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CHAPTER II
FINANCIAL STATEMENT
Financial statements are the summarised statements of accounting data produced at the end of
the accounting process by an enterprise through which it communicates the accounting
information to its users. They are the end product of financial accounting.
Financial statements includes
Balance sheet: It is a statement of assets and liabilities ie; financial position of an
enterprise at a given date. It is also known as Positional Statement.
Statement of Profit and Loss Account: It shows the net result of business operation
during the accounting period. It is also known as Income Statement.
Notes to Account: The balance sheet and Profit and Loss Account are supported by
the notes to account having details of items of Balance Sheet and Profit and Loss
Account and statements of accounting policies and explanation to material items.
Nature of Financial Statement

Relates to past period thus historic in nature

Expressed in monetary terms
Shows financial position through Balance Sheet and profitability through Statement of
Profit and Loss Account

Objective of Financial Statement

The basic objectives of financial statements are:
to present true and fair view of the financial performance of business
to present true and fair view of financial position of business.
Users of Financial Statements

Internal Users
External User

User
Management
Investors

Purpose
Overall performance and growth of business
Financial position, earning capacity and growth
prospectus of business
Lenders
Short term and long term solvency of the
business
Suppliers and trade Solvency of the business ie; the ability to meet
creditors
the debt when it falls due.
Government and its Regulate the activities of enterprise, determine
agencies
taxation policy, compilation of national income
statistics etc.
Tax Authorities
Determine tax payable eg. Income tax authority is
interested to know profit earned by the business
for imposing income tax etc.
Employee
Determine bonus and negotiate wages (since
bonus and wage revision depends on profit
earned by the business)

USER

INTERNAL

EXTERNAL

MANAGEMENT

INVESTORS

LENDERS

SUPPLIERS AND
TRADE
CREDITORS

GOVERNMENT
AND THEIR
AGENCIES

PUBLIC

TAX
AUTHORITIES

EMPLOYEES

Basic terms used in financial statements

Assets: Assets are economic resources of an enterprise that can be usefully expressed
in monetary terms. Assets can be broadly classified into
o Fixed Asset: Assets that are held on long term basis. Eg. Land, building,
machinery, furniture etc. They are used for normal operation of business.
o Current Assets:These are assets held for short term basis. Eg. Trade
receivable, stock, cash and bank balance etc.

Liabilities: Liabilities are obligations or debt that an enterprise has to pay at some
time in future. They are broadly classified into
o Long term liabilities: these are usually payable after the period of one year.
Eg.Loans from financial institution, debentures issued by the company
o Short term liabilities:These are obligation that are payable within the period
of one year. Eg. Bank overdraft, trade receivable etc.

Capital: The amount invested by the owner in the firm is known as capital. In a
company capital is brought by issue of shares.

Sales: Sales are total revenue from goods or services sold or provided to customers.
Sales may be in cash or credit.
Net Sales = Cash sales + Credit Sales- Sales return Excise Duty/VAT

Purchase: This is the total amount of goods procured by a business on credit and on
cash, for use or sale.
Net Purchase = Cash Purchase + Credit Purchase Purchase return

Revenue: The amount earned by the business by selling its products or providing
services to customers is called sales revenue. Other revenue earned includes interest,
dividend, commission, rentreceived, royalties etc. it is also known as income.

Expense: Cost incurred by business in the process of earning revenue are known as
expenses. Eg. Rent, depreciation, salaries, water, fuel etc.

Profit: The excess of revenues of a period over its related expenses during the
accounting year is profit.
Profit = Revenue - Expenses

Loss: The excess of expense of a period over its related revenues its termed as loss.
Loss = Expenses Revenue

Preparation of Financial Statement

A. Statement of Profit and Loss Account
Trading Account
Trading account is the first stage in preparation of financial statement of trading
concern. It is prepared to know the gross profit earned or gross loss incurred by the
enterprise during the accounting period by matching the selling price of goods and
service with the cost of goods and service rendered.
While preparing trading account, items like opening stock, purchases, direct expenses
(like wage, carriage inward, freight, fuel and water etc.) are debited to this account
and sales, closing stock are credited to this account. The net result from operation is
gross profit, if credit is more than debit or gross loss if debit is more than credit.
Gross Profit = Sales Cost of goods sold

Cost of goods sold = Opening Stock + Purchase + Direct Expenses - Closing Stock
Statement of Profit and Loss Account
This account is prepared to ascertain net profit earned or net loss incurred by the
enterprise during the accounting period. The account is credited with the balance
brought forward from trading account in respect of gross profit (or debit in case of
gross loss). All the indirect expenses such as salaries, rent and taxes, depreciation,
administration expenses, selling and distribution expenses etc. and losses including
loss on fire, theft are debited to this account all indirect income like commission,
interest received, dividend etc. and gains such as profit on sale of fixed assets are
credited to this account. If the total of credit side exceeds debit, the difference
represents net profit or if debit side total exceeds credit, then the net result from
operation is net loss.

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Net Profit = Income-Expenditure

B. Balance Sheet
Balance sheet is the next step after preparation of Statement of Profit and Loss
Account. It is a statement showing the assets and liabilities of the firm or a company
as at a certain date. It measures the financial position of the business as at a particular
point of time. The total of the asset must be equal the total of liabilities in balance
sheet.
Assets = Liabilities + Capital

Accounting Concepts and Conventions

Basic accounting concepts are fundamental idea or basic assumption underlying the theory
and practice of financial accounting. It is based on these concepts and conventions financial
statements are prepared.
Some of the concepts and conventions include:

Business Entity: This concept assumes that business has distinct and separate entity
from its owners. Thus, for the purpose of accounting, business and its owners are to
be treated as two separate entities.

Money Measurement: The concept of money measurement states that only those
transaction and happenings in an organisation, which can be expressed in terms of
money are to be recorded in the books of accounts.

Going Concern: The concept of going concern assumes that the business firm would
continue to carry out its operations indefinitely (for a long period of time) and would
not liquidatein near future.

Accounting period: Accounting period refers to the span of time at the end of which
the financial statements of the enterprise are prepared to know whether it earns profit
or incurred loss during the period and what exactly is the position of the assets and
liabilities, at the end of that period.

Cost Concept: The cost concept requires that all assets are recorded in the book of
accounts at their cost price, which includes cot of acquisition, transportation,
installation and making the asset ready for use.

Dual Aspect: This concept states that every transaction has a dual or two fold effect
on various accounts and should therefore be recorded in two places. The duality is
commonly expressed in terms of fundamental accounting equations ie;

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Revenue Recognisation: The concept requires the revenue for a business transaction
should be considered realised when a legal right to receive it arises.

Matching: This concept of matching emphasis that expenses incurred in an

accounting period should be matched with the revenues during that period. It follows
from this that the revenue and expenses incurred o earn these revenue must belong to
same accounting period.

Full disclosure: This concept requires that all material and relevant facts concerning
financial performance of an enterprise must be fully and completely disclosed in the
financial statement and accompanying notes to account.

Consistency: This concepts sate that accounting policies and practice followed by
enterprises should be uniform and consistent. Comparability results when the same
accounting principles are consistently being applied by different enterprise for the
period of comparison (inter firm comparison), or the same for a number of period
(intra firm comparison).

Conservatism: This concept requires that the business transactions should be

recorded in such a manner that profits are not overstated. All anticipated losses should
be accounted for but all unrealised gain should be ignored.

Materiality: This concept states that accounting should focus on material facts. If an
item is likely to influence the decision of reasonable prudent investor or creditor, it
should be regarded as material, and shown in the financial statement.