Chapter 2

The Financial Statements

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Chapter Outline

Meaning of Financial Statements

Nature of Financial Statements
Objectives of Financial Statements
Importance of Financial Statements
Types of Financial Statements
· Balance Sheet
· Profit and Loss Account or Income
Statement
· Cash flow statement
· Statements of Retained earnings
Users of Financial Statements
Limitations of Financial Statements

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Meaning of Financial Statements
Basically, Financial Statements are organized summaries of detailed information about the financial position and
performance of an enterprise. Traditionally, the term ‘Financial Statements’ is used to denote only two basic
statements, which are as under:
a) Balance Sheet (or Position Statement), which shows the financial position of an enterprise at a particular
point of time.
b) Trading and Profit and Loss Account (or Income Statement) which shows the financial performance of
business operations during an accounting period.
Now-a-days, in addition to the aforesaid two basic financial statements, a Statement of Retained Earnings and a
Cash Flow Statement and Value Added Statement are also prepared in practice.
Nature of Financial Statements
The chronologically recorded facts about events expressed in monetary terms for a definite period of time are the
basis for the preparation of periodical financial statements. These reveal the financial position as on a date and the
financial results obtained during a period.
The American Institute of Certified Public Accountants states the nature of financial statements as,
“The statements prepared for the purpose of presenting a periodical review of report on
progress by the management and deal with the status of investment in the business and the
results achieved during the period under review. They reflect a combination of recorded
facts, accounting principles and personal judgements.”
The following points explain the nature of financial statements:
a) Recorded facts:
Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The
original cost or historical cost is the basis of recording transactions. The figures of various accounts such as; cash
in hand, cash at bank, bills receivable, sundry debtors, fixed assets, etc. are taken as per the figures recorded in
the accounting books. The assets purchased at different times and at different prices are put together and shown
at their cost prices. As these are not based on market prices, the financial statements do not show current financial
condition of the concern.
b) Recording as per Accounting Conventions:
Certain accounting conventions are followed while preparing financial statements. The convention of valuing
inventory at cost or market price, whichever is lower, is followed. The valuing of assets at cost less depreciation
principle for balance sheet purposes is followed. The convention of materiality is also followed in dealing with small
items like pencils, pens, postage stamps, etc. These items are treated as expenditure in the year in which they are
purchased even though they are assets in nature. The stationery is valued at cost and not on the principle of cost
or market price, whichever is less. However, the use of accounting conventions makes financial statements
comparable, simple and realistic.
c) Following Accounting Postulates:
Financial statements are prepared on certain basic assumptions known as ‘postulates’ such as; Going concern
postulate, Money measurement postulate, Realisation postulate, etc. Going concern postulate assumes that the
enterprise is treated as a going concern and exists for a longer period of time. So the assets are shown on
historical cost basis, but not at the market prices. Money measurement postulate assumes that the value of money
will remain the same in different periods. Though there is drastic change in purchasing power of money, the assets
purchased at different times are shown at the amount paid for them. While, preparing profit and loss account the
revenue is included in the sales of the year in which the sale was undertaken, even though the sale price may be
received over a number of years in installments. The assumption is known as realisation postulate.
d) Based on Personal Judgments:
Under more than one circumstance, facts and figures presented through financial statements are based on personal
opinion, estimates and judgments. The depreciation is provided taking into consideration the useful economic life of
fixed assets. Provisions for doubtful debts are made on estimates and personal judgments. In valuing inventory,
cost or market value, whichever is less is being followed. While deciding either cost of inventory or market value of
inventory many personal judgments are to be made based on certain considerations. Personal opinion, judgments
and estimates are made while preparing the financial statements to avoid any possibility of over statement of
assets and liabilities, income and expenditure, keeping in mind the convention of conservatism.
Thus, financial statements are the summarised reports of recorded facts and are prepared following the accounting
concepts, conventions and requirements of Law.
Objectives of Financial Statements

