Understanding

Financial
Statement
Dr. Krishnendu Ghosh
Learning outcomes
• Nature of Financial Statements,
• Objectives of Financial Statements,
• Uses of Financial Statements,
• Form and content of Financial Statements,
• Users of Financial Statements
Financial Statements
 Financial statements are compilation of financial data, collected and
classified in a systematic manner according to the accounting principles, to
assess the financial position of an enterprise as regards to its profitability,
operational efficiency, long and short - term solvency and growth potential
 Financial statements are basic and formal means through which
management of an enterprise make public communication of financial
information along with select quantitative details
 Financial statements are structured financial representation of the financial
position, performance and cash flows of an enterprise
 Financial statements comprise a number of statements prepared at the end
of each financial year to assess the various financial activities and strength
of an enterprise
 Financial statements are the report card of business
Financial Statements (contd…)
 A company's financial statements are a window into its financial health
 There are three major financial statements: the balance sheet, statement of profit-
and-loss and cash-flow statement
The balance sheet shows a firm’s assets, liabilities and owner’s equity
The statement of profit-and-loss / income statement shows a firm’s revenues
and expenses and tells you about a company's profitability
The cash-flow statement is about the cash inflows and outflows for a company
over a period of time
The statement of owner’s equity reports the changes in owner’s equity that
have occurred over a specified period of time. It is also called as statement of
retained earnings
Supplementary notes includes explanations of various activities, additional
detail on some accounts, and other items as mandated by the applicable
accounting framework, such as GAAP or IFRS
Nature of Financial Statements (contd…)
 The American Institute of Certified Public Accountants (AICPA) stated: “they
(financial statements) reflect a combination of recorded facts, accounting
conventions and personal judgment, and the judgments and conventions
applied affect them materially.”
 Therefore the nature of financial statements are:
 Recorded facts: Financial statements are prepared on the basis of facts
in the form of cost data recorded in accounting books
 Accounting Conventions: Certain accounting conventions are followed
while preparing financial statements
 Postulates: Financial statements are prepared on certain basic
assumptions (pre-requisites) known as postulates such as going concern
postulate, money measurement postulate, realisation postulate, etc.
Nature of Financial Statements
 Legal implications:
 Personal judgment: Under more than one circumstance, facts and
figures presented through financial statements are based on personal
opinion, estimates and judgements
Qualitative Characteristics of the Financial
Statements:
 Four qualitative characteristics of the financial statements:

Understandability – the information is readily understandable by

users
Relevance – the information may be used to influence economic
decisions of users
Reliability – the information is free from material error and bias

Comparability – the information enables comparisons over time to

identify and evaluate trends
Objectives of Financial Statements
 The primary objectives of financial statements is to present the true and
fair value of the state of affairs of the firm with the help of its various
statements
 To supply necessary information to the users and analysts for taking
decisions which will be formulated in future
 To provide information about economic resources and obligations of a
business
 To provide information about the earning capacity of the business
 To provide information about cash flows
 To judge effectiveness of management
 To provide information about activities of business affecting the society
 Disclosing accounting policies
Users of Financial Statements
Users of Financial Statements (contd…)
What do internal users use it for?

 Planning, evaluating and controlling company operations

What do external users use it for?

 Assessing past performance and current financial position and

making predictions about the future profitability and solvency of
the company as well as evaluating the effectiveness of
management
Uses of Financial Statements
 They provides necessary information about the financial activities to the
interested parties
 They reveal the right and proper position of a business
 They provides necessary information about the efficiency or otherwise of the
management, regarding the proper utilization of the scarce resources
 They provide necessary information for predictions (financial forecasting)
 They help to evaluate the earning capacity of the firm by supplying a
statement of financial position, a statement of periodical earnings together
with a statement of financial activities to the various interested persons
 They facilitate decisions regarding the changes in the manner of acquisition,
utilization, preservation and distribution of the scarce resources
 They facilitate decisions regarding replacement of fixed assets and expansion
of the firm
Uses of Financial Statements (contd…)
 They provide necessary data to the government for taking proper decisions
relating to duties, taxes and price control, etc. and for some legal and
control purposes
 They device remedial measures for the deviations between the actual and
budgeted performances
 They also provide necessary data and information to the managers for
internal reporting and formulation of overall policies
 They also help to safeguard the interest of shareholders who are not
allowed to go through the day-to-day affairs of the firm
 They help the credit rating agencies to determine the rating of the
Company
Form and Content of Financial Statements of a Sole
Proprietor
 At the end of the financial period, after preparation of trial balance, the
financial results and financial position of the business is determined
 Once the trial balance is ready and the errors are rectified, trading and
profit & loss account are prepared by transferring balances of relevant
accounts from the trial balance. All real and personal accounts are shown
in the balance sheet
 The income statement/statement of profit or loss (or manufacturing,
trading and profit & loss account) determines the results or financial
performances of the business
 The Balance Sheet determines the financial position of the business
 The final accounts may be prepared in vertical or horizontal format
Form and Content of Financial Statements of a Sole
Proprietor (contd…)
 The following financial statements help in finding out the net profit or loss
and the financial position of a business as on a particular date:
Manufacturing Account
Trading account
Profit and Loss account, and
Balance Sheet
 The income statement /statement of profit or loss and the balance sheet is
known as the Final Accounts or Financial Statement
 The users of the final accounts or financial statements are the owners,
government, management, employees, creditors and other interested
agencies
Form and Content of Financial Statements of a Sole
Proprietor (contd…)
 Regulatorsdo not require segmentation into Manufacturing Account,
Trading Account and Profit & Loss Account
 Manufacturing Account shows the cost of goods manufactured

