Chapter 9: Financial Statements – I (Sole Proprietorship) — Study Notes

1. Meaning of Financial Statements

Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties. For a sole proprietorship, financial statements consist of: 1. Trading Account: Shows Gross Profit or Gross Loss. 2. Profit and Loss (P&L) Account: Shows Net Profit or Net Loss. 3. Balance Sheet: Shows the financial position (Assets, Liabilities, and Capital) on a specific date.

2. Capital and Revenue Expenditure/Receipts

Before preparing final accounts, one must distinguish between Capital and Revenue items. - Capital Expenditure: Incurred to acquire fixed assets, improve their capacity, or increase their lifespan. Its benefit extends beyond one year. (e.g., Purchase of machinery, installation costs, extension of building). Shown in Balance Sheet. - Revenue Expenditure: Incurred for the day-to-day running of the business. Its benefit is consumed within one accounting year. (e.g., Rent, salaries, depreciation, repairs). Shown in Trading/P&L A/c. - Capital Receipts: Receipts not of a revenue nature (e.g., capital introduced, loan taken, sale of fixed assets). Shown in Balance Sheet. - Revenue Receipts: Receipts obtained in the normal course of business (e.g., Sales, commission received). Shown in Trading/P&L A/c. - Deferred Revenue Expenditure: Heavy revenue expenditure whose benefit spans over a few years (e.g., heavy advertising). A portion is written off every year.

3. Trading Account

The Trading Account is prepared to ascertain the trading results, i.e., Gross Profit or Gross Loss, which arises from the buying and selling of goods. - Dr. Side (Direct Expenses): Opening Stock, Purchases (less returns), Wages, Carriage Inward, Freight, Custom Duty, Power, Fuel, Manufacturing expenses. - Cr. Side (Direct Incomes): Sales (less returns), Closing Stock. - Balancing Figure: If Cr > Dr = Gross Profit. If Dr > Cr = Gross Loss.

Formula: Cost of Goods Sold (COGS) = Opening Stock + Net Purchases + Direct Expenses - Closing Stock Gross Profit = Net Sales - Cost of Goods Sold

4. Profit and Loss Account

Prepared to ascertain the true Net Profit or Net Loss of the business. - It starts with the Gross Profit (on Cr. side) or Gross Loss (on Dr. side) brought down from the Trading Account. - Dr. Side (Indirect Expenses): Salaries, Rent, Insurance, Printing, Postage, Discount Allowed, Bad Debts, Depreciation, Interest Paid, Carriage Outward. - Cr. Side (Other Incomes): Discount Received, Commission Received, Rent Received, Interest Received. - Balancing Figure: If Cr > Dr = Net Profit. If Dr > Cr = Net Loss. Net profit is transferred (added) to Capital in the Balance Sheet.

5. Balance Sheet

The Balance Sheet is a statement (not an account) prepared to show the true financial position of a business as of a particular date. It is based on the equation: Assets = Liabilities + Capital. - Left Side: Liabilities and Capital. - Right Side: Assets.

Grouping and Marshalling of Assets/Liabilities:

Marshalling refers to the arrangement of assets and liabilities in a proper order. 1. Order of Liquidity: Highly liquid assets (Cash) are shown first, followed by less liquid ones (Debtors, Stock), and fixed assets (Goodwill, Building) at the last. Liabilities to be paid first are shown first. 2. Order of Permanence: Fixed assets are shown first, liquid assets at the last. Capital is shown first, short-term liabilities at the last. (Companies follow this).

Operating Profit vs. Net Profit

• Operating Profit: Profit earned through the normal, core operations of the business. Operating Profit = Net Profit + Non-Operating Expenses (e.g. loss by fire, interest on loan) - Non-Operating Incomes (e.g. profit on sale of asset)