Financial statement Theory notes for online classes form 4

Trial Balance
Trial Balance is a statement prepared with the debit and credit
balances of ledger accounts to verify the arithmetical accuracy of
the book.

The Trial Balance checks the equality of debits and credits in the ledger by
listing each account along with its ending balance.

Accounts to Accounts to be
be placed on placed on
debit side credit side
Assets Liabilities
Expenses Capital 
Drawings Revenue

What are Financial statements? 

Final statements consists of
 Income Statement (trading and profit account)
 Statement of Financial position (Balance Sheet)

Income Statement
It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS
LOSS arising as a result of trading activities of a business .

According to J.R.Batliboi:-
‘The Trading Account shows the results of buying and selling of goods. In preparing, this
account, the general establishment charges are ignored and only the transactions in
goods are included’

Importance of Trading Account

Trading Account is prepared for the following reasons
Financial statement Theory notes for online classes form 4

 To know the Gross Profit or Gross loss arising due to trading activities of the business.
 To find out the direct expenses incurred by the business for the goods sold during the
year.
 Find out how much closing stock is left as compared to previous years and thus find out
the performance of the business.
 Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss and to
assess the performance of the business and take corrective measures, if needed.

Preparation of Trading Account

The following items usually appear in a Trading Account

Sales turnover
Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales returns
(Return inwards).

Opening Stock
The closing stock of the previous accounting year is taken as the Opening stock for the
present year. If there is no Opening Stock then no entry is made.  Opening stock is derived
by balancing the Stock Account and bringing down its balance to the next period.

Purchases
Purchases include all the Cash and Credit purchases of goods made by the business during
the year.
Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net Purchases.

Direct Expenses
All expenses which are incurred in purchasing the goods and bringing them to the trading place
are recorded under this category. 
These include:

 Wages e.g. Warehouse worker wages.

 Carriage Inwards i.e. the cost of transport of goods to the trading place. The expense is usually
borne by the buyer.
 Duty on purchases, for example, Import duty or excise duty.

Closing Stock
All the goods which remain unsold at the end of the year are known as ‘Closing stock’.
Financial statement Theory notes for online classes form 4

The closing is stock is valued at Cost price or Market price, whichever is lower.
The reason for taking the lower value of the two is in accordance with the ‘Prudence Principle’.
Normally, ‘Closing stock’ is given outside the Trial Balance.  This is so because its valuation is made
after the accounts have been closed.

Note: Sometimes, the ‘Closing Stock’ may be given inside the Trail Balance. This means
that the entry to incorporate the closing stock in the books has already been passed and it
has already been deducted from the Purchases Account. In this case, ‘Closing Stock’ will
not be shown in the Trading Account will only appear in the Asset side of Balance Sheet’.

Cost of goods sold

This means the finding the cost of only those goods which have been sold during the year.
It can be calculated as follows:

(Net Purchases +Opening Stock) - Closing Stock

Profit and Loss Account

According to Prof. Carter:  

‘A Profit and Loss Account is an account into which all gains and losses are collected, in
order to ascertain the excess of gains over the losses or vice-versa’.

Why Profit and loss account is made?

 To find out the Net Profit or Net Loss
 Compare the net profit of the business with previous years and to assess the performance
of the business.
 Find out the amount of overheads of a business.

Items appearing on a Profit and

Financial statement Theory notes for online classes form 4

Loss account
Any Incomes or gains
Any income or gains of the business from sources other than sales are recorded on the
Credit side of Profit and loss account.

Gross Profit or Loss

It is transferred to the P/L account from the Trading Account. Gross Profit is transferred to
the Debit side whereas Gross Loss is transferred to the Credit side.

Office and Administrative expenses

Example include salaries, office rent, lighting, stationery etc.

Selling and Distribution expenses

Include advertising expense, commission, carriage outwards, bad-debts etc.

Miscellaneous expenses
Such as, interest on loan, interest on capital, depreciation etc.

Statement of financial position/

balance sheet
Balance Sheet is a statement which shows the financial position of the business on a
particular day.
According to A. Palmer 
“The Balance Sheet is a statement at a particular date showing on one side the trader’s
property and possessions and on the other hand the liabilities”.
Thus we can say that
 Balance sheet is a statement not an account.
 It is prepared to show the financial position of the business.
 It records all the assets and liabilities of the business.
 It shows the financial position on a particular day not for a period of time.
Financial statement Theory notes for online classes form 4

Need and Importance of Preparing a

Balance Sheet/ Statement of financial
position
A Balance Sheet serves the following purposes:
 The true financial position of the business can be ascertained at a particular point of time.
 Reveals the amount of assets owned by the business for example machinery, cash,
debtors/TR and so on.
 Show the liabilities of the business such as total creditors/ TP, share capital etc.
 To adjudge weather the firm is solvent or not.
 Opening entries for the next financial year are based on the Balance Sheet of the previous
year.

Items appearing on a Balance Sheet

Assets
Assets of a business are what it owns. They can be classified as:
NCA /Fixed assets:  All those assets which are owned by the business and last for more
than an accounting year. Examples include Land, building, machinery, vehicle, furniture
and fixtures and the like.
Current assets: It includes all those assets which either in the form of cash or can be
easily converted into cash within one accounting period. Current Assets include Cash,
Debtors/trade receivables and inventory/ Stock.

Liabilities
Liabilities represents what the business owes to outside persons other than owners.
These liabilities are classified on basis of time period of repayment.
Long term liabilities: These are liabilities which the business owes for more than one
accounting period, e.g. long term bank loans, debentures etc.
Current liabilities: These are short term debts of the business that are to be repaid within
one accounting period, e.g. creditors and bank overdraft.

Owner’s Equity
Owner’s equity represents what the business owes its owner.
It is equal to total assets minus total liabilities.
Financial statement Theory notes for online classes form 4

Important points regarding Balance Sheet

 The Balance Sheet is not an account but a statement.

 It does not have debit or credit side but has two sections i.e. assets and liabilities.
 The heading of Balance Sheet is ‘as on a particular date’. Thus a Balance Sheet may have
different figure on different dates.
 The balances shown in the Balance Sheet act as Opening Balances for the next
accounting period.
 Balance Sheet is based on the accounting equation
Assets= Owner’s Equity + Liabilities