An Introduction to Financial Statements

In the preparation of final accounts of a ​firm​, the ​financial statements

display the net results for the given year. They play a vital role in
allowing a user of a financial statement, to understand the results of a
firm for a given year. Let us find out more about what a financial
statement is and their relevance.

A financial statement is a formal record of the ​financial activities​, and

position of a ​business​, person, or other entity. It is presented in a
structured manner and in a form easy to understand.

The Components of a Financial Statement

Broadly, the following make up a part of the financial statements of
any firm or ​organization​:

● Balance sheet​: It shows a statement of financial position, the

entity’s assets, ​liabilities​, and stockholders’ equity as on the
report​ date. However, it does not show information that covers
a span of time as it shows figures of assets and liabilities on a
particular date.
● Income statement: It shows a statement of comprehensive
income, statement of revenue and expenses and p/l report. It
includes items of revenues, expenses, gains, and losses. It also
provides information on operations carried out by the
enterprise.
● Cash flow statement​: It helps in showing the changes in the
entity’s cash flows including operating, investing and financing
activities during the reporting period.
● Explanatory notes: These include explanations of various
activities, additional detail on some accounts, and other items.

What is the use of a financial statement?

As a whole, financial statements fulfil the following purpose, which
makes them indispensable:

● First, to scrutinize the ability of a business to generate cash and

the sources and utilization of that cash.
● Second, to ascertain whether a business has the capability to
pay back its debts.
● Third, to help track financial results on a trend line to spot any
looming profitability issues.
● Next, to help derive financial ratios from the statements that
can indicate the condition of the business.
● Lastly, to investigate the particulars of certain business
transactions, as mentioned in the disclosures that accompany
along with the statements.

If a business has plans to issue its financial statements to outside users

such as investors or creditors, the financial statements should be
ideally formatted in accordance with one of the major accounting
frameworks. These frameworks allow for some leeway in how
financial statements can be structured, so statements issued by
different firms even in the same industry are likely to have somewhat
different appearances. Financial statements that are being issued to
outside parties may be audited to verify their accuracy.

Browse more Topics under Financial Statements

● Distinction between Capital Revenue and Capital Expenditure
● Operating Profit
● Trading and Profit and Loss Account
● Balance Sheet and Opening Entry
● Stakeholders and their Information Requirement
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
● Manufacturing Account

Question for You

Ques: Give examples of some users of financial statements.

Answer –Following are some of the external users of financial
statements:

● Creditors: They wish to know the recoverability of their dues.

● Government: the authorities pay heed to the figures of revenue
in a financial statement so that they can calculate the taxes
correctly.
● Management: They wish to assess how well their decisions
have transformed into useful outputs and how far have they
been able to achieve the targeted results.
● Employees: they wish to create a demand for an extra bonus,
based on the revenue earned by a firm and judge the
reasonableness of their pay.

Distinction Between Capital Revenues

and Capital Expenditures

The Going Concern Assumption allows the ​accountant​ to classify the

expenditure as Capital Expenditures and Revenue Expenditures,
capital receipts and capital revenues. This distinction between capital
and revenue nature of the items is necessary in order to find out the
correct profit or loss during the year and also to ascertain the true and
fair position of the business.

The Distinction between Capital Revenues and

Capital Expenditures
Capital Expenditures

Capital Expenditure is that expenditure which we incur for acquiring

or bringing into existence an asset, for extending or improving the
fixed asset or for substantial replacement of an existing fixed asset,

In other words, we can say that the amount which a company spends
for possessing any long-term capital asset or to enhance the working
capacity of an existing capital asset, or to increase its lifespan to
generate future cash flows is known as Capital expenditure.
Capitalization of expenditure means that we disperse the amount of
expenditure over to the remaining useful life of the ​asset​.

