Financial statements are the collective names given to positional statement and income statement of an enterprise which show the financial position of the company whether the firm is making profit or not. For ascertaining the arithmetical accuracy of books of accounts a trial balance is prepared. Trial balance is a statement of accounts which appears in the ledger showing either the balances or the total amounts of debit and credit.
A trial balance is a statement with debit and credit of balances of the ledger accounts to test the arithmetical accuracy of the books of accounts.
Financial statements are also very useful in ascertaining the profit earned or loss incurred by the firm during a given period of time.
There are two basic financial statements:
Income statement i.e. Trading and Profit and Loss account
Positional statement i.e. Balance sheet
The income statement is used to assess the net result of the business operations during an accounting period and positional statement, statement of assets and liabilities shows the final position of the business enterprise on a particular date and time. Thus it can be said that preparation of the financial statements is the last step of accounting cycle.
in large business organizations usually one account i.e. Trading and Profit & Loss account is prepared for ascertaining the gross profit. While in small organizations this account is divided into two parts:
Trading Account
Profit and Loss Account
Trading account is prepared to know the gross profit, Profit and Loss Account is prepared to know the operating profit and net profit. Positional Statement is another name given to Balance sheet. The position of assets and liabilities of the business at a particular time period is determined by balance sheet.
USERS OF FINANCIAL STATEMENTS
There are several parties who have direct or indirect contact with the business and are interested in the analysis of the financial statements. The various internal and external users are:
Management
Investors
Suppliers and Creditors
Government
Lenders of Money
Employees
Bankers
Taxation authorities
Other parties
Public
The significance of financial statement analysis from the point of view of different parties is discussed as follows:
Management
Final accounts play a significant role in knowing the solvency, profitability and capital structure of the firm. Managers make an extensive use of accounting information to know about the profitability or financial position of the enterprise in the period to come.
Investors
Investors involve risk and they do not have any direct control over the business affairs. A person who is contemplating an investment in a business would like to know about the profitability and financial position of the firm.
Suppliers and creditors
Creditors are those parties who supply goods or services on credit. They are interested in the financial statements to determine the capability of the company to meet its debts as and when they fall due.
Government
Financial statements help the government authorities determine the progress of various industries and the need for financial help. These statements also help the government to take various policy decisions such as income tax, service tax, and excise duty.
Lenders of money
Lenders of money include Debenture holders, banks and suppliers of loans. These people are interested to know the short term as well as long term solvency position of the entity. They analyze the financial statements to assure themselves of the safety of their money and to know whether the firm is capable enough to repay the debts and interest thereon.
Employees
The employees are interested in financial statements to know various profit sharing and bonus schemes. The salaries of the employees are indirectly dependent on the profits earned by the company.
Bankers
Bankers are the suppliers of short term or long term credit in the form of overdrafts and loan etc. They are interested in determining the capacity of the enterprise to repay its liabilities on time which is done through analysis of financial statements.
Taxation authorities
Financial statements are used by taxation authorities to make sure that the financial statements are prepared as per the legal provision and that various figures relating to sales and income are correct in order to assess the tax liability of the business enterprise.
Other parties
Some other parties such as stock exchange authorities, researchers, economists and customers etc. may also be interested to analyze the financial statements of an enterprise for various reasons such as determining the price of securities, buying or selling decision of securities, knowing the contribution of public or private sector in the gross national product.
Public
An ordinary citizen may be interested in the accounting record of the institution with which he comes in contact in his daily life. Example: bank, public utilities such as gas, transport and electricity companies.
PREPARATION OF FINAL ACCOUNTS
Final accounts consist of income statement and positional statement. Income statement is prepared to determine the profit earned or loss sustained by the business enterprise and contain all nominal accounts and accounts related to goods appearing in the trial balance. Goods are the item of purchases and sales by the business enterprises.
Positional statement is prepared to show the position of all assets and liabilities and contains of all real and personal accounts.
The basic aim of preparing financial statements are:
To show the fair view of the financial performance of business enterprise.
To show the fair view of the financial position of the business enterprise.
To achieve these objectives business enterprises prepare Trading and Profit & Loss account and Balance sheet respectively.
TRADING ACCOUNT
Trading account explains whether purchasing and selling of goods has proved to be profitable for the business or not. It takes into account the cost of goods sold on one hand and on the other hand the value for which they have been sold away.
In case the sales value is higher than the cost of goods sold there is a profit and when the sales value is lower than the cost of goods sold there is a loss. The profit disclosed in the trading account is termed as Gross Profit while the loss disclosed by the Trading account is termed as Gross Loss.
Trading account is a nominal account and id prepared by a business enterprise during an accounting year. Trading account is not prepared as a separate account.