 Trading Account shows the gross profit earned during the reporting
period
 Profit & Loss Account shows the net profit / loss for the period
Mechanism Involved in Preparation of Final
Accounts from Trial Balance
Manufacturing Account
 Manufacturing concerns, prepare a Manufacturing Account prior to the
preparation of Trading Account, to find out cost of production
 Manufacturing account is debited with:
The cost of raw materials
Manufacturing wages & other manufacturing expenses
Depreciation on factory assets
 The purpose of the manufacturing account is to calculate the cost of goods
manufactured for inclusion in the Trading Account
 Manufacturing organizations do not simply buy in finished goods for
resale. Instead they buy in the raw materials from which the finished
goods are manufactured
Manufacturing Account (contd…)
 The cost of raw materials consumed in the period is calculated as follows:

Opening stock of raw materials XXXX

Add: Purchases of Raw Materials XXXX
(net of returns) XXXX
Less : Closing stock of raw materials XXXX
Cost of Raw Materials Consumed XXXX

 Theother costs of manufacturing the product are added to the cost of raw
materials consumed
Manufacturing Account (contd…)
 The cost of goods manufactured is then calculated by completing the work
in progress adjustment:
Cost of Raw Materials Consumed XXXX
Add: Opening work in progress XXXX
XXXX
Less: Closing work in progress XXXX
Cost of Goods Manufactured XXXX
Format of a Manufacturing Account

Source: https://www.kullabs.com/classes/subjects/units/lessons/notes/note-detail/5635
Trading Account
 This is an account which shows the result of buying and selling of goods and
services
 Trading account is debited with:
 Opening stock of Finished Goods
 Net Purchases of Finished Goods (if any)
 Cost of Production of Finished Goods transferred from Manufacturing
Account
 Any direct expenses
 Trading account is credited with:
 Net Sales
 Closing stock
 This account helps in finding out the gross profit or gross loss of a business
during a time period
Trading Account (contd…)
 The Trading Account can now be completed, with the cost of sales calculated as:
Opening stock of finished good XXXX
Add: Cost of goods manufactured XXXX
XXXX
Less: Closing stock of finished goods XXXX
Cost of sales XXXX
 Cost of Goods Sold (COGS) = Opening Stock + Purchases + Direct Expenses –
Closing Stock
 When preparing the Balance Sheet, the closing stock figure included in Current
Assets will be the total of Raw Materials Stock, Work in Progress and Finished
Goods Stock
Trading Account (contd…)
 The main objectives of preparing the Trading account are:
 To show all the transactions occurring during a trading period which
have a direct relation to the goods in which a business deals in a concise
form
 To ascertain gross profit or gross loss of a business during an accounting
period - usually a year
 Gross Profit is said to be made when the sale proceeds exceed the cost of
goods sold. Conversely, when sale proceeds are less than the cost of the
goods sold, gross loss is incurred
 Gross Profit is calculated as follows:
(Sales + Closing Stock) – (Opening Stock + Purchases + Direct Expenses)
OR
Sales – Cost of Goods Sold
Format of Trading Account – T Form

Source: https://images.app.goo.gl/EopAAhh6FKjR3qK19
Format of Trading Account – Vertical Form

Source: https://images.app.goo.gl/D5LeNsL3ZVBzQq2h6
Profit & Loss Account
 The profit and loss account is designed to highlight the net profit earned or
net loss incurred by a business entity during an accounting period
 Profit & Loss account is debited with:
 Operating expenses
 Financial Charges
 Tax expenses
 Losses incurred during the reporting period
 Profit & Loss account is credited with:
 Gross Profit
 Other Operating income
 Extraordinary Income
Profit & Loss Account (contd…)
 The Net Profit is calculated in the Profit and Loss Account and is what
remains after all other costs used up in the period have been deducted
from the Gross Profit
 The main objectives of preparing the Profit & Loss Account are:
To ascertain net profit or net loss of a business enterprise during an
accounting period
To determine the past performance of the enterprise
To predict future performance
To assess the capability of generating future cash flows
Profit & Loss Account (contd…)
 The limitations of the Profit & Loss Account are:

Items that might be relevant but cannot be reliably measured are not
reported (e.g. brand recognition and loyalty)
Some numbers depend on accounting methods used (e.g. using FIFO
or LIFO accounting to measure inventory level)
Some numbers depend on judgments and estimates (e.g.
depreciation expense depends on estimated useful life and salvage
value)
Types of Profits
 Gross Profit is the difference between the revenue from the sale of goods
and the cost of goods sold
 Operating profit (PBIT) is the gross profit + other income – administrative,
selling and distribution expenses
 Net profit (PAT) is the profit after interest and income tax expenses
 Top line profit: The term "top line" refers to the total revenues or sales
mentioned in the income statement. This refers to the fact that the total
revenues collected by a company appears at the top of the income
statement
 Bottom line profit: It is the net profit that is calculated after subtracting the
expenses from revenue. Since this forms the last line of the income
statement, it is generally referred to as the “bottom line”. It is important to
investors as it represents the profit for the year attributable to the
shareholders
Format of Profit & Loss Account (Horizontal Format)

Source: http://www.brainkart.com/article/Profit-and-loss-account_34233/
Format of Profit & Loss Account (Horizontal Format)(contd…)

Source: http://www.brainkart.com/article/Profit-and-loss-account_34233/
Profit & Loss Account (Vertical Format)
General Guideline for the Preparation of Trading
and Profit and Loss account
 The distinction between capital and revenue items is an important consideration
in the preparation of final accounts
 Items of revenue income, revenue expenditure and revenue losses are shown in
the trading and profit and loss account
 Capitalexpenditure, capital losses, capital income and capital receipts are
excluded from these accounts
 Thegeneral guideline for the preparation of trading and profit and loss account
on accrual basis is that only revenue income and revenue expenditure for the
current period are included in this account
 An expenditure which pertains to the future, though already incurred, is excluded
 An expense, which has already been incurred but the payment has not been made
such as outstanding salaries of employees, will be included
General Guideline for the Preparation of Trading
and Profit and Loss account (contd…)
 Income or receipts which pertain to the current period whether received
in cash or not, are included
 Closing stock of WIP, R/M and FG appear in income statement only when
given in additional information
 Purchase return is also termed as return outward/return to supplier
 Sales return is also termed as return inward/return from customer
 Carriage inward is also known as freight inward
 Carriage outward is also known as freight outward/cartage outward
 For numerical purpose ‘wages and salary’ goes to Trading A/c whereas
‘salary and wages’ goes to P & L A/c
Balance Sheet
 There is no prescribed format for preparing the balance sheet of sole
proprietor and partnership. For Joint Stock Company, the format of
preparing balance sheet is given under Schedule III of Indian Companies
Act, 2013
 Aftertransferring all nominal accounts, the items left out in trial balance
are real account and personal accounts. These are grouped under assets
(debit balance) and liabilities (credit balance) and presented in a balance
sheet
 Balance sheet is a statement of assets and liabilities of a business
enterprise at a given date. It shows what a business owns and what it owes
 Balancesheet is prepared on a particular date and not for a fixed period. It
discloses the financial position of a business on a particular date
Balance Sheet (contd…)
 On the left, it exhibits the liabilities and on the right, it shows assets within
the control of the enterprise
 The purpose of preparing a balance sheet is to ascertain the nature and
value of assets of a business to determine the nature and amount of
liabilities of a business and to determine its solvency
 Balance Sheet is prepared to fulfil some definite objectives. These are:
 To ascertain the proprietary interest of a person or business
organization
 To calculate the actual capital employed in the business
 To indicate the financial health
 To serve as a basis for purchase consideration
 To project the trend of working capital requirement
Balance Sheet (contd…)
 Balance Sheet is prepared to fulfil some definite functions. These are:
 Disclosure of values and natures of assets and liabilities: Differentiate
whether fixed or fluctuating or current or tangible, etc.
 Information about solvency: Short run solvency can be easily assessed
from its current assets and current liabilities. On the other hand, fixed
assets and long-term loans give an idea about long run prospect
 Information about liquidity: Exhibits the liquid assets and readily-
payable external debts which creates a transparency regarding the
liquidity position
 Information about other necessary aspects: Helps to know about the
capital employed, nature of capitalization, the risks factors involved,
business potential, etc.
Balance Sheet (contd…)
 There are few limitations of preparing Balance Sheet. These are:

 Fixedassets are shown in the Balance Sheet at historical cost less

depreciation up-to-date
 Intangible
assets are shown in the Balance Sheet at book values which
may bear no relationship to market values
 The Balance Sheet cannot reflect the value of factors such as skills and
loyalty of staff
 It may mislead untrained readers in inflationary situations
General Guideline for the Preparation of Balance Sheet
 On the basis of accrual principle, the impact of events on assets and
liabilities is recognized in the time period when services are rendered or
utilized, instead of when cash is paid or received
 Revenue is recognized as it is earned and expenses are recognized as
they are incurred
Balance Sheet Formats
 Balance Sheet may be prepared in two formats:

 Horizontal Format

Left side lists liabilities & details of its capital position and right side
lists various assets of the enterprise
 Vertical Format

It displays the amount invested in fixed assets and in working capital.
It clearly defines sources & applications of fund
Marshalling of Balance Sheet
 The order in which the assets and liabilities are arranged in a Balance Sheet is
called Marshalling
 There are two common ways in which the assets and liabilities can be
arranged
 In the order of Liquidity
Assets are arranged in order of the case with which they can be converted
into cash
Liabilities are so arranged in the order they are to be discharged
 In the order of Permanence
Assets are listed in order of permanence, i.e. starting with those least
‘realizable’ and working down to the most ‘liquid’ assets
Liabilities are also recorded in order of their permanence, i.e. the liability
which will have to be discharged last is shown first
Balance Sheet Equations
 The equations which holds for Balance Sheet :

 Horizontal Format

Total Assets = Total Liabilities + Owners’ Equity

 Vertical Format

Fixed Assets + Working Capital – Long Term Liabilities = Owner’s

Equity
OR
Fixed Assets + Working Capital = Long Term Liabilities + Owners’
Equity
Balance Sheet Format (Horizontal Format)

Source: http://www.brainkart.com/article/Balance-sheet_34234/
Balance Sheet Format (Horizontal Format) (contd…)

Source: http://www.brainkart.com/article/Balance-sheet_34234
Balance Sheet Format (Vertical Format)

Source: http://www.brainkart.com/article/Balance-sheet_34234
Balance Sheet Format (Vertical Format) (contd…)

Source: http://www.brainkart.com/article/Balance-sheet_34234
Balance Sheet Format (Vertical Format)

Source: Financial Accounting for Management, Paresh Shah. 2nd Edition, Published by Oxford University Press
Few Important Terms
 Liquid assets are the assets which are either in the form of cash or which
can be immediately converted into cash within a very short period of
time, such as cash at bank, bills receivable, short-term investments,
debtors and accrued incomes. In other words, if prepaid expenses and
closing stock are excluded from current assets, the balance is known
as liquid assets
 Fictitious or Nominal assets are assets only in name but not in reality.
These assets are not really assets but are shown on the assets side only
for the purpose of writing off by transferring them to the profit and loss
account gradually over a period of time in future. Such assets include the
expenditures, the benefit of which lasts for more than a year, not yet
written off, such as preliminary expenses, etc.
Few Important Terms (contd…)
 Contingent liabilities are the liabilities which are not certain at the time
of preparation of balance sheet. These liabilities may or may not occur.
These are the liabilities which will become payable only on the happening
of some specific event which itself is not certain, otherwise these need
not be paid. Such as, Liabilities for bills discounted – In case a bill
discounted with the bank is dishonoured by the acceptor on the due date,
the firm will become liable to the bank. Contingent liabilities are not
shown in the balance sheet. They are, however, shown as a foot note just
below the balance sheet so that the existence of such liabilities may be
revealed
Few Important Terms (contd…)
A contingent asset is a potential asset or economic benefit for a company. It
does not currently exist but may arise in the near future. The occurrence of
such a contingent asset depends on the occurrence or the non-occurrence of a
particular set of events over which the company itself does not have full
control. Such an asset or economic interest arises from an uncertain and
unpredictable event. Because of the concept of conservatism, a contingent
asset and gain will not be recorded in a general ledger account or reported on
the financial statements until they are certain. This is different from
contingent liabilities and contingent losses, which are recorded in accounts
and reported on the financial statements when they are probable and the
amount can be estimated. For example, if the company is locked in a legal
dispute and has the possibility of winning the case and being entitled to a
claim or damages or if the company is anticipating a merger
Adjustment Entries

Source: IBS Study Material on Foundations of Accounting

Adjustment Entries (contd…)

Source: IBS Study Material on Foundations of Accounting

Adjustment Entries (contd…)

Source: IBS Study Material on Foundations of Accounting

THANK YOU