It is a long-term investment by the company, in the name of assets, to

create financial gain for the years to come. Examples of capital
expenditures include the cost of land and building, plant and
machinery, furniture and fixtures, etc. Such capital expenditures
normally yield benefits which extend beyond the current accounting
year.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements
● Operating Profit
● Trading and Profit and Loss Account
● Balance Sheet and Opening Entry
● Stakeholders and their Information Requirement
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
● Manufacturing Account

Revenue Expenditures

Revenue Expenditure is that expenditure which a firm incurs for

maintaining the productivity or earning capacity of a business. In other
words, we need to incur it on a regular basis for conducting the
operational activities of the business. As per Accrual Accounting
Assumption, we recognize revenues when we receive or earn them.
Whereas, we recognize expenses when we incur them. Therefore, we
charge them to the Income Statement as and when they occur. This
satisfies Matching Principle in which we record the expenses in the
period of their incurrence.
Examples of revenue expenditure are –office and administration
expenses, Wages & Salary, Printing & Stationery, Electricity
Expenses, Repairs and Maintenance Expenses, Postage, Insurance,
taxes, travel expenses, etc. Some Non-operating expenses and losses
such as interest on loan taken, loss by theft, etc. The revenue
expenditure generates benefits for the current ​accounting​ year.

Capital Receipt

Capital Receipts are those receipts which are non-recurring in nature

and generate benefits for many years in the future. We show these
receipts on the liabilities side of the balance sheet. Examples of capital
receipts are the sale of fixed assets, capital contribution, loan receipts,
a loan from bank etc.

Revenue Receipt

Revenue receipts are those receipts which are recurring in ​nature and
are available to meet day to day expenses of the business. We show
these receipts on the credit side of profit and loss account. Its effect is
nil i.e., it neither increases nor decreases the value of asset or liability.

Examples of Revenue Receipts are the sale of stock-in-trade, revenue

from services rendered in the normal course of business, revenue from
permitting others to use the assets of the ​enterprise​, such as interest,
rent, loyalty, etc.

Source: Shutterstock

Difference Between Capital Revenues (Receipt) and Capital

Expenditure:

S.
N Basis for comparison Capital Revenues Capital Expenditure
o.

Capital expenditure is the

Capital revenues are a
1. Meaning expenditure that is
non-recurring incoming cash
incurred in acquiring a
flow into the business that
capital asset or improving
leads to the creation of
the capacity of an existing
 liability and a decrease in one, resulting in the
company assets. extension in its life years.

Capital revenues effect is

2. Effect Its effect is Long Term.
long Term.

We show Capital revenues

in the Balance Sheet on the
liability side. We show the Capital
expenditures in the
3. Appears in
Income Statement &
Balance Sheet

These are non-recurring in These are Non-recurring

4. Nature
nature. in nature.

Its benefit is enjoyed for Its benefit is received for

5. Benefits
many years in the future. more than one year

It decreases the value of

asset or we can say that it It increases the value of
6. Increase in value of assets
increases the value of the assets.
liability.

Sale of the fixed asset, loan Cost of land and building,

7. Example
taken from bank etc. furniture and fixtures etc.
Solved Example for You

Q: Find out the nature of expenditure and revenue. Also, give

appropriate reasons.

1. Expenses​ on foreign tour for purchasing new machinery.

2. ₹ 2,000 spent to remove a worn out part and replace it with the
new engine.
3. ‘A’ gave one of his offices on rent.
4. A petrol-driven engine of a passenger bus was replaced by a
diesel engine.
5. The expenses of ₹ 5,000 on repainting the factory.
6. The new partner brings a capital of ₹ 50,000.
7. Interest on loan for the purchase of machinery. The commercial
production for which has not begun till the last day of the
accounting year.
8. Interest​ on loan for the purchase of machinery. The commercial
production for which has already begun.

Solution:

1. Since the business incurs this expenditure up to the point the

machine is ready to use, it represents capital expenditure.
 2. It is a revenue expenditure since the firm incurs it to keep the
asset in working order.
3. This is a revenue receipt because it is not helping business.
4. It is a capital expenditure since it will increase the earning
capacity of the business by lowering the costs.
5. It is a revenue expenditure since it helps in maintaining the
factory in good condition.
6. Capital brought by a new partner is a capital receipt.
7. Such expenditure should be treated as capital expenditure since
the commercial production has not begun till the last day of the
accounting year.
8. Such expenditure should be treated as capital revenues
expenditure since ​commercial​ production has already begun.

Operating Profit

When it comes to the financials of a business, the operating profit is

regarded to be a very pivotal element in analysing the revenue earned
for a period. There is a lot more to the term that just some returns on
trade. Let us find out what operating profits means and why they hold
ample value for a business.
What is Operating Profit?