IMPORTANCE OF TRADING ACCOUNT
Trading account is prepared for the following purposes:
Calculation of gross profit or gross loss
Trading account helps in ascertaining whether the firm has made profit or has incurred loss i.e. it helps in calculating the gross profit or gross loss of the business enterprise. The concept of gross profit is used for judging the efficiency of the business and hence it facilitates the management to understand the different elements of cost of goods sold in a better way.
Comparison of the closing stock
In this the closing stock is properly valued and recorded. The trend of value of closing stock helps the management to understand whether excess stock has been piled up and reasons for having excess stock may then be examined.
Helps in deciding the element of profit in the selling price
The main aim of every business is to make profit. To survive in this competitive market price fixing plays an important role in the marketing strategy. Trading account helps in deciding the element of profit in the selling price because through this account we are able to calculate the cost of goods sold and also we can add a certain element of profit to the cost of goods sold.
Determining the trend of direct expenses and direct incomes of the business
Trading account helps in determining the trend of direct expenses and direct incomes involved in the cost of goods sold and sales respectively. This further helps in taking decision at higher management level so that the proper price of the final product can be fixed.
PROFIT AND LOSS ACCOUNT
Profit and loss account is prepared to find out the operating profit and net profit. Profit and Loss Account is a nominal account and measures the net income by matching total revenues and total expenses of the business enterprise.
IMPORTANCE OF PROFIT AND LOSS ACCOUNT
Profit and Loss Account is prepared for the following purposes:
Calculating net profit or net loss
Profit and loss account helps in ascertaining the net result of profit and loss account is either net profit or net loss which is very important information for any business enterprise.
Controlling the indirect expenses
All indirect expenses related to the business enterprise are incorporated in this account. In many business enterprises indirect expenses cover more tan 75% of the total expenses so proper watch is must for effective control of expenses.
Helpful in comparison
By comparing the profit and Loss account of two different enterprises or same enterprise for two different years we can compare the efficiency of any business enterprise.
Helps in preparation of balance sheet
Balance sheet is the last step in the preparation of the financial statement. The ultimate result of Profit and Loss Account i.e. net profit or net loss is transferred to the balance sheet. Preparation of balance sheet in the absence of profit and loss account is a very cumbersome job.
BALANCE SHEET
Balance sheet shows the position of assets and liabilities of the business on a particular day and at a specific point of time. The value of assets whose value is to be realized and liabilities to be paid off in the future are displayed in this statement.
It is termed as balance sheet because it is a sheet of balances of all real and personal accounts.
While its preparation it is divided into two equal halves. The left hand side is known as liabilities side and the right hand side is known as assets side.
IMPORTANCE OF BALANCE SHEET
Balance sheet is prepared for the following purpose:
To show true and fair view of the business organization
After having prepared the trading account and profit and loss account a businessman would like to know the current position of the business. Balance sheet helps to show the true and fair view of the business enterprise on a particular day and at a specific period of time.
Helps in judging the solvency of the business enterprise
Balance sheet helps in presenting the position of assets and liabilities of the business enterprise which can further facilitate to judge the solvency of the business enterprise.
Helps in judging the nature of various assets and liabilities
The balance sheet is divided into two equal halves where the left hand side is known as liabilities side and the right hand side is known as assets side. Through this grouping of assets and liabilities we can judge the monetary value of assets and liabilities having a particular type of nature.
Preparation of financial statements based on going concern concept
With the help of the going concern concept balance sheet helps to pass the opening entries in the journal.
Q-1 The following is the trial balance extracted from the books of Akhilesh as on 30th September 2011.
Name of the account
Debit Amount(Rs.)
Credit Amount(Rs.)
Capital Account
-
1,00,000
Plant and Machinery
78,000
-
Furniture
2,000
-
Purchases and Sales
60,000
1,27,000
Returns
1,000
750
Opening stock
30,000
-
Discount
425
800
Sundry Debtors/ Creditors
45,000
25,000
Salaries
7,550
-
Manufacturing wages
10,000
-
Carriage outwards
1,200
-
Provision for doubtful debts
-
525
Rent, rates and taxes
10,000
-
Advertisements
2,000
-
Cash
6,900
-
Total
2,54,075
2,54,075
Prepare trading and profit and loss account for the year ended 30 september 2001 and a balance sheet on that date after taking into account the following adjustments:
Closing stock was valued at Rs, 34,220.
Provision for doubtful debts is to be kept at Rs. 500.
Depreciate plant and machinery @ 10% p.a.
The proprietor has taken goods worth Rs. 5,000 for personal use and additionally
distributed goods worth Rs. 1,000 as samples.
Purchase of furniture Rs. 920 has been passed through purchases book.
