Financial Statements - I

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XI (Financial Accounting Part II), Chapter 8.

Did Anita's boutique make money?

Anita opens a boutique. At the end of the first year she asks two separate questions. Did I earn a profit this year? And what do I own and what do I owe today? The first is about performance over a period. The second is about position on one date. Accountants answer them with two different statements, and this chapter shows you how to build both from the trial balance.

The two statements in one line. The Trading and Profit and Loss Account (the income statement) shows financial performance for a year. The Balance Sheet shows financial position on the last day of the year. Both start from the trial balance, and a tallied trial balance is the first step.

Who reads financial statements

A stakeholder is anyone with an interest in the business, whether the interest is money or something else, active or passive, direct or indirect. Different readers want different things from the same statements.

Capital against revenue: the classification behind every statement

Before any statement is drawn up, every item must be classified. Expenditure is money spent for a purpose other than repaying an existing liability. The part of it consumed in the current year is the expense of that year.

The same split works for receipts. A capital receipt either creates an obligation to repay (a bank loan, extra capital from the owner) or comes from selling a fixed asset. Everything else, such as sales, interest, dividend and commission, is a revenue receipt.

Worked example: classify and see the damage. Classify each item for Anita's boutique, then find what happens if the van is wrongly treated as revenue.

If the van were charged to the Profit and Loss Account, that year's profit would be understated by ₹4,50,000 and the Balance Sheet would miss a van worth the same. The reverse mistake, treating petrol as an asset, would overstate both profit and assets. Either way the statements fail to give a true and fair view.

The launch advertising is written off over 3 years, so ₹3,00,000 ÷ 3 = ₹1,00,000 is charged each year, and the unwritten part waits on the Balance Sheet (₹2,00,000 after year 1).

Common wrong step. Treating the advertising as a capital expenditure just because its benefit lasts several years. It is revenue in nature, so it is only deferred, and it is still fully written off.

Pause and predict: your firm sells an old delivery van for ₹30,000. Is this a revenue receipt?

Check your answer: no. It is a capital receipt, because it comes from the sale of a fixed asset. Only the receipts from the firm's normal activities, such as sale of goods, are revenue receipts.

The Trading Account: gross profit

The Trading Account calculates the gross profit of buying and selling goods. The debit side holds what the goods cost. The credit side holds what they earned.

What is a direct expense? An expense that must be incurred to bring the goods to the place and condition of sale. Wages and carriage inwards are direct. Salaries and carriage outwards are indirect and go to the Profit and Loss Account.

$$\text{Cost of goods sold} = \text{Opening stock} + \text{Net purchases} + \text{Direct expenses} - \text{Closing stock}$$

$$\text{Gross profit} = \text{Net sales} - \text{Cost of goods sold}$$

Closing stock does not usually appear in the trial balance. It comes as additional information, and it is valued at cost. It is shown on the credit side of the Trading Account and again on the asset side of the Balance Sheet.

The Profit and Loss Account: net profit

The Profit and Loss Account starts with the gross profit brought down on the credit side and adds other incomes. It debits all indirect expenses. The balance is the net profit (or net loss), which is transferred to Capital.

$$\text{Net profit} = \text{Gross profit} + \text{Other incomes} - \text{Indirect expenses}$$

Worked example: Trading and Profit and Loss Account. The trial balance of Anita's Boutique on 31 March is below. Closing stock is ₹50,000. Prepare the Trading and Profit and Loss Account and find the gross profit and net profit.

Common wrong step. Putting carriage outwards (₹4,000) in the Trading Account because it has the word "carriage" in it. Inwards brings goods to the shop, so it is direct. Outwards delivers to customers, so it is an indirect selling cost for the Profit and Loss Account. Leaving closing stock out of the Trading Account is another classic slip. It would make gross profit ₹92,000 instead of ₹1,42,000.

Pause and predict: the closing stock of ₹50,000 appears in the Trading Account. Does it appear anywhere else?

Check your answer: yes, on the asset side of the Balance Sheet, as a current asset. The same closing stock is both the part of cost that is not used up this year and an asset the firm still holds.

