | 5,000 | Less: Returns Inwards | 5,000 | |
| To | Carriage Inwards | 1,000 | By | Closing Stock | 20,000 |
| To | Freight | 500 | |||
| To | Octroi Duty | 2,500 | |||
| To Profit and Loss A/c (Gross Profit) | 59,000 | ||||
| Total | 1,70,000 | Total | 1,70,000 | ||
Journal Entries
| Date | Particulars | L.F. | Dr. (Rs.) | Cr. (Rs.) |
|---|---|---|---|---|
| 2011 | ||||
| March 31 | Trading A/c … Dr. | 1,24,000 | ||
| To Opening Stock A/c | 10,000 | |||
| To Purchases A/c | 1,00,000 | |||
| To Return Inwards A/c | 5,000 | |||
| To Wages A/c | 5,000 | |||
| To Carriage Inwards A/c | 1,000 | |||
| To Freight A/c | 500 | |||
| To Octroi Duty A/c | 2,500 | |||
| (Being the transfer of accounts to the debit side of the Trading Account) | ||||
| March 31 | Sales A/c … Dr. | 15,000 | ||
| To Sales Tax A/c | 15,000 | |||
| (Being the transfer of sales tax paid to the Sales Account) | ||||
| March 31 | Sales A/c … Dr. | 1,55,000 | ||
| Return Outwards A/c … Dr. | 8,000 | |||
| To Trading A/c | 1,63,000 | |||
| (Being the transfer of sales (net of sales tax) and purchases return to Trading Account) | ||||
| March 31 | Closing Stock A/c … Dr. | 20,000 | ||
| To Trading A/c | 20,000 | |||
| (Being the recording of Closing Stock) | ||||
| March 31 | Trading A/c … Dr. | 59,000 | ||
| To Profit and Loss A/c | 59,000 | |||
| (Being the transfer of gross profit to the Profit and Loss Account) | ||||
Illustration 2. Prepare a Trading Account for the year ended 31st March, 2009 fromthe following balances as on 31st March, 2010:
| Rs. | |
| Stock on 1st April, 2009 | 10,000 |
| Sales Returns | 5,000 |
| Sales | 2,00,000 |
| Clearing Charges | 11,000 |
| Purchases | 2,00,000 |
| Purchases Returns | 2,500 |
| Carriage Inwards | 1,500 |
| Carriage Outwards | 3,000 |
| Freight Inwards | 2,500 |
The Closing Stock of goods as on 31st March, 2010 is Rs. 20,000.
Solution:
Trading Account
for the year ended 31st March, 2010
| TRADING ACCOUNT | |||||
|---|---|---|---|---|---|
| for the year ended 31st March, 2010 | |||||
| Particulars | Rs. | Particulars | Rs. | ||
| To Opening Stock | 10,000 | By Sales A/c | 2,00,000 | ||
| To Purchases A/c | 2,00,000 | Less: Returns | (5,000) | ||
| Less: Returns | (2,500) | 1,95,000 | |||
| 1,97,500 | By Closing Stock | 20,000 | |||
| To Carriage Inwards | 1,500 | ||||
| To Freight Inwards | 2,500 | ||||
| To Clearing Charges | 11,000 | By Gross Loss transferred to Profit and Loss A/c | 7,500 | ||
| Total | 2,22,500 | Total | 2,22,500 | ||
Note: Carriage outwards will be charged to the Profit and Loss Account.
| 3. From the following information prepare the Trading Account for the year ended 31st March, 2010: Adjusted Purchases Rs. 11,00,000, Sales Rs. 12,50,000, Freight and Carriage Inwards Rs. 6,000, Wages Rs. 14,000, Freight and Cartage Outwards Rs. 5,000. |
| Attention Required: 1. Trading Account shows Gross Profit or Gross Loss. 2. Gross Profit can be presented in the form of an equation as follows: Gross Profit = Net Sales – Cost of Goods Sold where, (i) Net Sales = Total Sales – Sales Return (ii) Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock (iii) Net Purchases = Total Purchases – Purchases Return. Gross Profit is usually ascertained by preparing the Trading Account. (iv) Sometime Gross Profit is depicted in form of percentage to Net Sale that is called Gross Profit Ratio. The Ratio is computed as follows: Gross Profit Ratio = (Gross Profit/Net Sales) x 100 3. Carriage Inwards is debited to the Trading Account and Carriage Outwards to the Profit and Loss Account. 4. Return Inwards are deducted from the sales whereas Return Outwards are deducted from the purchases in the Trading Account. |
Profit and Loss Account
Meaning
| Quick Review: A Profit and Loss Account is an account into which all gains and losses are collected in order to ascertain the excess of gains over the losses or vice versa. Prof. Carter |
The next step after preparing the Trading Account, is preparing the Profit and Loss Account. This account is prepared to ascertain the net profit or net loss of the business for a given accounting period.
The Profit and Loss Account starts with the credit from the Trading Account in respect of gross profit (or debit if there is gross loss). Thereafter, all indirect expenses or losses are debited to the Profit and Loss Account. In other words, all those expenses and losses which have not been entered in the Trading Account are entered on the debit side of the Profit and Loss Account.
If there is any income and gain beside the gross profit, it will also be transferred to the credit side of the Profit and Loss Account. The difference of the two sides of this account is either net profit or net loss. If the total of the credit side exceeds the total of the debit side, the difference represents the net profit. In a reverse situation, the difference will represent net loss. This difference (i.e., net profit or net loss) is transferred to the capital account of the proprietors. Net profit increases the capital or net loss decreases the capital. Indirect Expenses are those expenses which are not directly associated with the sale of goods or manufacture of goods. They include administrative. selling and distribution expenses such as salaries, rent and taxes, postage and stationery, insurance, depreciation, interest paid, office lighting, advertising, packing, carriage outwards, etc. Losses include items like loss by fire, loss by theft, etc.
Features of Profit and Loss Account
- It is the second stage in the preparation of the final accounts.
- It relates to a particular accounting period and is prepared at the end of that period.
- Accrual basis of accounting is followed in the preparation of this account.
- This account is credited with the gross profit and income from other sources and debited with indirect expenses and losses.
