Financial Statements - II — Study Notes

1. Introduction

Financial Statements - II completes the preparation of final accounts by taking up the complete format of the Balance Sheet and dealing with advanced adjustments. The Balance Sheet is a statement of the assets, liabilities and capital of the business as on a particular date. It is not an account, and it does not show any income or expense. It is the result of applying the accounting equation, since the total of the assets must always equal the total of the liabilities and capital.

This chapter also explains the classification of assets and liabilities into current and non-current categories, the treatment of items such as goodwill, patents, deferred revenue expenditure, prepaid expenses and accrued income, and the preparation of the final accounts of a sole proprietor with numerous adjustments. The Balance Sheet is prepared in a prescribed vertical or horizontal form and must always balance.

2. The Balance Sheet

The Balance Sheet is a statement of the financial position of a business, prepared on a particular date, showing the assets on one side and the liabilities and capital on the other. Since it is prepared from the accounting equation Assets = Liabilities + Capital, both sides must always be equal.

Classification of Assets

1. Fixed assets: long-term assets used for more than one year, such as land, building, machinery, furniture and goodwill. They may be tangible (land, machinery) or intangible (patents, trademarks).
2. Current assets: assets that are held for conversion into cash within one year, such as cash, bank, stock, debtors, bills receivable and prepaid expenses.
3. Fictitious assets: assets that have no real value or are of intangible nature and appear only in the books, such as preliminary expenses and deferred revenue expenditure.

Classification of Liabilities

1. Long-term or non-current liabilities: liabilities payable after more than one year, such as long-term loans and debentures.
2. Current liabilities: liabilities payable within one year, such as creditors, bills payable, outstanding expenses and income received in advance.
3. Contingent liabilities: liabilities that may or may not arise depending on a future event, such as a liability on a bill discounted. They are shown as a note, not in the Balance Sheet.

3. Vertical vs Horizontal Format

In the horizontal format, assets are shown on the right side and liabilities and capital on the left side. In the vertical format, the items are listed in a single column. For companies, a prescribed vertical format is used. For sole proprietors, the Balance Sheet is usually presented in the horizontal form.

4. Adjustments in Final Accounts

Besides the adjustments covered in Financial Statements - I, the following adjustments are also important:

1. Depreciation: deducted from the asset and charged to the Profit and Loss Account.
2. Bad debts: deducted from the debtors and charged to the Profit and Loss Account.
3. Provision for doubtful debts: charged to the Profit and Loss Account and deducted from the debtors.
4. Provision for discount on debtors: calculated on the debtors after deducting the provision for doubtful debts.
5. Interest on capital and drawings: interest on capital is added to the capital and debited to the Profit and Loss Account, while interest on drawings is deducted from the capital and credited to the Profit and Loss Account.
6. Goods withdrawn by the proprietor: treated as drawings, reduced from purchases.
7. Goods distributed as free samples: treated as an advertisement expense and reduced from purchases.
8. Deferred revenue expenditure: such as preliminary expenses, written off over a number of years.
9. Capital expenditure wrongly treated as revenue: rectified by treating the amount as an asset.

5. Interest on Capital and Drawings

If the proprietor is entitled to interest on capital, it is an expense of the business:

$$Interest \ on \ Capital = Capital \times Rate \times \frac{Period}{12}$$

If the proprietor is charged interest on drawings, it is an income of the business:

$$Interest \ on \ Drawings = Drawings \times Rate \times \frac{Period}{12}$$

When the drawings are of uniform amounts throughout the year, the average period is taken as six months for annual interest calculation.

6. Manager's Commission

A manager may be entitled to a commission calculated on the net profit before charging such commission or after charging such commission.

If the commission is on net profit before charging the commission:

$$Commission = \frac{Profit \times Rate}{100}$$

If the commission is on net profit after charging the commission:

$$Commission = \frac{Profit \times Rate}{100 + Rate}$$

7. Preparation of the Balance Sheet

The Balance Sheet of a sole proprietor is prepared by:

1. Bringing forward the capital at the beginning.
2. Adding the net profit and deducting drawings and interest on drawings.
3. Adding long-term loans and current liabilities.
4. Showing fixed assets (after depreciation), current assets and fictitious assets on the assets side.

The statement is complete only when the total of the assets equals the total of the liabilities and capital.

8. Uses of Financial Statements

Financial statements help in assessing the profitability and solvency of the business, in comparing the results of different years, in planning and control by the management, and in providing information to investors, creditors, government and other users.

Quick Revision Tables

Table 1: Classification of Assets

Table 2: Classification of Liabilities

Table 3: Key Formulas

Mind Map

Important Diagrams (SVG)

Diagram 1: Components of the Balance Sheet

Diagram 2: Adjustments and Their Two-Sided Effect

Common Mistakes

1. Students present the Balance Sheet as an account and balance it like a ledger, while it is only a statement.
2. Current liabilities and long-term liabilities are interchanged; loans repayable after a year are long-term liabilities.
3. Prepaid expenses are added to the current assets correctly but also added to the expense in the Profit and Loss Account.
4. Interest on capital is credited to the Profit and Loss Account, while it is debited as an expense.
5. Interest on drawings is debited as an expense, whereas it is credited to the Profit and Loss Account as an income.
6. Contingent liabilities are included in the Balance Sheet as liabilities, while they are shown only as a note.
7. Fictitious assets like preliminary expenses are treated as real assets and shown at full value instead of being written off.

Exam Tips

1. Write the Balance Sheet in a proper two-column format with assets on the right and liabilities and capital on the left.
2. Show the calculation of interest on capital and drawings clearly with the formula and the period.
3. In the commission question, state whether the commission is before or after charging the commission and apply the correct formula.
4. Deduct the provision for doubtful debts from the debtors and calculate the provision for discount only on the net debtors.
5. Present the adjustments in a table with columns for the Profit and Loss Account and the Balance Sheet.
6. Mention that the Balance Sheet is based on the accounting equation and must always balance.
7. Practise the format of the company Balance Sheet in vertical form as well as the sole proprietor's horizontal form.

Conclusion

Financial Statements - II completes the preparation of the final accounts by adding the Balance Sheet and advanced adjustments to the trading and profit and loss preparation. A proper classification of assets and liabilities into fixed, current and fictitious categories gives a true picture of the financial position. Adjustments such as depreciation, provisions, interest on capital and drawings, and the manager's commission ensure that the statements comply with the matching and accrual principles. A balanced Balance Sheet is the final proof that the entire accounting cycle, from recording to summarising, has been completed correctly.