Financial Statements – I

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Test Your Understanding – I
State True or False
  1. Gross profit is total revenue (❌ False)
  2. In trading and profit and loss account, opening stock appears on the debit side because it forms the part of the cost of sales for the current accounting year. (✔ True)
  3. Rent, rates and taxes is an example of direct expenses. (❌ False)
  4. If 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. (✔ True)
II Match the items given under ‘A’ with the correct items under ‘B’
  1. Closing stock is credited to (Trading Account)
  2. Accuracy of book of account is tested by (Trial Balance)
  3. On returning the goods to seller, the buyer sends (Debit Note)
  4. The financial position is determined by (Balance Sheet)
  5. On receiving the returned goods from the buyer, the seller sends (Credit Note)
Test Your Understanding – II
Choose the correct option in the following questions :
  1. The financial statements consist of:
    1. Trial balance
    2. Profit and loss account
    3. Balance sheet
    4. (i) and (iii)
    5. (ii) and (iii) ✔
  2. Choose the correct chronological order of ascertainment of the following profits from the profit and loss account :
    1. Operating Profit, Net Profit, Gross Profit
    2. Operating Profit, Gross Profit, Net Profit
    3. Gross Profit, Operating Profit, Net Profit ✔
    4. Gross Profit, Net Profit, Operating Profit
  3. While calculating operating profit, the following are not taken into account.
    1. Normal transactions
    2. Abnormal items
    3. Expenses of a purely financial nature ✔
    4. (ii) & (iii)
    5. (i) & (iii)
  4. Which of the following is correct :
    1. Operating Profit = Operating profit – Non-operating expenses – Non-operating incomes
    2. Operating profit = Net profit + Non-operating Expenses + Non-operating incomes
    3. Operating profit = Net profit + Non-operating Expenses – Non-operating incomes ✔
    4. Operating profit = Net profit – Non-operating Expenses + Non-operating incomes
Short Answers
1. What are the objectives of preparing financial statements?
The basic objectives of preparing the financial statements are to present a true and fair view of:
  1. Financial performance of the business.
  2. Financial position of the business
2. What is the purpose of preparing trading and profit and loss account?
The purpose of preparing the trading and profit and loss accounts is to present a true and fair view of:
  1. Financial performance of the business.
  2. Financial position of the business
3. Explain the concept of cost of goods sold.
Cost of goods sold is the total cost incurred for the production of goods sold by the company. It can be computed as follows:
When there are no goods left out: In otherwords everything that is produced is sold out. In this case the cost of goods sold is computed as:
Cost of goods sold = Purchases + Direct Expenses
When there is a closing stock: At the end of the accounting period there might be some stock that is left out. In this case the cost of goods sold is computed as:
Cost of goods sold = Purchases + Direct Expenses – Closing Stock
When there is an Opening stock: At the beginning of the accounting period there might be some stock carried forward to the current accounting period from the previous accounting period. This stock should be taken into consideration when calculating the cost of goods sold. In this case the cost of goods sold is computed as:
Cost of goods sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
4. What is a balance sheet. What are its characteristics?
Balance sheet is a statemnet prepared to give an account of the financial position of the business at a given date and contains the total assets and liabilities of the business. The debit balances represent the assets and the credit balances represent the liabilities. The balance sheet is prepared at the end of the accounting period. Preparation of trading and profit and loss account is a pre-requisite for preparing the balance sheet. As the name suggests the balance sheet contains the balances of
  1. the ledger accounts that are not transferred to teh trading and profit and loss account
  2. and are to be carried forward to the next accounting period through an open entry made in the journal at the beginning of the next accounting period.
The following are the characteristics of the balance sheet:
  1. It reflects the financial position of the business.
  2. It is prepared at the end of the accounting period
  3. It has dependency on the trading and profit and loss account and hence is prepared only after preparing the trading and profit and loss accounts.
  4. It is a legal requirement for the firm to prepare the balance sheet.
  5. It contains the balances of those ledger accounts that are not transferred to the trading and proftit and loss accounts.
  6. Classifies the assets and liabilities in the order of either permanence or liquidity etc.
  7. A reference point to create the opening entries in various journal/subsidiary books in the next accounting period.
5. Distinguish between capital and revenue expenditure and state whether the following statements are items of capital or revenue expenditure:
  1. Expenditure incurred on repairs and whitewashing at the time of purchase of an old building in order to make it usable.
