Financial Statements are prepared to know profit or loss and also the financial position of the business. These statements are presented to users of accounting information for decision - making. A complete set of financial statements include a. a balance sheet,b. a profit and loss account and c. schedules and notes forming part of balance sheet. In many countries, Financial Statements also include a statement of changes in financial position (which may be presented as cash flow statement or funds flow statement).
Users of Financial Statements
The information given in the Financial Statements is of much interest to a number of external parties. These include investors, Lenders, Suppliers and Trade Creditors, Government and their agencies, Public, Tax Authorities, Employees and Trade Unions, and Stock Exchanges.
Classification of Capital and Revenue Items
A business prepares a Profit and Loss Account to ascertain whether it has earned profit or incurred loss and the Balance Sheet to know the financial position as at the end of a period. Both are prepared on the basis of a Trial Balance which is compendium of the final position of all ledger accounts. There is a set rule that all the accounts appearing in the Trial Balance are transferred either to the Profit and Loss Account or to the Balance Sheet. Few enterprises also prepare Trading Account in addition to Profit and Loss Account. Which item of the Trial Balance is transferred to the Profit and Loss Account and which to the Balance Sheet depends on whether it is a Capital expenditure or a revenue expenditure. Revenue expenditure is transferred to the Trading and Profit and Loss Account and Capital expenditure to the Balance Sheet under fixed assets.
Capital Expenditure is the amount spent by an enterprise on purchase of fixed assets that are used in the business to earn income and are not intended for resale. Fixed assets purchased may be tangible or intangible.
Revenue Expenditure is the amount spent on running a business. In short, an expenditure which is not capital can be considered as revenue expenditure. The benefit of revenue expenditure is exhausted in the accounting period in which it is incurred.We even discussed about the differences between capital expenditure and revenue expenditure.
Improper Considerations in the Determination of Capital Expenditure and Revenue Expenditure
Whether any expenditure is capital or revenue should be determined only after considering the nature of the expenditure. One should not be guided by some of the issues discussed above.
Deferred Revenue Expenditure: It is that class of revenue expenditure which is incurred during an accounting period but, the benefit arising out of it extends beyond that accounting period. Such an expenditure is unusually larger than the normal expenditure under the head. An example of this is a large expense, say on advertising beyond the accounting period in which the expenditure was incurred.
Capital Receipts and Revenue Receipts
Capital Receipts: Capital receipts are the amounts received in the form of additional capital introduced in the business, loans received and sale proceeds of the fixed assets. You may observe that when a loan is received, it increases the business liability. Hence, it cannot be treated as revenue. Sale of any fixed asset reduces fixed assets hence, the amount received is not revenue earned in the normal course of business.
Revenue Receipts: These are the amounts received in the normal and regular course of businesses mainly through sale of goods and services. An important feature of revenue receipts is that the amount received does not need to be returned to any one. All such receipts are revenue receipts and are treated as incomes.
Final Accounts mean the financial statements prepared consequent to the drawing of Trial Balance. Financial Statements include:
- Trading and Profit and Loss Account or Income Statements
- Balance Sheet
Gross Profit or Gross Loss
After recording the above items in the respective sides of 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.
Closing Entries for Trading Account
Preparation of a Trading Account requires recording entries to transfer the balance 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
Profit and Loss Account
The next step after preparing the Trading Account, is preparing the Profit and Loss Account. Profit and Loss Account is prepared to calculate the net profit or net loss of the business for a given accounting period.
The features and need of preparing th Profit and Loss account were also discussed in this chapter
Closing Entries in Respect of the Profit and Loss Account
Entries that are to be recorded 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.
Operating Profit and Net Profit
Profit may be divided into two ie., Operating Profit and 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 includes office and administration 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.
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 non operating profit. Expenses which are incidental or indirect to the main operations of the business are called non-operating expenses.
The next step after preparing the Trading and Profit and Loss Account is preparing the Balance. A balance sheet is prepared from Real Accounts and Personal Accounts. The balance sheet may be defined as βA Statement which sets out the Assets and Liabilities if a firm or an institution as at a certain dateβ. In the words of Francis R. Stead, βA Balance Sheet is a screen picture of the financial position of a going business at a certain moment.β It is a statement which reports the property owned by the enterprise and the claims of the creditors and owners against these properties. It shows the status of the business as at a given moment of time, in so far as accounting figures can show its status.
The Balance Sheet has certain characteristics which should be noted. These are:
- It 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 together called the 'Final Accounts'.