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A financial statement is a document that quantitatively presents an organization’s financial activities or status.
Such activities include sales, purchases, borrowings, repayments, and investments. When a financial activity
occurs, the information regarding that activity is forwarded to the accounting
department. Initially, the activity is recorded using a process known as bookkeeping.
Once the information has been recorded, it goes through the accounting process.
Accounting is the classification, analysis, and determination of the appropriate method
of reporting the effects of the bookkeeping records in an organization’s financial
statements. The figure illustrates the accounting process by which flow of information
takes place from financial activity to financial statements.
Moreover, the purpose of the financial statements is to communicate information about
an organization’s financial activities, and the results of those activities, to individuals
who need to make informed financial decisions about the organization. Such individuals
can include management, investors, insurers, and employees. The three primary
financial statements are the balance sheet, the income statement, and the statement
of cash flows. Although each statement has its own purpose, they are interrelated.
When considered together, they present the organization’s financial condition,
including its resources, liabilities, and investment decisions. To help ensure consistency
between the financial statements of different organizations, these statements are
prepared using standardized accounting concepts and principles.
Thus, the primary objective of financial statements is to assist the users in their
decision-making. However, their specific objectives include the following:
(i) Providing information about the resources and obligations of a business:
Financial Statements are prepared to provide adequate, reliable and periodical information about economic
resources and obligations of a business firm to investors and other external parties who have limited authority,
ability or resources to obtain information.
(ii) Providing information about the earning capacity of the business:
Financial Statements are prepared to provide useful financial information which can gainfully be utilised by
outsiders to predict, compare, and evaluate the business firm’s present earning capacity and to estimate the
same for future.
(iii) Providing information about the Cash flows:
These are useful to investors and creditors for predicting, comparing and evaluating the potential cash flows in
terms of amount, timing and related uncertainties attached to it.
(iv) Providing information about the activities of business affecting the society:
Now-a-days social responsibility is considered as part of the business activities. The social activities undertaken
by a business organisation as reported through the financial statements serve as a basis to evaluate a firm’s
CSR activities.
(v) Judging the effectiveness of management:
The financial statements supply information useful for judging management’s ability in utilizing the resources of
a business effectively and efficiently.
(vi) Disclosing accounting policies:
These statements provide the significant information regarding changes in policies, concepts followed in the
process of accounting and changes taken up by the firm during the year to understand these statements in a
better and simplified manner.
Importance of Financial Statements
The importance of financial statements can be well understood from the following paragraphs:
(i) Report on stewardship function: Financial statements report the performance of the management to the
shareholders. The gaps between the management performance and ownership expectations can be well
understood with the help of financial statements.
(ii) Basis for fiscal policies: The fiscal policies, particularly taxation policies of the government, are related with
the financial performance of corporate undertakings. The financial statements provide basic inputs for
industrial, taxation and other economic policies of the government.
(iii) Basis for granting credit: Corporate undertakings, many times, borrow funds from banks and other financial
institutions for different purposes. These credit granting institutions take decisions on this matter based on
the performance of the undertakings as depicted in financial statements.
(iv) Basis for prospective investors: The investors include both short-term and long-term investors. Security and
liquidity of their investment with reasonable degree of profitability are the prime considerations in their

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 investment decisions. Financial statements help the investors to assess long-term and short-term solvency
of a company with profitability, which help them in taking sound investment decisions.
(v) Guide to evaluate the investment Already Made: Shareholders of companies are interested in knowing the
status, safety and return on their investment. They may also need information to take decision about
continuation or discontinuation of their investment in the business. Financial statements provide information
to the shareholders in taking such important decisions.
(vi) Aids trade associations in helping their members: Trade associations may analyse the financial statements
for the purpose of providing service and protection to their members. They may develop standard ratios and
design uniform system of accounts.
(vii) Helps stock exchanges: Financial statements help the stock exchanges to understand the extent of
transparency in reporting on financial performance and enables them to call for required information to
protect the interest of investors. The financial statements enable the stock brokers to judge the financial
position of different concerns and take decisions about the prices to be quoted.
Types of Financial Statements
Financial statements can be referred to as representation of the financial status of a company in a systematically
documented form. They are formal records of the financial activities of a
business and provide an overview of a business's financial condition in
both short and long term. Basically, there are three important financial
statements, which indicate the different activities occurring in a business
house.
a) Balance Sheet
b) Profit and Loss Account or Income Statement
c) Cash flow statement
In addition to above three, another statement known as Statements of
Retained earnings is also prepared to explain the changes in a company's
retained earnings over the reporting period.
(A) Balance Sheet
A Balance Sheet or Statement of Financial Position is a summary of an
organization's balances. It is often described as a snapshot of a
company's financial condition. It summarizes a company's assets,
liabilities and shareholders' equity at a definite point of time. These three
segments give an idea as to what the company owns and owes, as well as the amount invested by the
shareholders. Of the three basic financial statements, the balance sheet is the only statement which applies to a
single point of time.
A balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually
listed first and are followed by the liabilities. The difference between the assets and the liabilities is known as
equity or the net worth or capital of the company. It's called a balance sheet because the two sides balance out. A
typical format of the balance sheet has been given in the Table 2.1. It works on the following formula:
Assets = Liabilities + Shareholders' Equity

