Financial Accounting and Analysis

Chapter 4

Preparation of Financial Statements

 Lecture Sub-topics

Relationship between
01 Introduction Profit and Loss
02 Trial Balance 03
Account and Balance
Sheet

Preparation of Profit Preparation of

04 05 06 Adjustment Entries
and Loss Account Balance Sheet

Adjusted Trial
07
Balance
 Introduction
• Profit or loss made during the year can be determined by
preparing a Statement of Profit and Loss and their financial
position at the end of the year by preparing a Balance Sheet.

• Balance sheet shows the amount of assets and liabilities of the

business at the close of an accounting period.
 Trial Balance
• After the transactions are posted in the ledger, a statement showing the accounts
with debit and credit balances separately is prepared.
• This statement is called the trial balance.
• It serves as a summary of the contents of the ledger. It has two columns.
• The debit balances are listed in the left-hand column and the credit balances are
listed in the right-hand column.
• The trial balance is prepared on a particular date, which is mentioned at the top
of the trial balance.
• The general format of the trial balance.
 Trial Balance
• The trial balance agreement implies that the accounting work is free from clerical
errors, even though other errors may still be present.

• If the debit and credit totals of the trial balance do not agree, one or more of the
following errors might have been committed:

1. A debit amount is posted as a credit amount or vice-versa.

2. Arithmetic mistakes in determining account balances.

3. Error in carrying the amount from the ledger account to the trial balance
or listing the account balance in the wrong column of the trial balance.

4. Errors in calculating totals of the trial balance.

• The work of preparing financial statements starts after establishing the

agreement of the trial balance.

• Preparation of financial statements becomes difficult in the absence of an agreed

trial balance.
 Rectification of Errors
Agreement of the total of debit balances and credit balances in the Trial Balance does
not mean absence of errors in the books of account.
 Types of Errors

• Errors of Omission : occur when a transaction is omitted to be entered in the

books of account.
 Rectification of Errors
Agreement of the total of debit balances and credit balances in the Trial Balance does
not mean absence of errors in the books of account.

Types of Errors

• Errors of Commission : occur when the balancing or totalling of an account is

incorrect or an amount is wrongly posted or the balance of an account that is
carried forward to the next period is not correct.
 Rectification of Errors
Agreement of the total of debit balances and credit balances in the Trial Balance does
not mean absence of errors in the books of account.

Types of Errors
• Errors of Principle: occur when a capital expenditure is treated as a revenue
expenditure or vice versa.
 Rectification of Errors
Agreement of the total of debit balances and credit balances in the Trial Balance does
not mean absence of errors in the books of account.

Types of Errors

• Compensating Errors : errors that compensate each other and, therefore, do not
affect the agreement of the Trial Balance.
 LETS INDENTIFY THE
TREATMENT
CORRECT OR INCORRECT
 Find the correct accounting treatment

• Cheque of Rs 1700 received from a customer Rajesh recorded in the books as Rs

1070

• Wages paid for the construction of building Rs20000 debited to the wages account
 Treatment of Errors
• The accountant should take all steps to detect the errors.

• If the errors are not detected quickly, there may be a delay in closing the books of
account for the accounting year.

• To avoid such delay, the difference in the trial balance may be transferred to an
account known as ‘Suspense Account’.

• Suitable accounting entries are passed to rectify the errors.

• Rectification of all errors will result in closure of the Suspense Account.

• Depreciation charged on the buildingRs20000 was not debited to depreciation
account
• Depreciation charged on the buildingRs20000 was not debited to depreciation
account

• Error of Partial Omission

• Debit depreciation account by 20000 and credit suspense account

 Relationship Between Profit and Loss Account and Balance
Sheet
• Both the profit and loss account and the balance sheet are interrelated.

• A cost relating to the operations or the revenue earned during the period whose
benefits do not extend beyond that period is treated as an expense and is shown
in the profit and loss account.

• A cost relating to the operations of an accounting period or to the revenue earned

during the period whose benefits do not extend beyond that period is treated as
an expense and is shown in the profit and loss account.

• The profit earned during an accounting period and retained in the business forms
part of the owners’ capital in the balance sheet.
 Preparation of Profit and Loss Account

Gross Profit
• Difference between the sales revenue and the cost of goods sold.

• In the case of a trading firm gross profit consists of purchases and all other
expenses incurred in bringing the goods to their present location and condition.

• In a manufacturing concern, the cost of goods sold also includes all expenses
incurred in the factory for producing goods such as wages, power and fuel and
rent of factory premises.
Sales Revenue
• Total sales revenue for an accounting period is taken from the sales
account in which day-to-day sales transactions are entered on the basis
of sales invoices

Sales Returns and Allowances

• Part of sales revenue that represents the value of goods returned by
customers as they were not in accordance with the specifications, or
damaged or defective

Goods and Services Tax

• A deduction from gross sales.
• An indirect tax that the seller recovers from the customer and deposits it
with the government.
 Cost of Goods Sold

• Beginning inventory: The beginning inventory of an accounting

period is the closing inventory of the previous accounting period.

