Chapter 6: Financial Statements of Sole Proprietorship
Financial Statements
Financial Statements form the basic and formal annual reports through which the corporate management communicates financial information to its owners and various other external parties.
- Objectives: To ascertain the profit or loss of the enterprise and to portray the financial position.
Revenue and Capital Nature Items
- Capital Expenditure: Improves earning capacity or acquires long-term assets. Shown in Balance Sheet.
- Revenue Expenditure: Maintains earning capacity (day-to-day running expenses). Shown in Trading and P&L A/c.
- Deferred Revenue Expenditure: A revenue expenditure of large amount whose benefit is expected over a number of years (e.g., heavy advertising).
Trading and Profit and Loss Account
The Trading Account is prepared to calculate Gross Profit or Gross Loss, emphasizing the direct costs (factory wages, carriage inward) of buying or manufacturing goods. The Profit and Loss Account determines the Net Profit or Net Loss after considering all indirect expenses (rent, salaries, selling costs) and indirect incomes. \[ \text{Operating Profit} = \text{Gross Profit} - \text{Operating Expenses} + \text{Operating Incomes} \]
Balance Sheet
The Balance Sheet is a statement (not an account) that shows the financial position of a business as of a specific date. It details Assets, Liabilities, and Capital.
- Marshalling: The arrangement of assets and liabilities in a specific order (either in order of Liquidity or Permanence).
Layout of Balance Sheet (Order of Liquidity)
Adjustments in Preparation of Final Accounts
Adjustments are required to align with the Accrual Basis of accounting.
- Closing Stock: Credited to Trading A/c; Shown in Assets.
- Outstanding Expenses: Added to the expense in Trading/P&L A/c; Shown in Liabilities.
- Prepaid Expenses: Deducted from the expense in Trading/P&L A/c; Shown in Assets.
- Accrued Income: Added to the income in P&L A/c; Shown in Assets.
- Income Received in Advance: Deducted from income in P&L A/c; Shown in Liabilities.
- Depreciation: Debited to P&L A/c; Deducted from Asset in Balance Sheet.
- Bad Debts & Provision for Doubtful Debts: Debited to P&L A/c (after adding new to old, minus old provision); Deducted from Debtors in Balance Sheet.
- Manager’s Commission: Calculated on Net Profit.
- Before charging commission: \(\text{Profit} \times \frac{\text{Rate}}{100}\)
- After charging commission: \(\text{Profit} \times \frac{\text{Rate}}{100 + \text{Rate}}\)
Competency-Based Questions
Q1. The Trial Balance of Mr. Ram shows wages paid ₹50,000. Underneath as an adjustment, it says “Wages Outstanding: ₹5,000”. Why are adjustments necessary and how will this be treated?
Solution: Adjustments are necessary to comply with the Matching Concept and Accrual Concept to ascertain true profit. The outstanding wages relate to the current year. It will be added to wages on the Debit side of the Trading Account (making it ₹55,000) and recorded as a Current Liability in the Balance Sheet.
Q2. Identify whether the purchase of machinery for ₹2,00,000 and the installation charges of ₹10,000 are capital or revenue expenditures. How will they be presented?
Solution: Both the purchase of machinery and its installation charges are Capital Expenditures. According to the Cost Concept, all expenses incurred to bring an asset to its fully functional state form part of its cost. ₹2,10,000 will be presented as a Non-Current Asset in the Balance Sheet.
Q3. An adjustment reads: “Goods costing ₹10,000 were destroyed by fire, but insurance company admitted a claim for ₹8,000.” How will you account for this in the Final Accounts?
Solution:
- Deduct ₹10,000 from Purchases in the Trading Account (or show on credit side as Abnormal Loss).
- The unrecovered loss of ₹2,000 (10,000 - 8,000) is debited to the Profit and Loss Account.
- The expected receipt of ₹8,000 is shown as ‘Insurance Company Claim’ under current assets in the Balance Sheet.
Q4. A manager is entitled to a 10% commission on the net profit after charging such commission. If the Net Profit before his commission is ₹1,10,000, calculate his commission amount and how it affects the final accounts.
Solution: Commission = \(1,10,000 \times \frac{10}{100 + 10} = 1,10,000 \times \frac{10}{110} = 10,000\).
- ₹10,000 is Debited to the Profit and Loss Account as Manager’s Commission.
- The remaining ₹1,00,000 is transferred to the Capital Account as Net Profit.
- ₹10,000 is shown as Outstanding Commission (Current Liability) in the Balance Sheet.