- The balance of this account is the net profit or net loss.
- The capital of the owner is increased or decreased by the balance of this account (Net Profit or Net Loss).
Content of Profit and Loss Account
The expenses may be shown separately or grouped under proper heads to reflect the understandable Profit and Loss Account. The groups under which the expenses may be reflected are:
- Employee Cost.
- Salaries
- Staff Welfare
- Contribution to Profit Fund
- Contribution to ESI
- Leave Salary
- Administrative Expenses.
- Rent, Rates and Taxes
- Postage and Telephone Expenses
- Stationery
- Insurance
- Depreciation
- Interest,
- Office Lighting
- Legal Expenses
- Audit Fee
- Selling and Distribution Expenses.
- Salesmen’s Salaries and Commission;
- Commission of Agents;
- Advertising;
- Warehousing Expenses;
- Packing Expenses;
- Freight and Carriage on Sales;
- Export Duties;
- Maintenance of Vehicles for distribution of goods and their running expenses;
- Insurance of Finished Goods, Stock and Goods in Transit and (x) Bad Debts.
- Financial Expenses: These are those expenses which are incurred in respect of arranging finance for business. Financial Expenses include the following expenses:
- Interest on Loan;
- Interest on Capital and
- Discount Allowed.
Abnormal Losses: Abnormal Loss such as loss of stock by fire not covered by insurance, loss on sale of fixed assets, loss by theft, cash defalcation, etc., may occur during the accounting period. Abnormal Losses are treated as extraordinary expenses and debited and shown separately in the Profit and Loss Account.
| Attention Required: 1. Salaries: Salaries are paid for the services of the employees and are debited to the Profit and Loss Account being an indirect expense. Direct salaries, e.g., salary of the factory manager, salary of the purchase manager, foreman, are of course debited to the Trading Account. 2. Salaries and Wages: When wages are included in salaries, i.e., shown in the Salaries and Wages Account, they are treated as an indirect expenses and are taken to the Profit and Loss Account. On the other hand, Wages and Salaries are treated as direct expenses and debited to the Trading Account. Following expenses do not appear in the Profit and Loss Account: 1. Domestic expenses of the proprietor or partners, as they are personal expenses. 2. Drawings in the form of cash, goods by the proprietor or partners. 3. Personal income tax and life insurance premium paid by the firm on behalf of the proprietor or partners. If income tax appears in the Trial Balance of a sole proprietorship concern, it is treated as drawings and deducted from capital. |
As in the case of expenses, incomes may also be appropriately grouped and shown in the Profit and Loss Account. The groups may be as follows:
1. Incomes from Main Business: These refer to those profits and incomes whichare received from the operations of the main business. This includes the following types of profits and incomes:
- Sale,
- Profit on Consignment,
- Profit on Joint Venture, and
- Commission receivable, etc.
2. Financial and other Incidental Income: Income received from other sources,i.e., other than the main business comes under this category. It includes:
- Interest on fixed deposits,
- Income from investment,
- Rent received,
- Interest on drawings, and
- Discount received.
Form of Profit and Loss Account
Look at the following form. It shows various expenses, losses, incomes, etc., which usually appear in the Profit and Loss Account:
| PROFIT AND LOSS ACCOUNT | |||||
| Dr. | for the year ended on … | Cr. | |||
| Particulars | Rs. | Particulars | Rs. | ||
| To | Gross Loss transferred from | By | Gross Profit transferred from | ||
| To | Trading A/c | … | By | Trading A/c | … |
| To | Salaries | … | By | Rent | … |
| To | Rent, Rates and Taxes | … | By | Discount Received | … |
| To | Stationery and Printing | … | By | Commission Earned | … |
| To | Postage and Telegrams | … | By | Interest | … |
| To | Audit Fees | … | By | Bad Debts Recovered | … |
| To | Legal Charges | … | By | Income from Investment | … |
| To | Telephone Expenses | … | By | Dividends on Shares | … |
| To | Insurance Premium | … | By | Miscellaneous Revenue Gains | … |
| To | Business Promotion Expenses | … | By | Income from any other source | … |
| To | Repairs and Renewals | … | By | Net Loss transferred to Capital A/c | … |
| To | Depreciation | … | |||
| To | Interest | … | |||
| To | Sundry Trade Expenses | … | |||
| To | Conveyance | … | |||
| To | Bank Charges | … | |||
| To | Office Expenses | … | |||
| To | General Expenses | … | |||
| To | Car Running and Maintenance | ||||
| To | Office Lighting | … | |||
| To | Loss by Fire and Theft | … | |||
| To | Commission | … | |||
| To | Advertisement | … | |||
| To | Freight and Carriage Outwards | … | |||
| To | Discount Allowed | … | |||
| To | Packing Expenses | … | |||
| To | Travelling Expenses | … | |||
| To | Distribution Expenses | … | |||
| To | Bad Debts | … | |||
| To | Net Profit transferred to Capital A/c | … | |||
Balances of the Profit and Loss Account
Net Profit or Net Loss: The balance in the Profit and Loss Account represents thenet profit or net loss. If the credit side is more than the debit side, it shows net profit. If the debit side is more than the credit side, it shows net loss. Both (Net Profit or Net Loss) are transferred to the Capital Account. Net profit increases the capital or net loss decreases the capital.
Difference between Trading Account and Profit and Loss Account
| Basis | Trading Account | Profit and Loss Account |
| 1. Relation | Trading Account is a part of Profit and Loss Account. | Profit and Loss Account is the main account. |
| 2. Nature | The Gross Profit or Gross Loss is ascertained from the Trading Account. | The Profit and Loss Account is prepared to ascertain the net profit or net loss of the business. |
| 3. Transfer of Balance | The balance of the Trading Account is transferred to the Profit and Loss Account. | The balance of the Profit and Loss Account is transferred to the Capital Account of the proprietor. |
| 4. Items | Items shown in the Trading Account are purchases, sales, stock, direct expenses, etc. | Items like indirect expenses related to sales, distribution, administration, finance, etc., are shown in the Profit and Loss Account. |
Explanation Regarding Certain Items of Profit and Loss Account
- Salary: Salary is an indirect expense. The combined Salaries and Wages Account is also treated as an indirect expense and, therefore, it is transferred to the Profit and Loss Account. As pointed out earlier, a combined Wages and Salaries Account is treated as a direct expense and transferred to the Trading Account.
