MODULE - III

5
BASICS OF BALANCE SHEET AND
PROFIT AND LOSS ACCOUNT
Unit structure :

5.1 Objectives
5.2 Introduction
5.3 Meaning and Types of Financial Statements
5.4 Parties Interested In Financial Statements
5.5 Basics of Income Statement and Balance Sheet
5.6 Limitation of financial statement
5.7 Exercise

5.1 OBJECTIVE

After studying the unit, the students will be able to -

Understand the meaning and types of financial statement.
Know the parties interested in Financial statements
Understand the objectives of Financial statements
Explain the basics of Financial statements

5.2 INTRODUCTION

Government legislations require certain organizations to maintain proper

accounts and draw financial statement. Public can understand from the
financial statement the extent to which a company is discharging its social
responsibilities. While issuing shares, bonds, financial statement become
necessary as prospective investors can judge the financial position of the
organization and able to take a proper decision. Workers union may study the
financial statement and ascertain whether they can enforce their demand.
Tax legislature makes it obligatory for the business entities to draw fair and
objective financial statement. The financial statement serves as instruments
to regulate equity and debentures issued by companies.
 5.3 MEANING AND TYPES OF FINANCIAL
STATEMENTS

Meaning :
Financial statements are plain statements based on historical records, facts
and figures. They are uncompromising in their objectives, nature and
truthfulness. They reflect a judicious combination of recorded facts,
accounting principles, concepts and conventions, personal judgements and
sometimes estimates.

Financial statements consist of and

1. Revenue Account / Income Statement:

Revenue Account refers to and Loss or
or Revenue Account may

and Loss and Revenue

Account is prepared fora period, covering one year. This statement shows the
expenses incurred on production and distribution of the product and sales and
other business incomes. The final result of this statement may be profit of loss
for a particular period.

2. Balance Sheet:
Balance sheet shows the financial position of a business as on a particular
date. It represents the assets owned by the business and the claims of the
owners and creditors against the assets in the form of liabilities as on the date
of the statement.

3. Funds Flow Statement

It describes the sources from which the additional funds were derived and
the use of these funds. Funds flow statement helps to understand the
changes in the distribution of resources between two balance sheet periods.
The statement reveals the sources of funds and their application for different
purposes.
4. Cash flow Statement:
A cash flow statement shows the changes in cash position from one period to
another. It shows the inflow and outflow of cash and helps the management
in making plans for immediate future.An estimated cash flow statement
enables the management to ascertain the availability of cash to meet
business obligations. This statement is useful for short term planning by the
management.
5. Schedules:
Schedule explains the items given in income statement and balance sheet.
Schedules are a part of financial statements which give detailed information
about the financial position of a business organization.
 5.4 PARTIES INTERESTED IN FINANCIAL
STATEMENTS

In recent years, the ownership of capital of many public companies has

become truly broad based due to dispersal of shareholding. Therefore, one
may say that the public in general has become interested in financial
statements. However, in addition to the share holders, there are other persons
and bodies who are also interested in the financial results disclosed by the
annual reports of companies. Such persons and bodies include:
1. Creditors, potential suppliers or others doing business with the
company;
2. Debenture-holders;
3. Credit institutions like
4. Potential Investors;
5. Employees and trade unions;
6. Important customers who wish to make a long standing contract
with the company;
7. Economists and investment analyst;
8. Members of Parliament, the Public Accounts Committee and the
Estimates Committee in respect of Government Companies;
9. Taxation authorities;
10. Other departments dealing with the industry in which the
company is engaged; and
11. The Company Law Board

Financial Statement analysis, therefore, has become of general interest.

5.5 OBJECTIVES OF FINANCIAL STATEMENTS

The main object of financial statements is to provide information about the

financial position, performance and changes taken place in an enterprise.
Financial statements are prepared to meet the common needs of most users.
The important objectives of financial statements are given below:

1. Providing information for taking Economic decisions:

The economic decisions that are taken by users of financial statements
require an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
suppliers meet interest payments, repay loans and make distributions to its
owners.
 2. Providing information about financial position:
The financial position of an enterprise is effected by the economic resources
it controls, its financial structures its liquidity and solvency and its capacity
to adapt to changes in the environment in which it operates.