A Typical Format of a Balance Sheet

Table 2.1
Balance Sheet of Biswanita Company

LIABILITIES

Current Liabilities
 Current liabilities (1)
 Provisions

Long term Liabilities

 Secured Loans
(2)
 Unsecured loans
Reserves and surplus (3)
Share Capital (4)

= (1) + (2)
Total
+ (3) + (4)

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 ASSETS

Current Assets
 Inventories
 Sundry Debtors
 Cash and Bank balances (6)
 Loans and Advances
 Receivables
 Pre-paid Expenses

Fixed Assets
Gross Block
Less: Accelerated Depreciation
(7)
 Net Block
 Capital work in progress
 Investments

Total = (6) +(7)

The prescribed form of the Balance Sheet as per the Indian Companies Act, 1956
The Companies Act has laid down two forms of the Balance Sheet known as:
(i) Horizontal form
(ii) Vertical form
A Typical Format of Summarised Balance Sheet
(Horizontal Form)
SCHEDULE VI PART I
Balance Sheet of …. Co.Ltd. as on……..

Figures for
Figures for the Figures for the Figures for the
the current
previous year Liabilities previous year Assets current year
year
Rs. Rs. Rs.
Rs.
1. Share Capital 1. Fixed Assets
2. Reserves and surplus 2. Investments
3. Secured Loans 3. Current Assets,
4. Unsecured Loans Loans and Advances
5. Current Liabilities and (a) Current Assets
Provisions (b) Loans and adv
(a) Current Liabilities 4. Miscellaneous
(b) Provisions Expenditure
5. Profit and Loss A/c

Note: A footnote to the Balance Sheet may be added to show the contingent liabilities.

The format of the detailed Balance Sheet of a company in a horizontal form is given below:

Format of the Balance Sheet in Horizontal Form

Balance Sheet of ….(Name of the Company)
as on …..
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 Figures Figures Figures
Figures for the for the for the for the
previous year Liabilities current previous Assets current
Rs. year year year
Rs. Rs. Rs.
Share Capital Fixed Assets:
Authorised Goodwill
…shares of Rs…. Each Land
Preference Building
Equity Leasehold Premises
Issued: Railway Sidings
Preference Plant and Machinery
Equity Furniture
Less: Calls Unpaid: Patents and Trademarks
Add: Forfeited Shares Live Stock
Reserves and Surplus: Vehicles
Capital Reserve Investments:
Capital Redemption Reserve Government or Trust Securities,
Securities Premium Shares, Debentures, Bonds

Other Reserves Current Assets, Loans and

Advances:
Profit and Loss Account
(A) Current Assets:
Secured Loans:
Interest Accrued
Debentures
Stores and Spare parts
Loans and Advance from Banks
Loose Tools
Loans and Advance from
Stock in Trade
Subsidiary Companies
Work in Progress
Other Loans and Advances
Sundry Debtors
Unsecured Loans:
Cash and Bank balances
Fixed Deposits
(B) Loans and Advances:
Loans & Advances from
Subsidiaries Advances & Loans to Subsidiary

Companies Bills Receivable

Short Term Loans & Advances Advance Payments

Other Loans and Advances Miscellaneous-Expenditure:

Current Liabilities & Provisions: Preliminary Expenses

A. Current Liabilities Discount on Issue of Shares and

other Deferred Expenses
Acceptances
Profit and Loss Account
Debentures
(debit Balance: if any)
Sundry Creditors

outstanding Expenses

B. Provisions:
For Taxation
For Dividends
For Contingencies
For Provident Fund Schemes
For Insurance, Pension and
Other similar benefits

Format of the Balance Sheet in Vertical Form

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 Balance Sheet of …. As on …………..