• Purchases:
o purchases account in which day-to-day purchase transactions
are entered on the basis of purchase invoices.
o Net value after deducting any trade discount.
o Sometimes, suppliers also give allowances.
 Cost of Goods Sold

• Purchases returns: The cost of purchased items that is returned

to sellers is accumulated in the purchases returns account and is
shown as a deduction from the purchases figure in the profit and
loss account.

• Freight on purchases: A part of purchase cost and is added to the

purchase price of the goods for calculation of cost of goods sold.

• Wages: Wages paid to workers in stores and warehouses.

• Ending inventory: Unsold goods at the end of an accounting

period constitute the ending inventory.
 Cost of Goods Sold

• Operating Profit: Calculated as gross profit minus operating

expenses. Operating expenses are related to normal operations of
the business and include administrative, selling and general
expenses.

• Net Profit: Calculated by adjusting the operating profit for non-

operating revenues, non-operating expenses, gains and losses.

• Income Tax: Income tax is treated as a separate business

expense.
Preparation of Trading and Profit and Loss
Account
 Adjustment Entries
• Some business activities affect revenues and expenses of more than one
accounting period
• Adjustment entries affect both the income statement and the balance
sheet
• adjustments usually relate to the following:
1. Adjustments needed to convert assets into expenses:
(a) Prepaid expenses
(b) Depreciation and amortization
2. Adjustments needed to convert liabilities into revenue:
(a) Income received in advance or unearned income
3. Adjustments needed to accrue unpaid expenses and uncollected
revenue:
(a) Outstanding expenses
(b) Outstanding or accrued income
4. Adjustments needed to account for expected future expenses:
(a) Provision for bad debts
Depreciation and Amortization

• Depreciation is the charge for the consumption of

property, plant and equipment.
• Amortization is a charge for the expiry of benefits
from intangible assets, such as goodwill, patents, etc.
• Depreciation (amortization) account is debited and the
related asset account is credited.
• When the depreciation account is given in the trial
balance, it means that the value of the asset has
already been reduced by the amount of depreciation.
Income Received in Advance or Unearned
Income
• A firm receives an advance payment for goods to be
supplied or for services to be rendered in future.
• Such receipts cannot be treated as revenue until the
related goods have been supplied or the services have
been rendered.
• Part of the payment received, which has not been
earned at the end of the accounting year, is known as
income received in advance or unearned income.
 Outstanding (Accrued) Expenses

• Expenses that are not paid till the end of the accounting
year.
• If the outstanding expenses appear in the trial balance, it
implies that the amount of expenses paid during the
accounting period has already been increased by the
outstanding expenses.
• Sometimes interest on securities or deposits is earned, and
it is accumulated over time, but is not due for collection by
the firm till the end of the accounting year.
 Outstanding or Accrued Income

• A firm may have rendered services, which have not been billed
and collected by the end of the accounting year.
• These are examples of accrued or outstanding income.
• If the accrued income appears in the trial balance, it implies that
the amount of income earned during the accounting period has
already been increased by the accrued income.
• In such a case, the accrued income will not be added to the
amount of income earned when shown in the trading account or
profit and loss account.
 Provision for Bad and Doubtful Debts

• Bad debts are losses that result from debts that default on their
obligation to pay.
• The balance in the bad debts account is transferred to the debit of the
profit and loss account.
• As the amount of bad debts is uncertain, a provision is created for bad
and doubtful debts by debiting the profit and loss account and crediting
the provision for bad and doubtful debts account.
• In the balance sheet, the provision for bad and doubtful debts is shown
as deduction from the balance in the debtors account.
 Show how the following adjustments will be reflected in
the financial statement

• Salary 1290000

• Due but not paid so far Rs 250000

• Impact
 Show how the following adjustments will be reflected in
the financial statement

• Advertisement Expenses
paid for 11months Rs 770000

• Impact
 Show how the following adjustments will be reflected in
the financial statement

• Commission earned but yet not received so far

Impact
 Show how the following adjustments will be reflected in
the financial statement

• Interest received includes 500000

relevant for next year

Impact
Overall impact on the Financial Statment

PROFIT AND LOSS ACCOUNT

Overall impact on the Financial Statment

BALANCE SHEET
 Adjusted Trial Balance
• After posting of adjustment entries in the ledger, an adjusted trial
balance is prepared that carries a summary of updated account
balances.
 Adjusted Balance Sheet
• Assets, liabilities and owners’ equities are arranged either in a
horizontal or vertical format
 Closing Entries
• Revenue and expenses accounts are temporary accounts as these are not
carried forward to the next accounting year.

• To close these accounts, they are debited with a corresponding credit to

the profit and loss account, the amount being equal to the balance in the
account.

• After the balances in revenue and expense accounts have been

transferred to the profit and loss account, the balance in the profit and
loss account will either show the net profit or the net loss.
 Post-Closing Trial Balance

• Post-closing trial balance is prepared after closing the revenue and

expense accounts.

• Trial balance consists of only those accounts that appear in the balance
sheet.

• Purpose of preparing this trial balance is to check the accuracy in

posting of closing entries.