Information about financial structure is useful in predicting future borrowing

needs and how future profits and cash flows will be distributed among those
with an interest in the enterprise. This information is useful in predicting how
successful the enterprise is likely to be in raising further finance. Information
about liquidity and solvency is useful to predicting the ability of the enterprise
to meet the financial commitments as fall due.

3. Providing information about performance(working results)

of an enterprise:
Another important objective of the financial statements is that it provides
information about the performance and in particular its profitability, which
requires in order assessing potential changesin the economic resources that
are likely to control in future. Information about performance is useful in
predicting the capacity of the enterprise to generate cash inflows from its
existing resource base as well in forming judgment about the effectiveness
with which the enterprises might employ additional resources.

4. Providing Information about changes in financial position:

The financial statements provide information concerning changes in the
financial position of an enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods. This
information is useful in providing the user with a basis to assess the ability of
the enterprise to generate cash and cash equipments and the needs of the
enterprise to utilize those cash flows.

5.6 BASICS OF INCOME STATEMENT AND BALANCE

SHEET

Each business firm has to prepare two main financial statements viz. Income
Statement and Balance sheet. The income statement reveals the profit of loss
during a particular period generated from the activities of a business. Balance
sheet shows the financial position of a business on a particular date.
Income statement
Income statement summaries the incomes /gains and expenses /losses of a
Business for a particular financial period. The format of Income statement
explains in detail the items to be included in the statement. It is presented in
the traditional T Format and also in the vertically statement form.
1. Horizontal Form T form

Manufacturing Trading and Profit and Loss Account For the yearending
Dr. Cr.

Particulars Rs. Particulars Rs.

To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase of raw By Cost of finished
materials goods c/d
To Manufacturing wages By Sales
To Carriage/ Freight By Closing stock of
inwards Finished Goods
To Custom duty By Gross Loss c/d
To Other factory Expenses By Gross profit b/d
To Opening stock By Business incomes
and Gains
Finished Goods By Net Loss c/d
To Cost of finished By Balance b/d from
Previous year
Goods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office and
administration Expenses
To Interest and financial
Expenses
To Provision for Income tax

To Net Profit c/d

To Net loss b/d
To Transfer to General
reserve
To Dividend
To Balance c/f
 Particulars Rs. Rs.
Gross Sales xxx
Less : Sales returns xxx
Sales tax / Excise duty
Net Sales xxx
Less : Cost of goods sold
(Materials consumed +Direct xxxxxx
Labour + xxx
Manufacturing Expenses)
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a. Office and administration Expenses xxx
b. Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx
Add : Non Operating Income xxx
Less : Non Operating expenses (including xxx
interest)
Profit before interest and tax xxx
Less : Interest xxx
Profit before tax xxx
Less : Appropriations : xxx xxx
a. Transfer to reserves xxx xxx
b. Dividends declared / paid xxx
Surplus carried to Balance Sheet xxx

Balance sheet:
It is one of the major financial statements which presents a company's
financial position at the end of a specified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a moment
for e.g. the amounts reported on a balance sheet dated March 31st, 2016
reflects that all the transactions throughout December 31st have been
recorded. The balance sheet provides information related to the assets,
liabilities and the equity of the company as on a specific date.

Total Assets = Total Liabilities + Share equity

The companies Act, 1956 stipulates that the balance sheetof a joint stock
company should be prepared as per Part I of Schedule VI of the Act. However,
the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.
Understanding Corporate Balance Sheet:
A. Assets side:
1. Fixed Assets :
Fixed Assets are called long-term assets. These assets are used over
several periods. They are major sources of revenue to the business. They
are intended for long term use in the business.
group of fixed assets is explained in the
proforma. Generally the Fixed assets are classifies as:
a) Tangible movable assets;
b) Tangible immovable assets; and
c) Intangible assets.
a) Tangible movable assets are the assets which can be seen,
touched and moved from one place to another place. Plant and
Machinery, furniture and fixtures, transportation equipments
etc. are tangible movable assets.
b) Tangible immovable assets are the assets which can be
seen and touched but cannot be moved from one place to
another place. Such assets include land, buildings, mines, oil
wells, etc.
c) Intangible assets are the assets which cannot be seen and
touched. However, their existence can only be imagined such
as patents, trademarks, copyrights, goodwill, etc.
The Fixed Assets are presented as:
Gross Block - Provision for Depreciation = Net Blocks
2. Investments :
Investments may be short-term or long term. Short-term investments are
marketable securities and they represent temporary investments of idle
funds. These investments can bedisposed off by the company at any time.
Investments are shown at cost. Cost includes brokerage, fees and all other
expenses incurred on acquisition of investments. However, the market value
is shown by way of a note.
Long-term investments are held for a long time. They are required to be held
by the business by the very nature and conditions of the business. For
example, a company engaged in generating electricity may be required to
hold the bonds of the Electricity Board. These bonds are retained by the
company so long as the company uses electric power.