Schedule Figures as at the end of Figures as at the end of

Particulars
Number current financial year previous financial year

I. Source of Funds:
1. Shareholder’s Funds:
(a) Share Capital
(b) Reserves and Surplus
2. Loan Funds:
(a) Secured loans
(b) Unsecured loans

TOTAL (Capital Employed)

II. Application of Funds

1. Fixed Assets:
(a) Gross block
(b) Less : depreciation
(c) Net block
(d) Capital work-in-progress
2. Investments:
3. Current Assets, Loans and Advances:
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less: Current Liabilities and Provisions:
(a) Current liabilities
(b) Provisions
Net Current Assets
4. (a) Miscellaneous expenditure to the extent
not written-off or adjusted.
(b) Profit and Loss account
(debit balance, if any)
TOTAL

Note: A footnote to the Balance Sheet may be added to show the contingent liabilities.
How to Read a Company’s Balance Sheet
LIABILITIES SIDE
1. Share Capital
Unlike the non-corporate entities where the entire capital is brought in by the proprietors or the partners, in the
case of a company, it is brought in by the promoters, their friends, relatives as well as the general public in case of
listed companies. The capital is known ‘share capital’ and shareholders get dividend out of the profits of the
company as return on their investment. This Share Capital is broadly divided into: Authorised Capital, Issued
Capital, Subscribed Capital, Called up and Paid up capital.
(i) Authorised Capital is the maximum share capital that a company is allowed to issue during its lifetime. It
is stated in the Memorandum of Association.
(ii) Issued Capital is that part of authorized capital, which is offered to the public for subscription, including
shares offered to the vendors for subscription other than cash (i.e. issue of shares in consideration for
some other asset purchased).
(iii) Called-up capital means that part of subscribed capital which is called-up by the company for payment by
the subscribers to the shares.

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 (iv) Paid up capital is the amount of capital which the shareholders have actually paid to the company.
Calls in arrears must be shown by the way of deduction from the called up capital and Forfeited shares account by
the way of addition to the paid up capital.
2. Reserves and Surplus
Reserves represent that portion of earnings and receipts of a company which are set apart by the management for
a general or a specific purpose. This includes accumulated profits, reserves and funds; such as capital reserves,
capital redemption reserve, balance of securities premium account, general reserve, credit balance of profit and
loss account, and other reserves specifying the nature of each reserve and the amount in respect thereof including
the additions during the current year.
3. Secured Loans
Long-term loans, which are taken against security of one or more assets of the company, are included under this
head. Debentures and secured loans and advances from banks, subsidiary companies, etc., fall under this
category. Likewise interest accrued and due on secured loans is also recorded under the same head.
4. Unsecured Loans
Loans and advances which are not backed by any security in the form of assets of the company are shown under
this heading. This item includes fixed deposits, unsecured loans and advances from subsidiary companies, short-
term loans and advances from banks and other sources.
5. Current Liabilities and Provisions
Current liabilities refer to such liabilities, which mature within a period of one year. They include bills payable,
sundry creditors, advance payments and unexpired discounts, unclaimed dividends, Interest accrued but not paid,
and other liabilities. Provisions refer to the amounts set aside out of revenue profits for some specific liabilities
payable within a period of one year. Those include provision for taxation, proposed dividends, provision for
contingencies, provision for provident fund, provision for insurance; pension and similar staff benefit schemes, etc.
Both the sub headings current liabilities as well as provisions must be shown separately under two sub-heads- (a)
Current liabilities (b) Provisions.
6. Contingent liabilities
These are the liabilities which may arise in future on the happening of some uncertain event. Contingent liabilities
are not included in the total of the liability side. These are shown as a footnote to the Balance Sheet. Following are
the usual types of contingent liabilities:
(i) Claims against the company not acknowledged as debt.
(ii) Uncalled liability on shares partly paid.
(iii) Arrears of fixed cumulative dividend.
(iv) Estimated amount of contracts remaining to be executed on capital account and not provided for.
(v) Bills discounted not yet matured.

ASSETS SIDE
1. Fixed Assets
These are the assets which are meant for use in business and not for sale. These assets provide a long term
economic benefit, usually for more than one year to the firm. These include goodwill, land, buildings, leaseholds,
plant and machinery, railway sidings, furniture and fittings, patents, livestock, vehicles, etc. These assets are
shown at cost less depreciation till the date.
2. Investments
Business is supposed to great profit. When generated, this profit in excess of what is required for the business can
be invested into say, shares or debentures of various companies. Investments thus represent assets held by an
enterprise for earning income. Under this head, various investments made such as investment in government
securities or trust securities; investment in shares, debentures, and bonds of other companies, immovable
properties, etc., are shown.
3. Current Assets, Loans and Advances
Once the fixed assets are in a state of readiness to produce or provide goods and services, the company needs
current assets to carry out business operations. These assets are held for consumption, or for sale and are
expected to be realized in cash during the normal operating cycle. Current assets include inventories, debtors,
cash, etc. Loans and advances refer to those assets which are held for a short term period and are expected to be
realized within one year. These include advance payments, loans to subsidiary companies etc.
Both the sub headings - current assets as well as loans and advances must be shown separately under two sub-
heads- (a) Current Assets (b) Loans and Advances. It includes interest accrued on investment, inventories, sundry
debtors, bills receivable, cash and bank balances while loans and advances and other advances like prepaid
expenses, etc.
4. Miscellaneous Expenditure