- Depreciation: Depreciation is a decrease in the value of an asset due to wear and tear, use or lapse of time. It is treated as business expense and is charged to the Profit and Loss Account.
- Discount: Discount Allowed Account and Discount Received Account should be shown separately on the debit side and credit side of the Profit and Loss Account respectively.Loss by Fire: Loss of goods by fire is a loss to the business. It is debited to the Profit and Loss Account.Insurance: Generally, assets are insured to cover the risk of loss. Insurance premium is treated as a business expense and debited to the Profit and Loss Account.
- Bad Debts and Bad Debts Recovered: When a customer does not pay the amount due from him when it becomes irrecoverable, it is said to be a bad debt. It is a loss to the firm. Therefore, the Bad Debts Account is debited, which later on, is written on the debit side in the Profit and Loss Account.
If later the amount is recovered, it is treated as a gain; it is not credited to the party paying it; it is credited to Bad Debts Recovered Account. It is written on the credit side in the Profit and Loss Account.
Closing Entries in respect of the Profit and Loss Account: Entries that are to berecorded in the Journal for preparing the Trading and Profit and Loss Account, that is, for transferring the various accounts to these two accounts, are known as Closing Entries. To complete the Profit and Loss Account, the under-mentioned three closing entries are necessary:
(a) For items to be debited to the Profit and Loss Account, this account is debited and the various accounts concerned are credited. For example, Salaries Account, Rent Account, Interest Account are closed by transferring their balances to the debit side of Profit and Loss Account. The entry is:
Profit and Loss A/c …Dr.
To Salaries A/c
To Rent A/c
To Interest A/c
To advertising A/c
To Bank interest A/c
To Bank Charge A/c
To Miscellaneous Expenses A/c
(Being the expenses transferred to Profit and Loss A/c and account closed)
(b) Items of income or gain such as Interest Received Account, Miscellaneous Income Account are closed by transferring their balances to the credit side of the Profit and Loss Account. The entry passed is:
Interest Received A/c …Dr.
Discount Received A/c …Dr.
Miscellaneous Income A/c …Dr.
To Profit and Loss A/c
These two entries close all the nominal accounts.
(c) At this stage the Profit and Loss Account shows net profit or net loss. Both are transferred to the Capital Account. In case of net profit, i.e., when the credit side is bigger than the debit side, the entry is:
Profit and Loss A/c …Dr.
To Capital A/c
(Being the net profit transferred to Capital A/c)
In the other case of net loss, the entry will be just reverse, i.e.,
Capital A/c …Dr.
To Profit and Loss A/c
(Being the net loss transferred to Capital A/c)
| 4. State whether the following statement is true or false in relation to Profit and Loss Account. a. All income and expenses whether direct or indirect come in this account. b. We show domestic expenses of the proprietor in the debit side of the Profit and Loss Account as separate item. c. Profit and Loss Account is part of the Trading Account. d. ‘Salary’ is indirect expenses whereas ‘wages and salary’ is direct expense. e. In case of profit, Profit and Loss Account is debited and Capital Account is credited. f. Owners’ capital increases by profit and decreases by loss. |
Now, let us see in the following illustration how the closing entries are passed for the various items given in the Trial Balance.
Illustration 3: The following is the Trial Balance of C. Chand on 31st March,2010. Pass the closing entries and prepare the Trading and Profit and Loss Accounts for the year ended 31st March, 2010.
TRIAL BALANCE
As on 31st March, 2010
| Particulars | Dr. (Rs.) | Cr. (Rs.) |
|---|---|---|
| Capital A/c | 10,000 | |
| Stock A/c (1st April, 2009) | 2,000 | |
| Cash at Bank | 1,000 | |
| Cash in Hand | 440 | |
| Machinery A/c | 6,000 | |
| Furniture and Fittings A/c | 1,360 | |
| Purchases A/c | 15,000 | |
| Wages A/c | 10,000 | |
| Fuel and Power A/c | 3,000 | |
| Factory Lighting A/c | 200 | |
| Salaries A/c | 7,000 | |
| Discount Allowed A/c | 500 | |
| Discount Received A/c | 300 | |
| Advertising A/c | 5,000 | |
| Sundry Office Expenses A/c | 4,000 | |
| Sales A/c | 50,000 | |
| Sums owing by Customers (Sundry Debtors) | 8,500 | |
| Sundry Creditors (Sums owing to Suppliers) | 3,700 | |
| Total | 64,000 | 64,000 |
CLOSING ENTRIES
| Date | Particulars | L.F. | Dr. (Rs.) | Cr. (Rs.) |
|---|---|---|---|---|
| 2010 March 31 | Trading A/c …Dr. | 30,200 | ||
| To Stock A/c | 2,000 | |||
| To Purchases A/c | 15,000 | |||
| To Wages A/c | 10,000 | |||
| To Fuel and Power A/c | 3,000 | |||
| To Factory Lighting A/c | 200 | |||
| (Being the accounts in the Trial Balance which have to be transferred to the Trading Account, debit side) | ||||
| 2010 March 31 | Sales A/c …Dr. | 50,000 | ||
| To Trading A/c | 50,000 | |||
| (Being the amount of Sales transferred to the credit of the Trading Account) | ||||
| 2010 March 31 | Stock (Closing) A/c …Dr. | 2,700 | ||
| To Trading A/c | 2,700 | |||
| (Being the value of stock on hand on 31st March, 2010) | ||||
| 2010 March 31 | Trading A/c …Dr. | 22,500 | ||
| To Profit and Loss A/c | 22,500 | |||
| (Being the transfer of gross profit) | ||||
| 2010 March 31 | Profit and Loss A/c …Dr. | 16,500 | ||
| To Discount Allowed A/c | 500 | |||
| To Salaries A/c | 7,000 | |||
| To Advertising A/c | 5,000 | |||