Operating profit is the income earned from the performance of core

operations of a ​business​, excluding any financing or ​tax​-related issues.
The concept is used to investigate the profit-making potential of a
business, excluding all unusual factors. This information is
particularly valuable when monitored on a trend line, to see how a
business is performing over a long period of time. If operating income
is negative, a business will likely require additional outside funding to
remain in operation.

● Operating profit is stated as a subtotal on a company’s income

statement after all general and administrative expenses and
before the line items for interest income and expense, as well as
income taxes.
● Operating profit does not necessarily equate to the cash flows
generated by a business since the ​accounting​ entries made
 under the accrual basis of accounting can result in operating
profits being reported that are substantially different from cash
flows.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements
● Distinction between Capital Revenue and Capital Expenditure
● Trading and Profit and Loss Account
● Balance Sheet and Opening Entry
● Stakeholders and their Information Requirement
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
● Manufacturing Account

How to calculate Operating Profits?

For calculating the operating profits of a business, the following
formula can be used:

Operating Profit = Revenue – (Labour+cost of goods sold+expenses

incurred in the normal course of business)

Operating profits are important because it is an indirect measure of

efficiency. The higher the operating profit, the more profitable a
company’s core business is.

Several factors can affect the operating profit. These include the
pricing strategy of the business, ​prices​ for raw materials, or labour
costs. This is because these items directly relate to the day to day
decisions that ​managers​ make. Operating profit is also a measure of
managerial flexibility and competency, particularly during tough
economic times.

While the elimination of ​production​ costs from the overall operating

revenue, along with any costs that may be associated with depreciation
and amortization, are permitted when determining the operating profit,
the calculation does not ​account​ for any debt obligations that must be
met even if those obligations are directly tied to the company’s ability
to maintain normal business operations.

Operating income usually does not include any investment income

generated through a part stake in another ​company​. This also includes
the investment income that may be associated directly with the core
business operations of the secondary company. Additionally, the sale
of ​assets​ such as real estate and production equipment are not
included. This is because these sales are not a part of the core
operations of the business.

Question for You

Q: Consider the following figures and calculate EBIT.

● Revenue 10,00,000 INR

● Cost of goods sold 5,00,000 INR
● Labour 3,00,000 INR
● General & administrative expenses 50,000 INR

Answer –
EBIT is Earnings before Interest and Taxes. So EBIT, in this case, will
be Operating Profits

Operating Profit = INR 1,000,000 – INR 500,000 – INR 300,000 –

INR 50,000 = INR 150,000

Trading and Profit and Loss Account

In order to arrive at the balance sheet of a business, one needs to

prepare the trading account and​ profit and loss account first​. This
account is prepared to arrive at the figure of revenue earned or loss
incurred during a period. Let us understand the trading account and
profit and loss account in detail.

What is a Trading Account?

A trading ​account​ helps in determining the gross profit or gross loss of

a business concern, made strictly out of trading activities. Trading
involves buying and selling activities. In the trading account, the cost
of goods sold is subtracted from net sales for the period to calculate
gross profit​. Only direct revenue and direct expenses are considered in
it. Trading account is prepared mainly to know the profitability of the
goods bought by the businessman.

Learn about ​Balance Sheet and Opening Entry here in detail.​

The difference between ​selling price​ and cost of goods sold is the
earning for the businessman, which is also known as gross profit.
Whereas, net profit means all ​revenues​ minus all expenses including
the cost of goods sold, the selling, general and administrative
expenses, and the non-operating expenses. Thus in order to calculate
the gross earning, it is necessary to know the cost of goods sold and
sales figures. Also,

Gross Profit = Sales – COGS (Sales + Closing Stock) – (Stock in the

beginning + Purchases + Direct Expenses)

Items included on the debit side are opening stock, ​purchases​, and
direct expenses and on the credit side are sales and closing stock. The
resultant figure is either gross profit or gross loss.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements
● Distinction between Capital Revenue and Capital Expenditure
 ● Operating Profit
● Balance Sheet and Opening Entry
● Stakeholders and their Information Requirement
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
● Manufacturing Account

Closing entries for Gross Profit/Loss

In case of gross profit:

Trading A/c -Dr.

To Profit and Loss A/c

And, in case of gross loss:

Profit and Loss​ A/c -Dr.

To Trading A/c

What is the Profit and Loss Account?

The profit and loss account is opened by recording the gross profit on
the credit side or gross loss on the debit side.