As per Schedule VI of the Indian Companies Act 1956, investments are

shown separately, showing the nature of investments and the mode of
valuation of various classes of securities.
Long term Investments are grouped under fixed assets and short term
investments under current assets.
 3. Current Assets, Loans and Advances:
The item, Assets, Loans and is divided intotwo parts:
a. Current Assets, and
b. Loans and Advances.
a. Current Assets and Quick assets:
likely to be
converted into cash and the cash thus generated is available to pay current
liabilities. Current assets are not intendedfor long-term use in business.
Current assets represent employment of money by the company on a short-
term basis. They circulate within the group. For example, cash becomes
raw material when material is purchased, material becomes finishedgoods,
finished goods become cash or debtors when sold and so on.
Current Assets = Stock + Debtors + Cash & Bank + Loans &Advances
+ Marketable Securities + Other Current Assets

working
Quick Assets are known as assets. In other words, quick assets
are those which can be converted into cash quickly. Therefore, they are also
known as liquid assets. Cash and bank balances are the most liquid assets.
Debtors and cash advances can be converted into cash at a short notice.
Therefore, they are also regarded as quick assets. Marketable investments
can be converted into cash, fall into the category of quick assets. Inventory
does not fall in this category of quick assets, since itcannot be converted into
cash quickly, as material is to be converted into finished goods and then
they should be sold. Expenses paid in advance do not satisfy the criteria of
quick assets. They cannot be converted into cash. They can be received in
the form of services.
Therefore Quick Assets = Current Assets Inventory
Prepayments
b. Loans and Advances :
Loans and advances given are current assets. It includes different types of
advances such as advances against salary, advances against machinery,
advances to subsidiary, prepaid expenses on account of rent, taxes,
insurance, etc.

4. Miscellaneous Expenditures and losses :

This heading covers Fictitious Assets and other expenses which are made
for future on a mass basis. These expenses are really not assets but the
whole balance on the account of these
Profit and Loss A/c therefore the amount to the extent not written off or
adjusted is shown onthe Assets side as Miscellaneous expenditures.

The examples of fictitious assets are :

a. Preliminary expenses.
b. Brokerage on issue of shares and debentures.
c. Discount on issue of shares and debentures.
d. Share or debenture issue expenses.
e. Heavy Advertisement and Publicity expenditure.
f. Profit and Loss A/c debit balance.

Liquidity means easy convertibility into cash. Though ultimately all assets are
converted into cash, the term liquidity refers not only to the nature of assets
but also to the purposes of holding the assets. Assets are normally arranged
in order of permanency i.e., from least liquid to most liquid.

B. Liabilities Side
debt is
something that a person or an organization owes to another person or
organization. In other words, Liabilities are the claims of outsiders against the
business. Technically speaking, all liabilities shown in a balance sheet are
claims against all assets shown in it. But, there may be certain cases where
a liability has a claim against a specific asset. Even under such
circumstances, the liabilities are shown separately, not as a deduction from
the specific assets.

Classification of Liabilities :
The liabilities of an enterprise may be classified into threecategories
1. Permanent Funds or Funds.
2. Semi-permanent Funds or Long-term Borrowings.
3. Current liabilities and Provisions.

1. Funds :
These are the funds provided by the proprietors (owners) or the
shareholders. proprietors in
the business. This is the amount belonging to the
or
This is also known as the of the
business. Equity refers to the claimof the owners it includes :

= Capital (May be Equity Share Capital only or Equity and

Preference Share Capital) + Reserves + Profit and Loss A /c credit balance
Accumulated losses and Fictitious assets.

through fresh investments by the owners or

by way of increasing the earnings retained i.e., profits not distributed.
(Retained earnings are that part of the total earnings which have been
retained for use in the business)

a. SHARE CAPITAL :
Share capital is the amount that is raised by a companyfrom the public
at large, through the issue of shares. There are different concepts of share
capital from the legal and accounting points of view.