  2. Expenditure incurred to provide one more exit in a cinema hall in compliance with a government order.
  3. Registration fees paid at the time of purchase of a building
  4. Expenditure incurred in the maintenance of a tea garden which will produce tea after four years.
  5. Depreciation charged on a plant.
  6. The expenditure incurred in erecting a platform on which a machine will be fixed.
  7. Advertising expenditure, the benefits of which will last for four years.
The following are the differences between capital and revenue expenditure.
Base
of
Comparision
Capital Expenditure
Revenue Expenditure
1. Role on Earning Capacity
Increases the earning Capacity
Maintains the earning capacity.
2. Purpose of incur
Incurred to acquire fixed assets for operation of business
Incurred for meeting the day-to-day operational expenses of the business
3. Nature of Recurrence
Non-recurring by nature
Recurring in nature
4. Period of benefit
Benefits more than one accounting year.
Benefits one accounting year.
5. Recording in financial statements
Subjected to depreciation and recorded in balance sheet
Subject to adjustment for outsatnding and prepaid amount. Recorded into the trading and profit and loss account.
Classification of expenditures:
  1. Expenditure incurred on repairs and whitewashing at the time of purchase of an old building in order to make it usable. (Capital Expenditure)
  2. Expenditure incurred to provide one more exit in a cinema hall in compliance with a government order. (Revenue Expenditure)
  3. Registration fees paid at the time of purchase of a building (Capital Expenditure)
  4. Expenditure incurred in the maintenance of a tea garden which will produce tea after four years. (Capital Expenditure)
  5. Depreciation charged on a plant. (Revenue Expenditure)
  6. The expenditure incurred in erecting a platform on which a machine will be fixed. (Capital Expenditure)
  7. Advertising expenditure, the benefits of which will last for four years. (Deferred Revenue Expenditure)
6. What is an operating profit?
Operating profit, usually referred as EBIT, is the profit earned through the normal operations and activities of the business. It reflects the excess of operating revenue over operating expenses. The operating profit is computed by excluding the incomes and expenses that are purely financial in nature and and abnormal items like loss due to theft etc. The following equation is used to calculate the operating profit.
Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
Long Answers
1. What are financial statements? What information do they provide?
Definition: The statements that contains the financial information about the business and can satisfy the financial information requirements of both internal and external uses are known as financial statements. They serve as one source of financial information and cater to the diverse information needs of different users. The objective of preparing the financial statements is to present a true and fair view of
  1. the financial performance of the business
  2. the financial position of the business
To fulfil this purpose, the businesses prepare the financial statements in two formats
  1. Trading and Profit and Loss Account: It projects the financial performance interms of profit earned or loss incurred by the business.
  2. Balance Sheet: It projects the financial position of the business in the form of assets, liabilities and capital.
To prepare the financial statements, the trial balance and any other available additional information is used as reference.
Information provided by the financial statements: The financial statements provide the information related to the gross profit/loss, net profit/loss, book values of the assets and liabilities, liquidity/permanence of the various assets and liabilities, future performance etc. Various individuals/institutions will be interested in various types of information as described below.
  1. Current Owners: These internal users would like to know the profits in the previous accounting period and current position of the assets and liabilities.
  2. Managers: These internal users would like to know about the profits and financial position of the business as it is like their report card.
  3. Government: As an external user, the government would like to know the financial position of the business to ensure that the rights of the stakeholders are protected. The goverment is also interested in the profits earned by the firm to ensure that the taxes are properly paid. The government is also interested in other relevant information too.
  4. Prospective Owners: These external users would like to know the past profits and financial position and also the future performance of the business to make a call regarding whether to invest in the business or not
  5. Banks and other financial institutions: They are interested in the profits earned by the company as it gives a sense of assurance to recollect the loans and interest. The banks are also interested in the liquidity of the assets.
2. What are closing entries? Give four examples of closing entries.
Closing Entries: To prepare the trading and profit and loss account, the balances of accounts of all the concerned items are transferred to it for compilation. The entries created by transferring these balances are referred to as Closing Entries.