| To Sundry Office Expenses A/c | 4,000 | |||
| (Being the various expenses accounts transferred to the debit of the Profit and Loss Account) | ||||
| 2010 March 31 | Discount Received A/c …Dr. | 300 | ||
| To Profit and Loss A/c | 300 | |||
| (Being the credit balance of discount received transferred to the Profit and Loss Account) | ||||
| 2010 March 31 | Profit and Loss A/c …Dr. | 6,300 | ||
| To Capital A/c | 6,300 | |||
| (Being the transfer of Net Profit to the Capital Account) | ||||
C. Chand
TRADING ACCOUNT
for the year ended 31st March, 2010
| Particulars | Rs. | Particulars | Rs. |
|---|---|---|---|
| To Stock | 2,000 | By Sales | 50,000 |
| To Purchases | 15,000 | By Closing Stock | 2,700 |
| To Wages | 10,000 | ||
| To Fuel and Power | 3,000 | ||
| To Factory Lighting | 200 | ||
| To Gross Profit transferred to Profit and Loss A/c | 22,500 | ||
| Total | 52,700 | Total | 52,700 |
PROFIT AND LOSS ACCOUNT
for the year ended 31st March, 2010
| Particulars | Rs. | Particulars | Rs. |
|---|---|---|---|
| To Salaries | 7,000 | By Gross Profit transferred from Trading A/c | 22,500 |
| To Discount Allowed | 500 | By Discount Received | 300 |
| To Advertising | 5,000 | ||
| To Sundry Office Expenses | 4,000 | ||
| To Net Profit transferred to Capital A/c | 6,300 | ||
| Total | 22,800 | Total | 22,800 |
Illustration 4: Profit and Loss Account Preparation
From the following information, prepare the Profit and Loss Account of a sole proprietor for the year ended 31st March, 2010:
| Particulars | Rs. |
|---|---|
| Gross Profit | 2,00,000 |
| Salaries and Wages | 10,000 |
| Commission Allowed | 5,000 |
| Commission Received | 2,500 |
| Interest Paid | 3,500 |
| Interest Received | 2,000 |
| Carriage Outwards | 1,250 |
| Freight Outwards | 750 |
| Discount Allowed | 250 |
| Discount Received | 1,250 |
| Dividend Received | 1,900 |
| Rent Paid | 3,000 |
| Rent Received | 8,000 |
| Bad Debts Recovered | 6,000 |
| Brokerage Paid | 1,500 |
| General Expenses Paid | 9,000 |
| Miscellaneous Incomes | 7,000 |
| Depreciation on Machines | 6,000 |
| Postage and Telephones | 4,000 |
Solution:
PROFIT AND LOSS ACCOUNT
for the year ended 31st March, 2010
| Particulars | Rs. | Particulars | Rs. |
|---|---|---|---|
| To Salaries and Wages | 10,000 | By Gross Profit | 2,00,000 |
| To Commission Allowed | 5,000 | By Commission Received | 2,500 |
| To Interest Paid | 3,500 | By Interest Received | 2,000 |
| To Carriage Outwards | 1,250 | By Discount Received | 1,250 |
| To Freight Outwards | 750 | By Dividend Received | 1,900 |
| To Discount Allowed | 250 | By Rent Received | 8,000 |
| To Rent Paid | 3,000 | By Bad Debts Recovered | 6,000 |
| To Brokerage Paid | 1,500 | By Miscellaneous Incomes | 7,000 |
| To General Expenses | 9,000 | ||
| To Depreciation on Machines | 6,000 | ||
| To Postage and Telephones | 4,000 | ||
| To Net Profit transferred to Capital A/c | 1,84,400 | ||
| Total | 2,28,650 | Total | 2,28,650 |
5. From the following information of a trader, prepare his Profit andLoss Account for the year ended 31st March, 2010:
| Particulars | Rs. | Particulars | Rs. |
| Gross Profit | 2,62,500 | Salaries and Wages | 12,000 |
| Discount Received | 17,000 | Discount Allowed | 3,000 |
| Commission Received | 7,000 | Interest Received | 2,000 |
| Fire Insurance Paid | 6,000 | Commission Paid to Salesman | 14,000 |
| Interest Paid | 5,000 | Freight Outwards | 15,000 |
| Rent Paid | 14,000 | Rent Received | 12,500 |
| Printing and Stationery | 7,500 | Entertainment Expenses | 8,000 |
| Postage and Telegrams | 5,500 | Sales Promotion Expenses | 4,250 |
| Bad Debts | 3,250 | Audit Fees | 8,500 |
| Depreciation on Machines | 5,000 | Miscellaneous Income | 12,900 |
| Carriage Outwards | 4,100 | Repairs and Maintenance | 3,400 |
| Travelling Expenses | 6,500 | Water and Electricity Charges (Office) | 3,000 |
| Packing Expenses | 10,500 | Telephone Expenses | 6,000 |
| Bank Charges | 1,900 | Gain on Sale of Machine | 600 |
| Loss by Fire | 3,500 | Income from Investments | 11,500 |
| Loss on Sale of Furniture | 4,000 | Loss by Theft | 1,000 |
| Dividend Received on Shares | 6,250 | Legal Expenses | 11,250 |
| Advertising and Publicity Expenses | 9,000 |
Distinction between Gross Profit and Net Profit
| Gross Profit | Net Profit |
| 1. Gross Profit = Sales – Cost of Goods Sold | Net Profit = Gross Profit + All other Incomes – Indirect Expenses and Losses |
| 2. It is ascertained from the Trading Account. | It is ascertained from the Profit and Loss Acccount. |
| 3. Gross Profit is transferred to Profit and Loss Account. | Net Profit is transferred to the Capital Account. |
| 4. It does not include any income from other sources. | It may include income from other sources. |
| 5. It does not depend on the amount of net profit. | It depends on the amount of gross profit. |
| 6. Amount of Gross Profit depends on the valuation of stock. Increase in the value of closing stock will increase the gross profit. Similarly, reduction in the value of closing stock will reduce the gross profit. | Amount of Net Profit depends on the valuation of assets other than stock. For example, provision for doubtful debts, depreciation, etc |
OPERATING PROFIT AND NET PROFIT
Profit may be divided into two, i.e., (i) Operating Profit and (ii) Net 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 include office and administrative expenses, selling and distribution expenses, cash discount allowed, interest on bills payable and other short-term debts, bad debts and so on. Net sales means cash sales + credit sales – sales return.
