What are Financial Statements?
The means of communicating information about the profitability (income statement) and the financial position (Balance Sheet) of the business in an understandable manner at the end of accounting period is known as financial statements.
In the financial statements part I you have learned about the nature of the financial statements, difference between the capital and revenue expenditure and receipts, the concept of trading; and profit and loss account and its preparation and the concept of balance sheet and its preparation. In this article, we will talk about financial statements part II which has topics such as the need for adjustments while preparing the financial statements, the adjustments to be made regarding depreciation, bad debts, provision for doubtful debts, provision for discount on debtors; preparing profit and loss account and balance sheet with adjustments; and making vertical presentation of financial statements.
Why do we need adjustments while preparing the financial statements?
It is important to record the adjusting entries in the preparation of final accounts to assess the true net profit or net loss of the business organization. It helps us in recording those adjustments that were left and were not recorded in the accounts. It also helps in separating all the financial transactions into a year-wise category. Only those entries are included in the financial statements that belong to the current year. It does not consider previous and forthcoming years’ entries as they are the basis for accrual basis of accounting. Further, it also allows us to make various provisions which are made at the end of the year, after assessing the entire year’s performance. Apart from these, there are certain items which are not recorded on day-to-day basis such as depreciation on fixed assets, interest on capital, etc. These are adjusted at the time of preparing financial statements. The items which usually need adjustments are :
- Closing stock
- Outstanding/expenses
- Prepaid/Unexpired expenses
- Accrued income
- Income received in advance
- Depreciation
- Bad debts
- Provision for doubtful debts
- Provision for discount on debtors
- Manager’s commission
- Interest on capital
From the table given below, you can see the treatment of various types of adjustments:
| Adjustment | Adjustment Entry | Treatment in Trading and Profit and Loss Account | Treatment in Balance Sheet |
| 1. Closing stock | Closing stock A/c Dr. To Trading A/c |
Shown on the credit assets side and profit and loss account | Shown on the assets side |
| 2. Outstanding expenses | Expense A/c Dr. To outstanding expense A/c | Added to the respective expense on the debit side | Shown on the liabilities side |
| 3. Prepaid/ Unexpired expenses |
Prepaid expense A/c Dr. To Expenses A/c. | Deducted from the respective expense on the debit side | Shown on the assets side |
| 4. Income earned but not received | Accrued income A/c Dr. To Income A/c | Added to the respective income on the credit side | Shown on the assets side |
| 5. Income received in advance |
Income A/c Dr. To Income received in advance A/c | Deducted from the respective income on the credit side | Shown on the liabilities sides |
| 6. Depreciation | Depreciation A/c Dr. To Assets A/c | Shown on the debit side | Deducted from the value of asset |
| 7. Provision for bad and doubtful debts |
Profit and Loss A/c Dr. To Provision for doubtful debts | Shown on the debit side | Shown as deduction from debtors |
| 8. Provision for discount on debtors | Profit and Loss A/c Dr. To Provision for discount debtors | Shown on the debit side | Shown as deduction from debtors |
| 9. Manager’s commission |
Manager’s Dr. commission A/c To outstanding commission A/c | Shown on the debit side | Shown on the liabilities side |
| 10. Interest on capital |
Interest on capital A/c Dr. To capital A/c | Shown on the debit side | Shown as addition to capital |
| 11. Further bad debts |
Bad debts A/c Dr. To Sundry Debtors A/c | Shown on the debit side | Deducted from debtors |
Illustration 1- The following balances has been extracted from the trial of M/s Runway Shine Ltd. Prepare a trading and a profit and loss account and a balance sheet as on December 31, 2005.
| Account Title | Amount Rs. | Account Title | Amount Rs. |
| Purchases | 1,50,5000 | Sales | 2,50,000 |
| Opening stock | 50,000 | Return outwards | 4,500 |
| Return inwards | 2,000 | Interest received | 3,500 |
| Carriage inwards | 4,500 | Discount received | 400 |
| Cash in hand | 77,800 | Creditors | 1,25,000 |
| Cash at bank | 60,800 | Bill payable | 6,040 |
| Wages | 2,400 | Capital | 1,00,000 |
| Printing and stationary | 4,500 | ||
| Discount | 400 | ||
| Bad debts | 1,500 | ||
| Insurance | 2,500 | ||
| Investment | 32,000 | ||
| Debtors | 53,000 | ||
| Bills recieveable | 20,000 | ||
| Postage and telegraph | 400 | ||
| Commission | 200 | ||
| Interest | 1,000 | ||
| Repair | 440 | ||
| Lighting charges | 500 | ||
| Telephone charges | 100 | ||
| Carriage outward | 400 | ||
| Motor car | 25,000 | ||
| 4,89,440 | 4,89,440 |
Adjustments
1.Further bad debts Rs. 1,000. Discount on debtors Rs. 500 and make a provision on debtors @ 5% 2. Interest received on investment @ 5% . 3.Wages and interest outstanding Rs 100 and Rs 200 respectively. 4.Depreciation charged on motor car @ 5% p.a. 5.Closing stock Rs 32,500.
