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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  :

  1. Closing stock
  2. Outstanding/expenses
  3. Prepaid/Unexpired expenses
  4. Accrued income
  5. Income received in advance
  6. Depreciation
  7. Bad debts
  8. Provision for doubtful debts
  9. Provision for discount on debtors
  10. Manager’s commission
  11. 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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