Operating Profit = Net Sales – Operating Cost
= Net Sales – (Cost of Goods Sold + Administration and Office Expenses + Selling and Distribution Expenses) Or
Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Income
Net Profit means the excess of revenue (whether operating or non-operating) over expenses and losses (whether operating or non-operating). In other words, net profit is arrived by deducting operating expenses from operating profit as well as nonoperating profit. Expenses which are incidental or indirect to the main operations of the business are called Non-Operating Expenses. They include interest on loan, charities and donations, loss on sale of fixed assets, extraordinary losses due to theft, loss by fire and so on. Similarly, non-operating incomes are added while computing the net profit. Non-operating incomes include, receipt of interest, rent, dividend, profit on sale of fixed assets, etc.
Illustration 5: Compute the Operating Profit and Net Profit from the following particulars
| Rs. | Rs. | ||
| Gross Profit | 4,40,000 | Interest on Loans | 22,000 |
| Carriage Outwards | 4,800 | Interest on Investments | 2,800 |
| Advertising | 12,000 | Printing and Stationery | 3,600 |
| Salaries | 1,78,000 | Loss on Sale of Furniture | 35,000 |
| Rent and Taxes | 62,000 | General Expenses | 1,400 |
| Lighting | 15,000 | Donation | 5,100 |
| Insurance Charges | 2,400 | Rent Received | 6,000 |
| Bad Debts | 1,500 | Loss by Fire | 20,000 |
| Audit Fees | 2,000 | Gain on Sale of Machine | 50,000 |
Solution:
| Rs. | Rs. | |||
| Gross Profit | 4,40,000 | |||
| Less: Selling and Distribution Expenses: | ||||
| Carriage Outwards | 4,800 | |||
| Advertising | 12,000 | |||
| Bad Debts | 1,500 | 18,300 | ||
| Less: Office and Administrative Expenses: | ||||
| Salaries | 1,78,000 | |||
| Rent and Taxes | 62,000 | |||
| Lighting | 15,000 | |||
| Insurance Charges | 2,400 | |||
| Audit Fees | 2,000 | |||
| Printing and Stationery | 3,600 | |||
| General Expenses | 1,400 | 2,64,400 | 2,82,700 | |
| Operating Profit | 1,57,300 | |||
| Add: | Non-Operating Incomes: | |||
| Interest on Investments | 2,800 | |||
| Rent Received | 6,000 | |||
| Gain on Sale of Machine | 50,000 | 58,800 | ||
| 2,16,100 | ||||
| Less: Non-Operating Expenses: | ||||
| Interest on Loans | 22,000 | |||
| Loss on Sale of Furniture | 35,000 | |||
| Donation | 5,100 | |||
| Loss by Fire | 20,000 | 82,100 | ||
| Net Profit | 1,34,000 | |||
Balance Sheet
| Quick Review: A statement which sets out the assets and liabilities of a firm or an institution as at a certain date. Francis R. SteadA Balance Sheet is a screen picture of the financial position of a going business at a certain moment. |
Having prepared the Trading and Profit and Loss Account, the Balance Sheet remains to be prepared. It is a statement which reports theproperty owned by the enterprise and the claims of the creditors and owners against these properties. It shows the financial position of the business as at a given time. The financial position of a concern is indicated by its assets on a given date and its liabilities on that date. Excess of assets over liabilities represent the capital and is indicative of the financial soundness of a company. It is prepared from the Real Accounts and Personal Accounts. In other words,the debit and credit balance ofthose ledger accounts which have not been closed till the preparation of Trading and Profit and Loss Account are shown in the Balance Sheet. The debit balance is shown on the ‘Assets’ side and credit balance is shown on the ‘Liabilities’ side.
The purpose of preparing the Balance Sheet is to ascertain the financial position of a business on a certain date. This is why the Balance Sheet has the heading: Balance Sheet as at … as against the heading of Trading Account and Profit and LossAccount which usually is for a year. Since even a single transaction will make a difference to some of the assets or liabilities, the Balance Sheet is true only at a particular point of time. That is the significance of the words ‘as at’.
Need. A Balance Sheet is prepared with a view to measure the true financial positionof a business at a particular point of time. It is a device to show the financial position of a business in a systematic and standard form. It is a screen picture of the financialposition of the business. Through it the position of the business, at a particular point of time, can be understood at a glance. Just as a doctor will feel the pulse of a person and know whether he is enjoying good health or not, in the same manner by looking at the Balance Sheet one can know whether the firm is solvent or not. If the assets exceed liabilities it is solvent; in the other case, it would be insolvent. It may serve as the basis for determining purchase consideration of the business.
Form of Balance Sheet: The usual items found in the Balance Sheet of a firm are given below:
BALANCE SHEET OF [Entity Name]
as on [Date]
| Liabilities | Rs. | Assets | Rs. |
|---|---|---|---|
| Sundry or Trade Creditors | … | Cash in Hand including Petty Cash | … |
| Bills Payable | … | Cash at Bank | … |
| Bank Overdraft | … | Bills Receivable | … |
| Employees Provident Fund | … | Sundry Debtors/Book Debts | … |
| Loans (Cr.) | … | Loans (Dr.) | … |
| Mortgage | … | Closing Stock | … |
| Reserves or Reserve Fund | … | Loose Tools | … |
| Capital | … | Investments | … |
| Add: Interest on Capital | … | Furniture and Fittings | … |
| Add: Net Profit | … | Plant and Machinery | … |
| … | Land and Building | … | |
| Less: Drawings | … | Freehold/Leasehold Land | … |
| Less: Income Tax | … | Business Premises | … |
| Less: Interest on Drawings | … | Patents and Trade Marks, etc. | … |
| Less: Net Loss | … | Goodwill | … |
| Total | … | Total | … |
Characteristics
The Balance Sheet has certain characteristics which should be noted. These are:
- The Balance Sheet is prepared at a particular date, rather on the close of the day and not for a period. It is true only on that date and not later.