The following chart details the different concepts of capital :

 Share Capital

Authorised Capital (Registered or

Nominal Capital)

1. Issued Capital
+ 2.
Unissued Capital

1. Subscribed Capital + 2. Unsubscribed Capital

1. Called up Capital + +
2. Uncalled Capital 3. Reserve Capital

+ 1. Paid up Capital Calls-in-Arrears or Calls Unpaid

i. Authorised Capital : Authorised Capital is the maximum

capital a company can raise as mentioned in the Memorandum
of Association under its Capital Clause.

ii. Issued Capital : A company usually does not need the entire
registered capital. Issued capital is that part of the Authorised
capital; which is actually offered to the prospective investors for
subscription. The balance of the Authorised capital which is not
issued is called

iii. Subscribed Capital : Subscribed capital is that part of the

issued capital which has been subscribed or taken up by the
public. Therefore, the subscribed capital may be equal to or
less than the issued capital.

Called up Capital Uncalled Capital: The company, therefore, may collect

the capital in several instalments as per its need. The called- up capital is
that portion of the subscribed capital which has been called or demanded by
the company to be paid. The capital that is not demanded from the
shareholders is called uncalled capital.

iv. Paid up Capital: Paid up capital is that part of the called up

capital which has been actually paid by the members. The paid-
up capital is the called-up amount less calls not paid. (Calls
unpaid or calls-in-arrears).

v. Reserve Capital : It is that part of the uncalled capital which

may only be demanded on winding up or liquidation, but not
when the company is a going on. A company may determine
 this amount by a Special Resolution.

b. RESERVES AND SURPLUS :

A business may have to meet certain compulsory or voluntary, foreseen or
unforeseen, recurring or non-recurring obligations in future. It is
advantageous to for the organization to make provision in advance to meet
them. If not sudden payment may adversely affect the financial health of the
company. In orderto avoid such situations some part of profit are retained
in each
means the reserves represent amounts set aside out of divisible
profits. They are appropriations of profits. Indian Companies Act requires
every company to transfer a specific percentage (upto 10%) of the profits to
accounts.

Reserve created for a specific purpose is called as a

a reserve created for a general purpose is
General reserves are free and can be utilized for Payment of Dividends,
Development and expansion purpose or for any other purpose the company
thinks proper.
amount written
off by way of providing for depreciation, renewals or diminution in value of
assets or retained by way of providing for any

It is compulsory for the business organization to disclose each individual

head of the reserves in the balance sheet with its opening balance as per last
balance sheet, additions thereto and deductions there from in the current
yare.

2. LONG-TERM LIABILITIES :
A company raises finance either from owners or throughexternal borrowings.
External borrowings of a company which constitute its are
important sources of long-term finance. These borrowings are termed as
liabilities or term- They may take
various forms suchas debentures, public deposits, bank loans, deferred
payments,etc. They may be fully secured or partly secured or unsecured.

3. CURRENT LIABILITIES AND PROVISIONS:

a. Current Liabilities :
Current liabilities are those short-term obligations of an enterprise which
mature within one year or within the operating cycle. They constitute short-
term sources of finance. It includesSundry Creditors, Bills Payable, Interest
accrued but not due, outstanding expenses, Unclaimed dividends and Bank
Overdraft.

These liabilities are not normally secured and no interest is payable on them
with the exception of bank overdrafts. These liabilities, are generally paid off
by utilizing current assets or by creating a current liability.