For earning the net profit, a businessman has to incur many more
expenses in addition to the direct expenses. Those expenses are
deducted from profit or added to a gross loss and thus, the resultant
figure will be net profit or a net loss.

Expenses included in the profit and loss account are Selling and
distribution​ expenses, Freight & carriage on sales, ​Sales tax​,
Administrative Expenses, Financial Expenses, Maintenance,
depreciation​ and ​Provisions​ and more. On the credit side, Discount
received, Commission received, Profit on sale of assets and more
appear.

What is the difference between Capital Revenue and Capital

Expenditure?

Closing entries for Net Profit/Loss

In case of a net profit:

Profit and Loss A/c -Dr.

To Capital A/c

And, in the case of net loss:

Capital A/c -Dr.

To Profit and Loss A/c

Solved Question for You

Question: The following trial balance has been taken out from the
books of XYZ as on 31st December 2009.
Particulars Dr. Cr.

Plant and Machinery 100,000

Opening stock 60,000

Purchases 160,000

Building 170,000

Carriage inward 3,400

Carriage outward 5,000

Wages 32,000

Sundry debtors 100,000

Salaries 24,000
Furniture 36,000

Trade expense 12,000

Discount on sales 1,900

Advertisement 5,000

Bad debts 1,800

Drawings 10,000

Bills receivable 50,000

Insurance 4,400

Bank balances 20,000

Sales 480,000

Interest received 2,000

Sundry creditors 40,000

Bank loan 100,000

Discount on purchases 2,000

Capital 171,500

795,500 795,500
Closing stock is valued at INR 90,000. Prepare the trading and profit
and loss account of the ​business​ for the year ended 31.12.2009 and a
balance sheet​ as at that date.

Solution:

XYZ

Trading and Profit and Loss Account

For the year ended 31st, December 2009

Particulars Amt Amt Particulars Amt Amt

480,00
Opening stock 60,000 Sales
0

160,00 Less 478,10

Purchases 1,900
0 discount 0

158,00
Less discount 2,000
0
 Closing
90,000
stock

Carriage inward 3,400

Wages 32,000

Gross profit
314,70
(transferred to
0
P&L)

568,10 568,00
0 0

Gross
profit 314,70
Carriage outward 5,000
(transferre 0
d to P&L)
 Interest
Salaries 24,000 2,000
received

Trade expenses 12,000

Advertisement 5,000

Bad debts 1,800

Insurance 4,400

Net profit
264,50
(transferred to
0
capital)

316,70 316,70
0 0
Balance Sheet and Opening Entry

When preparing the accounts of any firm for any year, there will be
certain opening entries that will need to be incorporated in the ​balance
sheet​. Without these entries, the accounts will fail to show the true and
fair view of the financial status of the firm. Let us understand how to
pass an opening entry.

What is an Opening Entry?

The opening balance is usually that balance which is brought forward

at the beginning of an accounting period from the end of a previous
accounting period​. The opening balance is the amount of capital or
fund in a ​company’s​ account at the start of a new financial period. It is
the very first entry in the ​accounts​.
In an operating firm, the ending balance at the end of one month or
year becomes the opening balance for the beginning of the next month
or ​accounting​ year. The opening balance may appear on the credit or
debit side of the ​ledger​, as the case may be!

Browse more Topics under Financial Statements

● An Introduction to Financial Statements
● Distinction between Capital Revenue and Capital Expenditure
● Operating Profit
● Trading and Profit and Loss Account
● Stakeholders and their Information Requirement
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
● Manufacturing Account

How to Pass an Opening Entry?

When the next financial year begins, the ​accountant​ passes one journal
entry at the beginning of every financial year in which he shows all
the opening balance of assets and all the liabilities include capital.
After that, the journal entry is called an opening journal entry.
Because all assets have a debit balance, so these are debited in an
opening journal entry and all liabilities have a ​credit balance​, hence
these are credited in an opening ​journal​ entry.

Dat
Particulars Amount Amount
e

D
Assets​ A/c XX
r.

Liabilities A/c XX

Capital A/c XX

In case all assets exceed all ​liabilities​, the excess will be the value of
capital which is showed credit side in the opening journal entry. If
however, liabilities are more than the value of all assets, then the
resulting excess will be goodwill and it will be debited in the opening
journal entry.