- The Balance Sheet is prepared after the preparation of the Profit and Loss Account; this is the reason why the Profit and Loss Account (including the Trading Account) and the Balance Sheet are together called the ‘Final Accounts’.
- The Balance Sheet shows the financial position of a business as a going concern.
- The Balance Sheet is not an account but only a statement of assets and liabilities.
On the left-hand side, the liabilities of the business are shown whereas on the right-hand side the assets of the business appear.
- The total of the asset side must be equal to the total of liabilities side, i.e., the two sides of the Balance Sheet must have the same totals. If this is not the case, there is certainly an error somewhere.
Distinction between Balance Sheet and Trial Balance
Comparison: Balance Sheet vs. Trial Balance
| Basis | Balance Sheet | Trial Balance |
|---|---|---|
| Purpose | The purpose is to portray the financial position. | The purpose is to establish the arithmetical accuracy of the books of account. |
| Information about Profits | It provides information as to the profitability and financial position of the firm. | No such information is possible from the Trial Balance. |
| Necessity | It is essential to prepare a Balance Sheet to complete the accounting process. | Though desirable, it may be possible to dispense with its preparation. |
| Headings | The two sides are headed as assets and liabilities. | The two columns are headed as debit and credit. |
| Coverage | Only personal and real accounts appear in the Balance Sheet. | In the Trial Balance, all accounts must be written; no account can be left out. |
| Closing Stock | This account appears in the Balance Sheet. | Normally, a closing stock does not figure in the Trial Balance. |
| Period | Normally, it is prepared only at the end of the trading period. | A Trial Balance is prepared normally every month and whenever desired. |
| Adjustment | A Balance Sheet cannot be prepared without making adjustments for outstanding and prepaid items and without taking into account all events and transactions for the year. | A Trial Balance can be prepared at any stage, without even making adjustments. |
Grouping and Marshalling (Arrangement) of Assets and Liabilities
| Quick Review: ‘Grouping’ means putting items of a similar nature under a common heading. The arrangement of assets and liabilities in a particular order in the Balance Sheet is called ‘Marshalling’. |
The assets and liabilities should be shown in a certain order in the Balance Sheet. Therefore, they should be arranged in certain groups and in a particular order. This is called ‘Grouping’ and ‘Marshalling’ of the Balance Sheet. Thus, ‘Grouping’ means putting items of a similar nature under a common heading. The arrangement of assets and liabilities in a particular order in the Balance Sheet is called ‘Marshalling’.
Before we discuss the arrangement of assets and liabilities in the Balance Sheet, let us first understand what assets and liabilities mean. The term ‘assets’ denote the economic resources (property) of the business and includes all current and fixed assets. These are discussed subsequently. The term ‘liabilities’ denote all claims against the assets of the business and include those of the outsiders (Creditors) or those of the owners of the business. Assets and liabilities are shown in the Balance Sheet either in the order of liquidity or in the order of permanence.
(i) In the Order of Liquidity: Liquidity means the facility with which the assetsmay be converted into cash; those assets which are most difficult to convert into cash are written last. Liabilities are to be shown first as short- term liabilities and then as long -term liabilities and last of all as capital. According to this arrangement, the form of a Balance Sheet is as follows:
BALANCE SHEET OF [Entity Name]
as on [Date]
| Liabilities | Rs. | Assets | Rs. |
| Bills Payable | … | Cash in Hand | … |
| Sundry Creditors | … | Cash at Bank | … |
| Bank Overdraft | … | Bills Receivable | … |
| Loans | … | Debtors | … |
| Capital | … | Closing Stock | … |
| Opening Balance | … | Investment | … |
| Add: Net Profit | … | Furniture | … |
| … | Plant and Machinery | … | |
| Less: Drawings | … | Land and Buildings | … |
| Goodwill | … | ||
| Total | … | Total | … |
(ii) In Order of Permanence. Assets, which are to be used permanently in thebusiness and are not meant to be sold are written first. Assets, which are most liquid such as cash in hand, are written last. Liabilities may also be shown according to their performance arrangement. In this method, first show the capital, then long-term liabilities and in the last of all short-term liabilities like amounts due to suppliers of goods or bills payable. The form of a Balance Sheet under such an arrangement would be as follows:
BALANCE SHEET OF [Entity Name]
as on [Date]
| Liabilities | Rs. | Assets | Rs. |
| Capital: | Goodwill | … | |
| Opening Balance | … | Land and Building | … |
| Add: Net Profit | … | Plant and Machinery | … |
| Total | … | Furniture | … |
| Less: Drawings | … | Investment | … |
| Loans | … | Closing Stock | … |
| Bank Overdraft | … | Debtors | … |
| Sundry Creditors | … | Bills Receivable | … |
| Bills Payable | … | Cash at Bank | … |
| Cash in Hand | … | ||
| Total | … | Total | … |
Some of the assets may be capable of being sold easily like investment in government securities or shares of some companies. They should be treated as liquid or permanent according to the intention of the firm.
Classification of Assets and Liabilities
As already discussed, a Balance Sheet is prepared to show the financial position of a business concern, this financial statement shows the various types of assets and liabilities.
BALANCE SHEET
| Liabilities | Assets | ||
| Fixed or Long-Term Liabilities | Fixed Assets | ||
| Current or Short-Term Liabilities | Investments | ||
| Owner’s Funds (Capital) | Current Assets |
It is desirable that in a Balance Sheet various types of assets and liabilities should be shown separately and prominently. This would give meaningful and logical information. We shall now discuss the nature of various types of assets and liabilities.
The assets given above in the Balance Sheet are divided into two parts as follows:
1. Fixed Assets. Fixed Assets are those assets that are acquired for continued use inbusiness to generate revenue. They are not meant for resale, although at a later date they may be sold. They may be tangible assets like land, buildings, plant and machinery, furniture and fixtures, etc., or intangible like goodwill, patents, etc.
Fixed Assets may be: (i) Tangible and (ii) Intangible.