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The expenditure, which has not been fully written off, is shown under this heading. It includes preliminary
expenses, advertisement expenditure, discount on issue of shares and debentures, share issue expenses, etc.
5. Profit and Loss Account
When the Profit and Loss account shows a debit balance (i.e., loss), which could not be adjusted against general
reserves, then the same is shown on the asset side of the Balance Sheet.
(B)Income Statement
Income Statement, also called ‘Profit and Loss Account’ (P&L Account) and ‘Statement of Operations’ is financial
statement that summarizes the revenues, costs and expenses incurred during a specific period of time - usually a
fiscal quarter or year. These records provide information that shows the ability of a company to generate profit by
increasing revenue and reducing costs. The purpose of the income statement is to show managers and investors
whether the company made or lost money during the period being reported. The important thing to remember
about an income statement is that it represents a period of time. This contrasts with the balance sheet, which
represents a single moment in time. A typical format of the Profit & Loss Statement has been given in the following
Table2.2.
Format of Income Statement
As we know, an income statement consists of three accounts:
(i) Trading Account,
(ii) Profit & Loss Account and
(iii) Profit and Loss Appropriation Account.
The Trading account is prepared to ascertain the Gross profit or Gross loss of the trading activities of the business.
But these are not the final results of business operations of an enterprise. Apart from direct expenses, there are
indirect expenses also. These may be conveniently divided into office and administrative expenses, selling and
distribution expenses, financial expenses, depreciation and maintenance charges etc.
Similarly, there can be income from sources other than sales revenue. These may be interest on investments,
discount received from creditors, commission received, etc. Therefore, another account is prepared in which all
indirect expenses and revenues from sources other than sales are recorded. This account when balanced shows
profit (or loss). This account is termed as Profit and Loss Account. The profit shown by this account is called ‘net
profit’ and if it shows loss it is known as ‘net loss’.
Profit and Loss Appropriation Account shows all appropriations from the current year’s profit and balance of profit
or loss of last year and surplus or deficit at the end of the period.
The simplified form and contents of Trading Account, Profit and Loss Account and Profit and Loss Appropriation
Account is given below:

Table 2.2
Profit and Loss Account of Biswanita Company Ltd.
for the year ended.....

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 Dividend xxx Net profit b/d
xxx
Retained Profits xxx (for the current year)

Process adopted for preparation of Profit and Loss Statement/Income Statement

(i) All the revenue receipts appearing on the credit side of the trial balance are recorded on the credit side of
income statement after making suitable adjustments for revenues received in advance or revenues
realised but not received, etc.
(ii) All the revenue expenditure items appeared on the debit side of trial balance are recorded on the debit
side of income statement after making adjustments for outstanding, prepaid expenses, depreciation,
provisions for bad debts, taxes, etc.
(iii) All the non-operating incomes and gains are recorded on the credit side of income statement.
(iv) All the non-operating expenses and losses are recorded on the debit side of the income statement.
(v) Then the difference between totals of credit items and totals of debit items is ascertained.
(vi) If the credit items are more than the debit items, it is known as net profit and if it is the other way round,
it is called as net loss.
It may be noted that the Companies Act, 1956 does not prescribe any format for the profit and loss account.
However, Part II of Schedule VI of the Act gives detailed requirements as to the profit and loss account and clearly
states that it “shall be made out as clearly to disclose the result the working of the company during the period
covered by the account, and shall disclose every material feature.”
Important items of Trading account
(i) Stock
Stock refers to the goods lying unsold on a particular date. It can be of two types: Opening stock and Closing
stock.
 Opening stock: It refers to the value of goods lying unsold at the beginning of the accounting year. It is shown
on the debit side of the Trading Account. In the first year of business there is no opening stock
 Closing Stock: It is the value of goods lying unsold at the end of the accounting year. It is valued at the cost
or market price whichever is lower. It is shown on the credit side of the Trading Account.
(ii) Purchases
Purchases mean total items purchased for resale during the year. It can be both in cash and on credit. Purchases
are shown on the debit side of the Trading account. These are always shown as net purchases, i.e. amount of
Purchase returns or return outwards is deducted from the total amount of purchases made. Goods received on