Usually, different assets and liability will be positive and the excess
value of assets will be shown as ​capital​ on the credit of journal entry.
Figures of opening balances can be obtained by taking a look at the
balance sheet of the previous year.

Solved Question for You

Q: From the following balances, pass the opening journal entry as on 1

April 2009.

Assets: Building Rs. 30000, machinery Rs. 10000, furniture Rs. 2000,
bill receivable Rs. 5000, debtors Rs. 12000, stock Rs. 9000, cash at
bank Rs. 15000, cash in hand Rs. 2000

Liabilities: Bill payable Rs. 4000, X’s ​loan​ Rs. 15000, sundry
creditors Rs. 20000

Answer: Here, Capital = assets – liabilities

Total assets = 85000

Less total liabilities = 39000

Capital = 46000

Opening entry –

Date Particulars Amount Amount

01/04/2 D
Building A/C 30,000
009 r

D
Machinery A/c 10,000
r

D
Furniture A/c 2,000
r

D
Bills Receivable A/c 5,000
r
 D
Sundry Debtors A/c 12,000
r

D
Stock A/c 9,000
r

D
Bank A/c 15,000
r

D
Cash A/c 2,000
r

To Bills Payable A/c 4,000

To Sundry Creditors 20,000

To X’s Loan A/c 15,000

To Capital A/c 46,000

Stakeholders and Their Information
Requirement

The ​financial statements​ of an entity are not only prepared for internal
users but also for external stakeholders. It is important to understand
the needs of these stakeholders so that the financial statements can be
prepared in accordance with those needs. Let us understand the crucial
external users that matter.

External and Internal Stakeholders of Financial

Statements
Following are some of the interested stakeholders of financial
information of any firm:

Owners

Having invested their earnings in the firm, the main interest of owners
in financial statements is to assess the returns on their investment and
how prosperous do they appear for the future. Owners generally have
access to all financial records and files.

Browse more Topics under Financial Statements

● An Introduction to Financial Statements
● Distinction between Capital Revenue and Capital Expenditure
● Operating Profit
● Trading and Profit and Loss Account
● Balance Sheet and Opening Entry
● Depreciation, Bad Debts and Provision for Bad and Doubtful
Debts
● Need for Adjustment, Closing Stock and Outstanding Expenses
● Prepaid Expenses, Accrued Income and Income Received in
Advanced
● Provision for Discount on Debtors, Managers Commission and
Interest on Capital
 ● Manufacturing Account

Management

The ​management​ team of a business needs to understand the

profitability, liquidity, and cash flows of the organization each month,
so that it can make operational and financing decisions about the
business. Management will also have access to all records.

Competitors

Firms which are in competition against a ​business​ will attempt to gain

access to the rival’s financial statements, in order to evaluate their
financial position. This could be used to craft necessary competitive
strategies.

Customers of the business

When a customer is considering which supplier to select for a major

contract​, it wants to review their financial statements first, in order to
judge the financial ability of a supplier to remain in business long
enough to provide the goods or services mandated in the contract.

Employees
A ​company​ may elect to provide its financial statements to employees,
along with a detailed explanation of what the documents contain. This
helps increase the level of employee involvement in and
understanding of the business.

Government

A ​government​ in whose authority a company is located would request

the financial statements in order to determine whether the business is
paying the right amount of ​taxes​ and relevant laws are being adhered
to.

Analysts

Outside analysts want to see financial statements in order to decide

whether they should recommend the company’s securities to their
clients. Auditors will also need to analyse financial records.

Creditors

An entity loaning ​money​ to an organization will require financial

statements in order to estimate the ability of the borrower to pay back
all loaned funds and related interest charges.

Suppliers
Suppliers will require financial statements in order to decide whether
it is safe to extend credit to a company.

Trade unions

A union requires the financial statements of a business in order to

evaluate the ability of a business to pay the due compensation to the
union members that it represents.

There may even be other users of financial statements than the above
mentioned. There are many advantages of studying the financial
statement for these parties. They can rely upon the information
contained in such financial statements and to act upon that information
as desired.

Solved Question for You

Q: In cases of arbitration, do financial statements come in any use?

Answer: Even in the cases of an arbitration, the audited financial

statements​ of a company can come to be very useful as they provide a
base for the management or a third party to make a stand.