(i) Tangible Fixed Assets refer to those fixed assets which can be seen and touched, e.g., Land and Building, Plant and Machinery, Furniture and Fixture, etc.
(ii) Intangible Fixed Assets refer to those fixed assets which are not in a physical form, i.e., they can neither be seen nor touched, e.g., goodwill of a firm or the know-howwhich it possesses, patents, trademarks, etc.
Note: Fixed Assets are valued at costlessdepreciation.
Investments*. Investments represent capital expenditure on purchase ofshares, debentures, bonds, etc., to earn interest, dividend and other benefits.
* Investment is shown separately in the Balance Sheet.
Distinction between Tangible Assets and Intangible Assets
Comparison: Tangible Assets vs. Intangible Assets
| Basis | Tangible Assets | Intangible Assets |
| Physical Existence | Tangible Assets are generally defined as assets having a physical existence. Example: Land and Building, Plant and Machinery, etc. | Intangible Assets are fixed assets having no physical existence. Example: Goodwill, Patents, Trademarks, etc. |
| Fixed vs. Current | Tangible Assets can be fixed or current, e.g., stock. | Intangible Assets usually fall in the category of fixed assets. |
| Depreciation or Amortization | Fixed Tangible Assets are depreciated. | Intangible Assets are amortized. |
| Risk of Loss | These assets may be lost due to fire. | These assets cannot be lost due to fire. |
| Acceptance as Security | Lenders accept such assets as security for providing loans. | Lenders usually do not accept these assets as security for providing loans. |
| 6. State whether the following statement is true or false in relation to Balance Sheet. a. A Balance Sheet is prepared with a view to measure the true financial position of a business for a period of time. b. Balance sheet is an account that is prepared at the end of all account. c. Total assets must be equal to the total liabilities in the balance sheet. d. Only real and nominal account appears in the Balance Sheet. e. The arrangement of assets and liabilities in a particular order in the Balance Sheet is called ‘Grouping’ f. Fixed Assets are valued at cost price or market price whichever is less. g. Current assets are those assets which realised within a period of one year or during the normal operating cycle. h. Contingent liabilities are shown as a separate item in the balance sheet. |
8. The following is the Trial Balance of Ram Chandra on 31st March, 2011. Draw the final accounts from the balances therefrom:
| Particulars | Dr. (Rs.) | Cr. (Rs.) |
| Capital | 1,50,000 | |
| Stock on 1st | 30,000 | |
| Cash at Bank | 10,000 | |
| Cash in Hand | 5,000 | |
| Machinery | 1,00,000 | |
| Furniture | 13,000 | |
| Purchases | 2,00,000 | |
| Wages | 50,000 | |
| Carriage Inwards | 33,000 | |
| Salaries | 70,000 | |
| Discount Allowed | 4,000 | |
| Discount Received | 5,000 | |
| Advertising | 50,000 | |
| Office Expenses | 40,000 | |
| Sales | 5,00,000 | |
| Sundry Debtors | 90,000 | |
| Sundry Creditors | 40,000 | |
| Total | 6,95,000 | 6,95,000 |
Value of Closing Stock as on 31st March, 2011 was Rs. 50,000.
METHODS OF PRESENTATION OF FINANCIAL STATEMENTS
The Trading and Profit and Loss Account and the Balance Sheet can be presented either in the Horizontal Form or in Vertical Form.
(i) Horizontal Form: Under this form of presentation, the items are presented in ‘T’ form, which we have already discussed in this Chapter. The final accounts in the above illustrations have been prepared in horizontal form.
(ii) Vertical Form: Under this form of presentation, the items are presented in a single column statement in a purposeful sequence.
1. Trading Account
Trading Account can be prepared either in the horizontal format, which we have already discussed or in the vertical format. The horizontal format of a Trading Account and the usually appearing entries therein are shown on the next page (using imaginary figures).
TRADING ACCOUNT OF Z
for the year ended 31st March, 2011
| Dr. | Rs. | Cr. | |||
|---|---|---|---|---|---|
| Particulars | Rs. | Particulars | Rs. | ||
| To Opening Stock | 80,000 | By Sales | 6,06,000 | ||
| To Purchases | 3,50,000 | Less: Return Inwards | 6,000 | ||
| Less: Return Outwards | (10,000) | 6,00,000 | |||
| 3,40,000 | By Closing Stock | 1,30,000 | |||
| To Direct Expenses: | |||||
| Freight and Carriage | 10,000 | ||||
| Customs and Insurance | 20,000 | ||||
| Wages | 60,000 | ||||
| Gas, Water and Fuel | 6,000 | ||||
| Lighting and Heating | 4,000 | ||||
| Factory Expenses | 10,000 | ||||
| 1,10,000 | |||||
| To Gross Profit c/d | 2,00,000 | ||||
| Total | 7,30,000 | Total | 7,30,000 |
The Vertical Format of a Trading Account is given below. This format IS more commonly used for profit statements and reporting.
TRADING ACCOUNT OF Z
for the year ended 31st March, 2011
| Particulars | Rs. | Rs. | Rs. |
| Sales | 6,06,000 | ||
| Less: Return Inwards | 6,000 | ||
| Opening Stock | 80,000 | 6,00,000 | |
| Purchases | 3,50,000 | ||
| Less: Return Outwards | 10,000 | 3,40,000 | |
| Direct Expenses: | |||
| Freight and Carriage | 10,000 | ||
| Customs and Insurance | 20,000 | ||
| Wages | 60,000 | ||
| Gas, Water and Fuel | 6,000 | ||
| Lighting and Heating | 4,000 | ||
| Factory Expenses | 10,000 | 1,10,000 | |
| 5,30,000 | |||
| Less: Closing Stock | 1,30,000 | ||
| Cost of Goods Sold | 4,00,000 | ||
| Gross Profit | 2,00,000 |
2. Profit and Loss Account
Like the Trading Account, the Profit and Loss Account can also be prepared either in Horizontal or Vertical Formats.
The Horizontal Format of a Profit and Loss Account is given on next page (using imaginary figures).