1. The 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. The corresponding entries would be
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
2. The purchases returns or return outwards are closed by transferring the balance to the purchases account. The corresponding entries would be
Purchases return A/c
Dr
To Purchases A/c
3. Similar to the purchases return, the sales returns or returns inwards account is closed by transferring its balance to the sales account. The corresponding entries would be
Sales A/c
Dr
To Sales return A/c
4. The sales account is closed by transferring its balance to the credit side of the trading and profit and loss account. The corresponding entries would be
Sales A/c
Dr.
To Trading A/c
5. Items of expenses, losses etc are closed by recording the folllowing entries
Proift and Loss A/c
Dr
To Expenses (individually) A/c
To Losses (individually) A/c
6. Items of incomes, gains etc are closed by recording the following entries
Incomes (individually) A/c
Dr
Gains (individually) A/c
Dr
To Profit and Loss A/c
3. Discuss the need of preparing a balance sheet.
The following are the needs of preparing the balance sheet.
Balance sheet is prepared for showing the financial position of the business. It contains the summary of the assets and liabilities of the business at any given date. The assets project the debit balances and the liabilities (capital is relected under liabilities) project the credit balances. Balance sheets are prepared at the end of the accounting period. Before preparing the balance sheet, the accounts team will prepare the profit and loss account which will then be used to prepare the balance sheet. Balance sheet is required to summarize all the account details that have not been transferred to the trading and profit and loss account. Balance sheet also acts as a reference where in the balances of the accounts that need to be carried forward to the next accounting period are summarized. These balances of the accounts in the balance sheet make an open entry to the accounts in the next financial year.
When prepared and publicly available, it caters to the informational needs of diversified set of users like current owners, managers, employees, Government, prospective owners, creditors, shareholders, banks and other financial institutions etc. These individuals refer to the balance sheet to get an idea of the current position of the assets/liabilities, future prospects etc. Additional information like the liquidity/permanance order can also be obtained by referring to the balance sheet.
Apart from the summary of the assets and liabilities, the balance sheet contains any additional notes that add value to the current information and will be useful to the users seeking information.
It also acts as a source of reference for the management to plan out and control the business operations.
4. What is meant by Grouping and Marshalling of assets and liabilities. Explain the ways in which a balance sheet may be marshalled.
Grouping: Grouping refers to putting together the assets and liabilities of similar nature under a common accounting head. All such assets/liabilities are shown under a common heading. For instance, if a business has 3 or 4 different types of creditors, all of them will be grouped under one section. Similarly, raw materials, work in progress, and finished goods can be put together under one head. Similarly, if a business owns a number of patents all these assets can be put together under one head.
Marshaling: Arrangement of assets and liabilities either in the order of liquidity or permanance is known as marshalling.
  1. Permanence: The most permanent asset or liability is put on the top in the balance sheet and the remaining assets are arranged in the order of reducing level of permanence. The following is an example of assets arranged in the order of permanence.
    1. Furniture
    2. Debtors
    3. Bank
    4. Cash

    In the above, furniture is the most difficult to convert to cash i.e. is has more permanence. Compared to bank it takes more time to get the cash from debtors. And compared to the cash in bank, cash at hand is readily available.
    The following is example of arrangement of liabilities in the order of permanence.

    1. Capital
    2. Long term loan
    3. Creditors

    In the above, capital is more likely to stay in the business for more time than the other. It takes more time to pay the long term loan compared to the short term creditors.

  2. Liquidity: Liquidity is the opposite order of the permanance and refers how easily an asset can be converted to cash or a liability can be paid out.The following is an example of assets arranged in the order of liquidity.
    1. Cash
    2. Bank
    3. Debtors
    4. Furniture

    In the above, compared to cash at bank, the cash is the most one that can be most easily liquefied. Compared to debtors, the cash at bank is more easily available. Also, it is easy to get the cash from debtors compared to converting the furniture to cash.
    The following is example of arrangement of liabilities in the order of liquidity.

    1. Creditors
    2. Long term loan
    3. Capital

    In the above, the creditors are the ones that will paid out first and then the long term loan. capital is more likely to stay in the business for more time than the other.