Accountancy: Class 11 (Part 2) — Chapter 8: Financial Statements - I

8.1 Stakeholders and their Information Requirements

Financial accounting is a sequential activity starting from Journalizing, Posting, and Trial Balance, leading to the preparation of Financial Statements. The objective is to communicate meaningful financial information to various stakeholders (users) to help them make informed decisions.

Classification of Stakeholders

Stakeholders are classified into internal and external users:

User Category	Type	Objective for Participating	Accounting Information Requirements
Current Owners	Internal	To make investment and wealth grow.	Wants to know the extent of profit/loss and current position of assets/liabilities.
Managers	Internal	For career progression; act as agents of owners.	Wants financial statements as a report card of profits and financial position.
Government	External	Regulatory role, tax levying, and public interest.	Interested in profitability, tax compliance, and protection of stakeholder rights.
Prospective Owners	External	Expecting to make future investments.	Interested in past profits and financial position as indicators of future performance.
Banks / Lenders	External	Safety of principal and periodic interest.	Interested in adequacy of profits and liquidity (how assets are held).

8.2 Distinction between Capital and Revenue

A fundamental distinction in accounting is between capital and revenue items. Revenue items form part of the Trading and Profit and Loss Account, while capital items help in the preparation of the Balance Sheet.

8.2.1 Expenditure

An outlay made for a purpose other than settling an existing liability is called expenditure.

Revenue Expenditure: Benefits the business for only one accounting period (e.g., salaries, rent). It is recurring and maintains earning capacity.
Capital Expenditure: Benefits the business for more than one accounting period (e.g., purchase of machinery, furniture). It is non-recurring and increases earning capacity.
Deferred Revenue Expenditure: Large revenue expenditures that yield benefits over multiple periods (e.g., heavy advertising campaigns).

8.2.2 Receipts

Capital Receipts: Receipts that create a liability or reduce a fixed asset (e.g., additional capital introduced, bank loans, sale of machinery).
Revenue Receipts: Receipts arising from routine business operations (e.g., sales revenue, interest received on investments).

8.3 & 8.4 Trading and Profit and Loss Account

The Trading and Profit and Loss Account (Income Statement) is prepared to determine the financial performance of the business over an accounting period.

8.4.1 Relevant Items

Debit Side (Expenses/Losses):

Opening Stock, Purchases (less returns), Wages, Carriage Inwards, Fuel/Power, Salaries, Rent, Interest, Commission, Repairs, Depreciation, and Bad Debts.

Credit Side (Revenues/Gains):

Sales (less returns) and Other Incomes (e.g., rent received, interest received, discount received).

8.4.2 Closing Entries

Closing entries transfer the balances of nominal accounts to the Trading and Profit and Loss Account:

For closing expenses:
Trading A/c Dr.
To Purchases A/c
To Wages A/c

For closing revenues:
Sales A/c Dr.
To Trading A/c

8.4.3 Concept of Gross Profit and Net Profit

The Trading Account determines Gross Profit, while the Profit and Loss Account determines Net Profit.

$$\text{Gross Profit} = \text{Sales} - (\text{Purchases} + \text{Direct Expenses})$$

$$\text{Net Profit} = \text{Gross Profit} + \text{Other Incomes} - \text{Indirect Expenses}$$

$$\text{Cost of Goods Sold} = \text{Opening Stock} + \text{Purchases} + \text{Direct Expenses} - \text{Closing Stock}$$

8.5 Operating Profit (EBIT)

Operating Profit is the profit earned through the normal operating activities of the business, excluding purely financial incomes/expenses and abnormal items.

$$\text{Operating Profit} = \text{Net Profit} + \text{Non-Operating Expenses} - \text{Non-Operating Incomes}$$

8.6 Balance Sheet

The Balance Sheet is a statement showing the financial position of a business at a given date, listing its assets, liabilities, and capital.

8.6.2 Relevant Items

Current Assets: Cash, bank balance, debtors, bills receivable, closing stock.
Fixed Assets: Land, buildings, plant, machinery, furniture.
Intangible Assets: Goodwill, patents, trademarks.
Current Liabilities: Creditors, bills payable, bank overdraft.
Long-term Liabilities: Long-term bank loans.
Capital: Owner's equity, adjusted for net profit/loss and drawings.

8.6.3 Marshalling and Grouping

Marshalling is the arrangement of assets and liabilities in a specific order:

Order of Permanence: Most permanent assets (e.g., Fixed Assets) and liabilities (e.g., Capital) are shown first.
Order of Liquidity: Most liquid assets (e.g., Cash) and urgent liabilities (e.g., Creditors) are shown first.

8.7 Opening Entry

An Opening Entry is recorded in the journal at the beginning of a new financial year to open the accounts of assets, liabilities, and capital carried forward from the previous year's balance sheet.

Example Journal Entry:
Assets A/c Dr.
To Liabilities A/c
To Capital A/c