Actually all current liabilities are payable within a short period of time.
However, Bank Overdraft is the current liability which is not paid immediately
or in a very short-time, in practice. Therefore, Bank Overdraft is not
considered as a quick liability. It is a permanent arrangement with the
banker. Hence
Quick Liabilities = Current Liabilities Bank Overdraft
 b. Provisions :
for any known
liability of which the amount cannot be determined with substantial accuracy.
Provisions have to be made for maintaining the integrity of assets or for
known liabilities. Although the amount of liability is not certain organization
has to made provision on best estimates. The examples of provisions are
Provision for depreciation on assets, Provision for doubtful debts, Provision
for proposed dividends, Provision for taxation.
4. CONTINGENT LIABILITIES :
According to ICAI, Contingent liability refers to an obligation relating to an
existing condition or situation which may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events. These
liabilities may or may not be converted into actual liabilities at some future
date. It is a liability which may or may not occur. But on the date of the
Balance Sheet,it is not known definitely whether the liability would arise or
not. But as a matter of caution, it is indicated in the balance sheet for the
sake of information and disclosure, under the head Liabilities.
Some of the examples of Contingent Liabilities are Discounted Bills of
Exchange, Disputed liability on account of income-tax, etc., about which
appeal has been filed, Uncalled amount on partly paid-up shares and
debentures held by the company as investments, Cumulative preference
dividend in arrears, Matters referred to arbitration, Claims not acknowledged
as debts, Estimated amount of contracts remaining to be executed on capital
account and not provided for, Guarantees given by the company, Bonds
executed. and debentures held by the company as investments, Cumulative
preference dividend in arrears, Matters referred to arbitration, Claims not
acknowledged as debts, Estimated amount of contracts remaining to be
executed on capital account and not provided for, Guarantees given by the
company, Bonds executed.

Following are the proforma of the Balance sheet

1) Horizontal Form :

Liabilities Rs Assets Rs

Share Capital Fixed Assets

(with all particulars of 1. Goodwill
authorized, issued, 2. Land and Building
subscribed and Called up 3. Lease hold Property
capital) 4. Plant and Machinery
Less: Calls in arrears 5. Furniture and fixture
Add: Forfeited shares
6. Patents and trade marks
7. Vehicles

Investments
Reserve and Surplus
1. Capital Reserve Current assets, Loans and
2. Capital Redemption Advances
Reserve
a. Current assets
3. Share premium
1. Interest accrued on
4. Other Reserves Investment
2. Loose tools
Less: P&L a/c Debit balance
3. Stock in Trade
5. Profit and Loss
4. Sundry debtors
appropriation A/c
Less Provision for Bad debts
6. Sinking fund A/c
5. Cash in Hand
6. Cash at Bank
 Long term loans b. Loans and Advances
a. Secured loan 1. Advances to
Debentures subsidiaries
Add: Outstanding Interest 2. Bills receivables
Loan from Banks 3. Prepaid expenses

b. Unsecured loans Miscellaneous expenditure

Fixed deposits 1. Preliminary expenses
Short term loans andadvances 2. Discount on issue of
shares and Debentures
Current liabilities and 3. Underwriting commission
Provisions 4. Profit and Loss a/c (debit
a. Current liabilities balance)
1. Bills payables
2. Sundry creditors
3. Bank overdraft
4. Income received in
advance
5. Unclaimed Dividends
6. Other liabilities
b. Provisions
1. Provision for taxation
2. Proposed dividends
3. Provident fund and
Pension fund

Contingent Liabilities

2. Vertical Form

Income Statement of for the year ending

Previous Particulars Schedule Current Year

I. Sources of Funds
1. Funds
a. Capital
b. Reserves and surplus
2. Loan funds
a. Secured loan
b. Unsecured loans

TOTAL
II. Application of Funds
1. Fixed Assets
a. Gross Block
Less Depreciation
 b. Net Block
2. Investments
3. Current Assets, Loans and
Advances
Less Current Liabilities and
Provisions
Net Current Assets
4. Miscellaneous expenditure to
the extent not written off or
adjusted Profit and Loss a/c
debit balance
TOTAL

Statement of Retained Earnings:

The Statement of Retained Earnings is prepared to showhow the balance in
Profit and Loss accounts is appropriated for various purposes like provision for
dividend, transfer to reservesetc. The balance on this account is finally shown
on the Balance sheet Under the heading Reserve and Surplus.

5.7 LIMITATION OF FINANCIAL STATEMENT

Following are the limitations of financial statements:

1. The information being of historical nature does not reflect the future.
2. It is the outcome of accounting concept, convention combined with
personal judgement.
3. The statement portrays the position in monetary term. The profit or
loss position excludes from their purview things which cannot be
expressed or recorded in term of money.
To overcome from the limitations it becomes necessary to analyse the financial
statements.