Solution-
Trading Account
Dr. Cr.
| Particulars | Amount Rs | Particulars | Amount Rs |
| Opening Stock | 50,000 | Sales 2,50,000 | |
| Purchases 1,50,000 | Less: Return Inwards (2,000) | 2,48,000 | |
| Less: Return Outwards (4,500) | 1,45,500 | Closing Stock | 32,500 |
| Carriage Inwards | 4,500 | ||
| Wages 2,400 | |||
| Add: Outstanding Wages 100 | 2,500 | ||
| Gross Profit | 78,000 | ||
| 2,80,500 | 2,80,500 |
Dr. Profit and Loss Account Cr.
| Particulars | Amount Rs | Particulars | Amount Rs |
| Carriage Outward | 400 | Gross Profit | 78,000 |
| Printing and Stationary | 4,500 | Interest Received | 3,500 |
| Discount | 400 | Discount Received | 400 |
| Bad Debts 1,500 | Interest Received on Investment | 1,600 | |
| Add: Further Bad Debts 1,000 | |||
| Add: New Provision 2,600 | 5,100 | ||
| Discount on Debtors | 500 | ||
| Insurance | 2,500 | ||
| Postage and Telegraph | 400 | ||
| Commission | 200 | ||
| Interest 1,000 | |||
| Add: Outstanding Interest 200 | 1,200 | ||
| Repair | 440 | ||
| Lighting Charges | 500 | ||
| Telephone Charges | 100 | ||
| Depreciation on Motor Car | 1,250 | ||
| Net Profit | 66,010 | ||
| 83,500 | 83,500 |
Balance Sheet
| Liabilities | Amount Rs | Assets | Amount Rs |
| Creditors | 1,25,000 | Cash in Hand 77,800 | |
| Add: Interest Received 1,600 | 79,400 | ||
| Bills Payable | 6,040 | Cash at Bank | 60,800 |
| Capital 1,00,000 | Investment | 32,000 | |
| Add: Net Profit 66,010 | 1,66,010 | Debtors 53,000 | |
| Less: Further Bad Debts 1,000 | |||
| Outstanding Interest | 100 | Less: New Provision 2,600 | |
| Outstanding wages | 200 | Less: Discount on Debtors 500 | 48,900 |
| Motor Car 25,000 | |||
| Less: Depreciation 1,250 | 23,750 | ||
| Bills Receivable | 20,000 | ||
| Closing Stock | 32,500 | ||
| 2,97,350 | 2,97,350 |
What are the methods of presenting the Financial Statements?
The financial statements, i.e. trading and profit and loss account and balance sheet can be presented in two ways:
(1) Horizontal form
(2) Vertical form
Under horizontal form of presentation, items are shown side by side in the trading and profit and loss account and also in the balance sheet as I have shown above. This format is rather technical in nature and is not easily comprehensible for many users.Therefore, now-a-days, most firms present them in a simpler form called a vertical presentation. Under vertical presentation, the final accounts are prepared in a form of statement with different items being shown on below the other in a purposeful sequence. Under vertical presentation, the trading and profit and loss account will appear as shown below.
Income Statement for the period ended ……
| Particulars | Amount | Amount Rs |
| Sales (Gross) | … | |
| Less Returns | … | … |
| Net sales | ||
| Cost of goods sold | ||
| Opening stock | … | |
| Purchases | … | |
| Less Returns | … | |
| Carriage Inwards | … | … |
| Wages | … | |
| Cost of goods available for sale | … | |
| Less Closing stock | … | … |
| Gross Profit | … | |
| Operating Expenses | ||
| (a) Selling expenses | ||
| Advertising | … | |
| Discount | … | |
| Allowances | … | |
| Bad debts and Provisions | … | |
| Carriage outwards | … | |
| Total selling expenses | … | |
| (b) General and Administration expenses | ||
| Salaries | … | |
| Rent and Rates | … | |
| Insurance | … | |
| Depreciation | … | |
| Postage | … | |
| Repairs | … | |
| General expenses | … | … |
| Total operating expenses | … | … |
| Net Income from operations (Operating profit) | … | |
| Other Income (Non-operating gains) | ||
| Interest earned | … | |
| Commission earned | … | |
| Profit on sale of fixed assets | … | … |
| Less Deductions (Non-operating expenses) | ||
| Interest paid | … | |
| Loss by fire | … | |
| Net non-operating gains | … | … |
| Net income (Net profit) | … |
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