Beyond the textbook. For the exam: closing stock is valued at cost. In reality: accounting standards require stock to be valued at the lower of cost and net realisable value, so goods that will now sell for less than they cost are written down. Why it matters: in a real firm the closing stock figure can be lower than cost, which would reduce the gross profit calculated here.

Closing entries: moving balances into the statements

The ledger balances reach the Trading and Profit and Loss Account by closing entries. Purchases returns are closed into Purchases, and sales returns into Sales, so the net figures appear. Direct expenses and stock go to the debit of Trading. Net sales and closing stock go to the credit. The balance of Trading goes to Profit and Loss, and the balance of Profit and Loss goes to Capital.

Worked example: closing entries for Anita's Boutique.

Common wrong step. Debiting Closing Stock to Trading. Closing stock is an asset that is brought into the books and Trading is credited, not debited.

Operating profit

Operating profit (profit before interest and tax) measures the profit from the normal operations of the business. To get it from net profit, add back anything that is not part of normal operations and remove incomes that are not operating.

$$\text{Operating profit} = \text{Net profit} + \text{Non-operating expenses} - \text{Non-operating incomes}$$

Non-operating expenses are items such as interest paid on borrowings and abnormal losses like loss by fire. Non-operating incomes are items such as dividend received, interest received on investments and profit on sale of investments.

Worked example: operating profit. A firm reports a net profit of ₹1,00,000. It includes interest paid ₹8,000, loss by fire ₹3,000, dividend received ₹5,000 and profit on sale of investments ₹2,000. Find the operating profit.

Common wrong step. Subtracting the expenses and adding the incomes (1,00,000 − 11,000 + 7,000 = 96,000). That pushes the net profit further from operating profit. The logic is that you want profit as if the financing and abnormal items did not exist, so reverse their effect: add back expenses, take away incomes.

The Balance Sheet

The Balance Sheet is a statement, not an account. It lists the assets and liabilities of the business on a date, and the two sides must be equal. For a sole proprietor the horizontal format is normally used.

On the liabilities side: capital, long term liabilities and current liabilities. On the assets side: fixed assets, intangible assets, investments and current assets. The closing capital is not the opening figure. It must be updated.

$$\text{Closing capital} = \text{Opening capital} + \text{Additional capital} + \text{Net profit} - \text{Drawings}$$

Income tax paid by the proprietor on his own account is also deducted, like drawings.

Worked example: Anita's Balance Sheet. Prepare the Balance Sheet of Anita's Boutique on 31 March in the order of liquidity.

Common wrong step. Writing the opening capital of ₹2,00,000 on the liabilities side. The two sides would then differ by ₹30,000, the net effect of profit less drawings. Drawings are never an expense. They reduce capital, not profit.

Marshalling and grouping. Marshalling is the order in which items are arranged. Grouping is putting items of similar nature under one head.

Beyond the textbook. For the exam: the proprietor's Balance Sheet may follow either order, in the horizontal format. In reality: companies must follow a prescribed format under the Companies Act, set out in Schedule III, which is vertical and groups items under heads. The horizontal format for sole proprietors is only a convention. Why it matters: the order a question names tells you the order of the items, but the totals never change.

Opening entry: starting the next year

At the beginning of the new year, the closing balances of assets and liabilities from the Balance Sheet are brought back into the books by a single entry in the journal proper.

Worked example: opening entry on 1 April.

All assets are debited and all liabilities and capital are credited. The Capital figure is the balancing figure (assets less outside liabilities).

Common wrong step. Crediting the assets and debiting the liabilities, which is the reverse. Assets always carry debit balances.

Exam traps

Formats and formula sheet

Here OS is opening stock, CS is closing stock, GP is gross profit and NP is net profit.

Trading and Profit and Loss Account skeleton.

60-second revision

Where this chapter connects

• Previous: Depreciation, Provisions and Reserves supplies the depreciation charged in the Profit and Loss Account and the fixed assets shown net on the Balance Sheet.
• Earlier idea reused: Trial Balance and Rectification of Errors is where this chapter starts, since every figure above came from a tallied trial balance.
• Next: Financial Statements II adds year end adjustments (outstanding and prepaid items, provisions, commission) to these statements.
• Class XII link: Analysis of Financial Statements reads the Balance Sheet and the income statement for comparison, and Accounting Ratios turns their figures into ratios.