PROFIT AND LOSS ACCOUNT OF Z
for the year ended 31st March, 2011
| Particulars | Rs. | Particulars | Rs. | |
| Management Expenses | By Gross Profit bid | 2,00,000 | ||
| To Salaries (Administrative) | 50,000 | Other Income | ||
| To Office Rent, Sales and Taxes | 10,000 | By Discount Received | 24,000 | |
| To Printing and Stationery | 1,000 | By Commission Received | 6,000 | |
| ToT elephone Charges | 3,000 | Non-Trading Income | ||
| To Insurance | 3,000 | By Bank Interest | 26,000 | |
| To Audit Fee | 2,000 | By Rent of Property Let-out | 32,000 | |
| To Legal Charges | 1,000 | Abnormal Gains | ||
| To | Electricity Charges | 3,000 | By Profit on Sale of Machinery | 46,000 |
| Maintenance Expenses | By Profit on Sale of Investment | 46,000 | ||
| To Repairs and Renewals | 2,000 | |||
| To Depreciation on Machinery | 2,000 | |||
| Selling and Distribution Expenses | ||||
| To Salaries (Selling Staff) | 30,000 | |||
| To Advertisement | 2,000 | |||
| To | Godown Rent | 2,400 | ||
| To | Carriage Outwards | 1,600 | ||
| To | Bad Debts | 1,000 | ||
| To | Provision for Doubtful Debts | 400 | ||
| To | Selling Commission | 3,600 | ||
| Financial Expenses | ||||
| To Bank Charges | 200 | |||
| To | Interest on Loans | 400 | ||
| To | Discount on Bills | 600 | ||
| To | Discount Allowed to Customers | 800 | ||
| Abnormal losses | ||||
| To Loss on Sale of Fixed Assets | Nil | |||
| To | Loss on Sale of Investment | Nil | ||
| To | Loss by Fire or Accident | Nil | ||
| To | Net Profit transferred to Capital Nc | 2,60,000 | ||
| 3,80,000 | 3,80,000 | |||
Notes:
1. Gross Loss will appear on the debit side of the Profit and Loss Account.
2. Net Loss will appear on the credit side of the Profit and Loss Account.
The Vertical Format of Profit and Loss Account is given below. This, too, is more commonly used for profit statements and reporting.
PROFIT AND LOSS ACCOUNT OF Z
for the year ended 31st March, 2011
| Particulars | Rs. | Rs. | Rs. | |
| Gross Profit | 2,00,000 | |||
| Add: | Other Incomes | |||
| Discount Received | 24,000 | |||
| Commission Received | 6,000 | 30,000 | ||
| Add: | Non-Trading Incomes | |||
| Bank Interest | 26,000 | |||
| Rent of Property Let-out | 32,000 | 58,000 | ||
| Add: | Abnormal Gains | |||
| Profit on Sale of Machinery | 46,000 | |||
| Profit on Sale of Investments | 46,000 | 92,000 | 1,80,000 | |
| 3,80,000 | ||||
| Less: | Management Expenses | |||
| Salaries (Administrative) | 50,000 | |||
| Office Rent, Sales and Taxes | 10,000 | |||
| Printing and Stationery | 1,000 | |||
| Telephone Charges | 3,000 | |||
| Insurance | 3,000 | |||
| Audit Fees | 2,000 | |||
| Legal Charges | 1,000 | |||
| Electricity Charges | 3,000 | 73,000 | ||
| Less: | Maintenance Expenses | |||
| Repairs and Renewals | 2,000 | |||
| Depreciation on Machinery | 2,000 | 4,000 | ||
| Less: | Selling and Distribution Expenses | |||
| Salaries (Selling Staff) | 30,000 | |||
| Advertisement | 2,000 | |||
| Godown Rent | 2,400 | |||
| Carriage Outwards | 1,600 | |||
| Bad Debts | 1,000 | |||
| Provision for Doubtful Debts | 400 | |||
| Selling Commission | 3,600 | 41,000 | ||
| Less: | Financial Expenses | |||
| Bank Charges | 200 | |||
| Interest on Loans | 400 | |||
| Discount on Bills | 600 | |||
| Discount Allowed to Customers | 800 | 2,000 | ||
| Less: | Abnormal Losses | |||
| Loss on Sale of Fixed Asset | Nil | |||
| Loss on Sale of Investment | Nil | |||
| Loss by Fire or Accident | Nil | Nil | 1,20,000 | |
| Net Profit transferred to Capital Ale | 2,60,000 | |||
3. Balance Sheet (Vertical Format)
The Balance Sheet presentation used so far in this Chapter is known as the Horizontal Format. Limitations with the said presentation include the fact that it does not show the value of the organisation. The net worth of an organisation to the owner is the value of the owner’s capital. The Vertical Format clearly displays the net worth of the business to the owner, i.e., the capital. This format also provides information about the amount of investments in the fixed assets and in the working capital, which is the difference between the current assets and current liabilities.
The Vertical Format merely involves a rearrangement of the information shown by a Balance Sheet presented in the Horizontal Format. The Vertical Format of a Balance Sheet is shown below (using imaginary figures):
BALANCE SHEET OF Z
as at 31st March, 2011
| Particulars | Rs. | Rs. | Rs. |
| Fixed Assets | |||
| Land | 4,00,000 | ||
| Building | 8,00,000 | ||
| lant and Machinery | 6,00,000 | ||
| Furniture | 2,00,000 | ||
| Delivery Van | 4,00,000 | 24,00,000 | |
| Current Assets | |||
| Stock | 3,00,000 | ||
| Debtors | 5,00,000 | ||
| Bills Receivable | 1,00,000 | ||
| Cash at Bank | 70,000 | ||
| Cash in Hand | 30000 | 10,00,000 | |
| Current Liabilities | |||
| Creditors | 2,00,000 | ||
| Bills Payable | 1,80,000 | ||
| Outstanding Expenses | 20,000 | 4,00,000 | |
| Working Capital (Current Assets – Current Liabilities) | 6,00,000 | ||
| Net Assets Employed | 30,00,000 | ||
| Financed by | |||
| Capital | 27,40,000 | ||
| Add: Net Profit | 2,60,000 | 30,00,000 |