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consignment basis are never treated as purchases. Similarly, goods received on ‘sale or return’ basis are never
treated as purchases.
(iii) Sales
Sales refer to the total revenue from sale of goods of the business enterprise for which the Trading account is
being prepared. It includes both cash and credit sales. These are recorded on the credit side of the Trading
Account. Sales are shown at their net value i.e. sales return or returns inward is deducted from the total sales.
Cash sales plus credit sales minus sales returns constitute net sales. Goods sent on ‘sale or approval’ are not part
of sales until approval is received.
(iv) Direct Expenses
Direct expenses are the expenses that can be attributed directly to the purchase of goods or goods manufactured.
These are shown on the debit side of the Trading Account. These are shown at the amount as shown in the Trial
balance. For example, wages are recorded on the debit side of Trading Account at the amount shown in the Trial
balance.
Important items of direct expenses
a) Wages i.e. wages must relate to production or purchase. If amount under this head includes wages paid
for construction of building or manufacturing of furniture for office, it will be subtracted from the amount
of wages.
b) Carriage/ Cartage/Freight i.e. amount paid for carriage of goods purchased for sale or raw material
purchased for manufacturing.
c) Other direct expenses are customs and import duty, packing materials, gas, electricity water, fuel, oil, gas
grease, heating and lighting, factory rent and insurance and many more such items.
(v) Gross Profit/Gross Loss
It is the excess of net sales revenue over cost of goods sold. Gross Profit is equal to net sales minus cost of goods
sold. If total of the credit side exceeds the total of debit side, the excess amount is termed as ‘gross profit’ and is
shown on the debit side of Trading Account. On the other hand, if debit side is more than the credit side, the
difference in amount is called ‘gross loss’ and is shown on the credit side of the Trading Account.
Gross profit = Net sales – Cost of goods sold
Gross loss = Cost of goods sold – Net sales

Important items of Profit and Loss Account

DEBIT ITEMS
As stated earlier, all indirect expense are written on the debit side of Profit and Loss A/c. These can be classified
under the following heads:
(i) Selling and Distribution expenses
To materialise sales, the expenses incurred are called selling and distribution expenses. Examples are: Carriage on
sales/carriage outwards, advertisement, selling expenses, travelling expenses and salesman commission,
depreciation of delivery van, salary of driver of the delivery van, etc.
(ii) Office and Administration expenses
These are the expenses incurred on establishment and maintenance of office. Some of the expenses that may be
under this head are: rent, rates and taxes, postage, printing and stationery, insurance, legal charges, audit fees,
office salaries, etc.
(iii) Financial expenses
Finances are to be arranged for business. Expenses that are incurred in this connection are called financial
expenses. Some of the financial expenses are: interest on loan, interest on capital, discount on bills, etc.
(iv) Depreciation and Maintenance charges
Depreciation means decline in the value of fixed asset due to wear and tear, lapse of time, obsolescence, etc. The
total value of a fixed asset like machinery, building, furniture, etc. is not charged to profit and loss account in the
year in which it is purchased. Such assets help running business for a number of years to come. Therefore, only a
part of the value of such assets is treated as an expense and is charged to Profit and Loss A/c as depreciation.
Expense incurred on repairs and renewals and maintenance of assets are expenses other than depreciation under
this category too.
(v) Other expenses
These are the expenses which are not included under the above mentioned heads of expenses, For example, losses
due to fire, theft, etc.
CREDIT ITEMS

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On the credit side of Profit and Loss Account, items of revenue and incomes are written. The first item on this side
of Profit and Loss Account is the gross profit transferred from trading account. Other items of the credit side are:
Interest on investment, Interest on fixed deposits etc. Rent Received, Commission Received, Discount Received,
and Dividend received on shares.
(C) Cash Flow Statement
In financial accounting, a ‘Cash Flow Statement’ or ‘Statement of Cash Flows’ is a financial statement that shows
cash flow of a company. The money coming into the business is called cash inflow, and money going out from the
business is called cash outflow. The statement shows how changes in Balance Sheet and Profit and Loss Account
affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. As
an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company,
particularly its ability to pay bills. International Accounting Standard-7 (IAS-7) is the International Accounting
Standard that deals with cash flow statements. People and groups interested in cash flow statements include:
(i) Accounting personnel, who need to know whether the organization will be able to cover payroll and other
immediate expenses
(ii) Potential lenders or creditors, who want a clear picture of a company's ability to repay
(iii) Potential investors, who need to judge whether the company is financially sound
(iv) Potential employees or contractors, who need to know whether the company will be able to afford
compensation
Purpose
The cash flow statement reflects a firm's position of liquidity or solvency. The balance sheet is a snapshot of a
firm's financial resources and obligations at a single point in time, and the Profit and Loss Account summarizes a
firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis
accounting used by firms to match revenues with the expenses associated with generating those revenues.
Contrary to these two, the cash flow statement includes only inflows and outflows of cash and cash equivalents. It
excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include
depreciation or write-offs on bad debts to name a few. The cash flow statement is a cash basis report on three
types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are
usually reported in footnotes.
The cash flow statement is intended to
(i) provide information on a firm's liquidity and solvency and its ability to change cash flows in future
circumstances
(ii) provide additional information for evaluating changes in assets, liabilities and equity
(iii) improve the comparability of different firms' operating performance by eliminating the effects of
different accounting methods
(iv) indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations,
which might be derived from different accounting methods, such as various timeframes for depreciating fixed
assets.
Cash flow activities
The cash flow statement is partitioned into three segments, namely: cash flow resulting from operating activities,
cash flow resulting from investing activities, and cash flow resulting from financing activities. A typical format of
cash flow statement is given below:

Cash Flow Statement

Cash flows from operating activities

Cash receipts from customers 27,500
Cash paid to suppliers and employees (20,000)
Cash generated from operations (sum) 7,500
Interest paid (2,000)
Income taxes paid (2,000)
Net cash flows from operating activities 11,000

Cash flows from investing activities

Proceeds from the sale of equipment 7,500
Dividends received 3,000
Net cash flows from investing activities 10,500
Cash flows from financing activities
Dividends paid (12,000)

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 Net cash flows used in financing activities (12,000)
Net increase in cash and cash equivalents 9,500
Cash and cash equivalents, beginning of year 1,000
Cash and cash equivalents, end of year 10,500
.
(D) Statement of Retained Earnings
The Statement of Retained Earnings (also known as Equity Statement, Statement of Owner’s Equity for a single
proprietorship, Statement of Partner's Equity for partnership, and Statement of Retained Earnings and
Stockholders' Equity for corporation) is one of the basic financial statements as per Generally Accepted Accounting
Principles (GAAP), which explains the changes in a company's retained earnings over the reporting period. It
breaks down changes affecting the account, such as profits or losses from operations, dividends paid, and any
other items charged or credited to retained earnings. A retained earnings statement is required by Generally
Accepted Accounting Principles (GAAP) whenever comparative balance sheets and income statements are
presented. It may appear in the balance sheet, in a combined income statement and changes in retained earnings
statement, or as a separate schedule.
Therefore, the statement of retained earnings uses information from the income statement and provides
information to the balance sheet. Retained earnings are part of the balance sheet (another basic financial
statement) under “stockholders equity,” and are mostly affected by net income earned during a period of time by
the company less any dividends paid to the company's owners/stockholders. The retained earnings account on the
balance sheet is said to represent an "accumulation of earnings" since net profits and losses are added/subtracted
from the account from period to period.
The general equation can be expressed as following:

Ending Retained Earnings = Beginning Retained Earnings+ Net Income - Investments - Dividends Paid

Users of Financial Statements

Financial statements are intended to be understandable by readers who have "a reasonable knowledge of business
and economic activities and accounting and who are willing to study the information diligently". There are different
kinds of users of financial statements, who may be inside or outside the business. They use financial statements for
a large variety of purposes and their ability to understand and analyze financial statements helps them to success
in the business world. The various users of financial statements are classified and detailed as follows:
1. Internal Users
The internal users of financial statements are the individuals
who have direct bearing with the organization.
Shareholders:
The shareholders use the balance sheet and profit and loss
account produced by limited companies to decide if they are
going to increase or decrease their holding.
Management:
Management in every level of the business, from director level
to supervisor level, relies on accounting information to do their
job properly. They all use the same information for different
purposes. For example, directors use it for strategic purposes
and middle management can use it to see if they are meeting
their financial targets.
Employees:
The financial reports or the financial statements are of immense use to the employees of the company for making
collective bargaining agreements. Such statements are used for discussing matters of promotion, rankings and
salary hike.
2. External Users
Institutional investors:
The external users of financial statements are basically the investors who use the financial statements to assess
the financial strength of a company. This would help them to make logical investment decisions.

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 Financial Institutions:
The users of financial statements are also
the different financial institutions like
banks and other lending institutions who
decide whether to help the company with
working capital or to issue debt security
to them.
Government:
The financial statements of different
companies are also used by the
government to analyze whether the tax
paid by them is accurate and is in line
with their financial strength.
Vendors:
The vendors who extend credit to a
business require financial statements to
assess the creditworthiness of the
business.
Customers:
Before another company becomes a
customer or enters into a joint venture,
they will look at the company's finances
to make sure the company is not in
trouble and that their supplies are not
about to dry up.
General Mass and Media: The common people as well as media are also the users of financial statements for
different purposes.
Competitors:
It may seem odd, but existing competitors and new entrants have to consider the likelihood of their success or
failure in trying to conquer the market by going through the financial statements of leading firms in the industry in
which they are operating.
Trade unions:
They are interested in financial statements for negotiating the wages, salaries or bonus agreement with the
management.
Researchers:
They are interested in financial statements in undertaking research work in business affairs and practices.
Stock exchanges:
The stock exchange members take interest in financial statements for the purpose of analysis because they provide
useful financial information about companies to the investors.
Limitations of Financial Statements
Financial Statements are the key tools used to convey the economic state of an entity that help individuals make
informed decisions. These statements are produced considering the concepts of consistency, full disclosure,
materiality and conservatism. They provide a solid picture of an entity's performance and with comparative
statements for consecutive years, the users of financial statements can easily spot changes in the entity's financial
position and in the results of its operation. However there are a lot of limitations with the financial statements.
(i) Do not address any of the qualitative information:
They convey good details about the quantitative economic data but do not address any of the qualitative economic
variables. Qualitative attributes such as; the morale of the employee force or the quality of the management team
are some of the critical factors that are relevant to the decisions and judgments that the financial statement user is
making. The current accounting process has no way of measuring the value of these intangible assets. Hence, even
though the entity's human resources and information resources are its most valuable assets, they are simply
ignored in the financial statements. Similarly trademarks and brand value of a company are not recorded as assets.
Brand value of a company is built over time and has a lot of economic value.
(ii) Do not consider market value of assets:
Assets are always valued at their original price. Even if the value of an asset has significantly increased over time,
it is still reported at the original cost. The value of land has significantly may have risen over the past few decades,
but entities still report it at the original cost for which they had bought it.
(iii) Do not consider impact of inflation:

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The impact of inflation is also not considered when preparing financial statements. The impact to the usefulness of
financial statements is negligible when inflation is low but it is significantly higher when inflation rate reaches 10%
or more. A typical example is that the cost of goods sold reflects original cost even though the cost of replacement
might be significantly higher.
(iv) Do not capture important changes in the market and industry:
Another limitation of financial statements is that those do not capture important changes in the market place and
industry and hence sudden deviation in the financial performance of an entity is not addressed in the right context.
This can mislead a lot of individuals from making the right decisions.
(v) Do not compare with competitors:
A key factor for understanding the financial standing of a company is by comparing it with competitors in the same
industry. Comparability between firms using different accounting techniques is very difficult and with the current
globalization this becomes even more complicated as accounting standards are different across the world.
(vi) Do not reflect opportunity cost:
Financial statements also do not reflect opportunity cost. This concept is related to income forgone because an
opportunity to earn income was not pursued. The significance of this can be very high for companies with huge
assets.
(vii) Are based on estimates:
Another key limitation of financial statements is that it is based on estimates. The only known fact about estimates
is that it is not the original value. Even though estimates are made with the best of the tools available, they are
still estimates.
(viii) Are dumb:
The data contained in the financial statements are dumb; they do not speak themselves. The human judgment is
always involved in the interpretation of statement. It is the analyst or users who provides tongue to those data and
make them to speak.
Hence though financial statements provide a good picture of the economic standing of an entity, it is important to
understand its limitations and work around them to make sound decisions.
Questions
1. Explain the nature of the financial statements.
2. Explain in detail about the significance of the financial statements.
3. Explain the limitations of financial statements.
4. Prepare the format of income statement and explain its elements.
5. Prepare the format of balance sheet and explain the various elements of balance sheet.
6. Explain how financial statements are useful to the various parties who are interested in the affairs of an
undertaking?
7. ‘Financial statements reflect a combination of recorded facts, accounting conventions and personal
judgments’ discuss.

8. What is meant by Statement of Retained Earnings?

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