CHAPTER – 6

Preparation of Financial Statements

Sr.
Course Outline Topics
No
1 Components of Financial Statements and Accounting Equations
2 Proper format of Income Statement
3 Proper format of Balance Sheet
4 Practice

Topic videos 58-61 are mandatory part of this module

Components of financial statements

Although a trial balance reveals the amounts of final balances of each accounting head (chart of accounts)
appearing in the main ledger, but one cannot construct an opinion about the profitability or financial strength of
the entity with the help of trial balance alone. To achieve this objective an accountant has to prepare some
financial statements that include:
1. Income statement (Statement of profit or loss and other comprehensive income)
2. Balance sheet (Statement of financial position)
(According to International Accounting Standard (IAS) 1, there are five components of financial statements; 1)
Statement of Financial Position 2) Statement of Profit or Loss and Other Comprehensive Income 3) Statement
of Cash Flows 4) Statement of Changes in equity and 5) Notes to the Financial Statements, but at initial stage
only two components i.e. Statement of Profit or Loss and Other Comprehensive Income (commonly known as
Income Statement) and Statement of Financial Position (commonly known as Balance Sheet) are discussed,
rest of the components will be discussed later.
Income statement (Statement of Profit or Loss and Other Comprehensive Income) is prepared to know the
financial performance of an entity. Financial performance refers to the profitability (profit or loss) of entity
during the year. This is prepared with the help of all balances relating to incomes & expenses appearing in the
trial balance. Income statement is prepared for a specific period for which starting and ending dates are
defined, normally a year, that is known as reporting period.

Remember this equation: Incomes – Expenses = Profit Equation 6.1

Balance sheet (Statement of Financial Position) is prepared to know the financial position of an entity.
Financial position refers to the financial strength of entity on a specific date. Normally it is prepared as on
closing date of the accounting year, which is known as reporting date of the reporting period. Financial
strength of the entity is known through the sum of total asset (resources) of the entity and the sum of total
financial sources required to finance these assets i.e. owners’ equity and liabilities (sources).

Remember this equation: Assets = Owners equity + Liabilities Equation 6.2

Equations 6.1 & 6.2 provide the basic ideology of income statement and balance sheet respectively. In actual
practice the income statement and balance sheet are not prepared in equation style. The detailed formal
format of these statements will be discussed later. For now, we shall do a little practice to identify the items to
be shown in the income statement and balance sheet.
Practice 6.1
Prepare income statement and balance sheet with the help of following trail balance.
Accounting heads Debit Credit
Rs. Rs.
Bad debts 305
Advertisement 1,506
Telephone Bill 1,615
Stationery 500
Repairs 600
Sales Revenue 40,600
Purchases Expense 28,500
Salaries and wages 4,850
Machinery 12,500
Creditor 5,250
Debtors 7,810
Furniture 5,600
Land 28,000
Drawings 7,218
Rent Income 1,000
Capital 52,154
Total 99,004 99,004
Closing stock valued at Rs. 9,960

Income Statement for the reporting period…

Income - Expense = Net Profit

Sales Revenue 40,600 Purchases Expense 28,500

Rent income 1,000 Less: closing Stock* (9,960)
Cost of goods sold 18,540
Bad debts 305
Advertisement 1,506
Telephone bill 1,615
Stationery 500
Repairs 600
Salaries & wages 4,850
41,600 - 27,916 = 13,684

Balance Sheet as on the reporting date…

Assets = Owner’s equity + liabilities

Debtor 7,810 Capital 52,154 Creditors 5,250

Stock closing* 9,960 Add Net profit 13,684
Furniture 5,600 Less Drawings (7,218)
Machinery 12,500
Land 28,000
58,620 + 5,250

63,870 = 63,870

*The cost that expires during the reporting year is reported as expense. Cost of closing stock is un-expired
cost and its economic benefit shall flow to the entity in future. Closing stock represents the unsold purchased
goods. Therefore, this is subtracted from the purchases (expenses) and included in the list of assets.
Proper Format of Income Statement and Balance Sheet

Entity’s Name
Income Statement
For the year ended 31 December 20X9

Rs. Rs.

Sales Revenue ***

Cost of Goods Sold (Note 1)
Opening stock ***
Purchases ***
Closing stock (***) (***)
Gross Profit (Note 2) ***
Operating Expenses (Note 3) (***)
Operating Profit ***
Other Income (Note 4) ***
Net Profit (Note 5) ***

Entity’s Name
Balance Sheet
As at 31 December 20X9
Rs. Rs.
Assets
Fixed Assets (Note 6)
Land ***
Building ***
Machinery ***
Furniture *** ***
Current Assets (Note 7)
Stock / Inventory ***
Debtors ***
Bank balance ***
Cash in hand *** ***
***
Owner’s Equity (Note 8)
Capital ***
Add: Net profit ***
Less: Drawings (***) ***

Liabilities:
Long term loans (Note 9)
Loan from bank ***
Finance lease liability *** ***
Current liabilities (Note 10)
Creditors ***
Bank overdraft ***
Short term loans *** ***
***
Notes:
1 Cost of Goods Sold
Although the purchases account is an accounting head that belongs to the main head EXPENSES
and should be straightaway subtracted from sales account to ascertain gross profit of the entity, but all
the goods purchased are rarely sold out in the year of purchase. Some of the goods purchased might
remain unsold on the closing date of the reporting period, therefore such unsold goods (closing stock)
is deducted from the purchases to calculate the figure of cost of those goods that have been sold
during the period (cost of goods sold). In-fact it is the cost which has expired during the period to earn
sales income and the portion not yet expired is closing stock which shall be shown in the balance
sheet as an ASSET.
The closing stock of the previous reporting period becomes opening stock for the current reporting
period and its sales become part of current reporting period’s income, therefore the opening stock is
included in the current reporting period’s cost of goods sold as an EXPENSE.
2 Gross Profit
Income statement is divided into two portions, first portion ends at Gross Profit. Gross profit shows
potential of the entity to meet operating expenses during the period. That the goods were sold at a
reasonable margin and this margin (gross profit) is available to meet operating expenses i.e.
administrative, selling and distribution expenses of the same reporting period.
3 Operating Expenses
These are the expenses which are incurred to run/operate the entity. These include;
1. Administrative expenses
2. Selling, distribution and marketing expenses
A business cannot even think to sell its goods or services without incurring operating expenses. These
operating expenses are deducted from the gross profit to ascertain operating profit of the business.

3.1 Administration Expenses

These are routine expenses of the entity that are incurred to run the administrative affairs. These
include but not restricted to; staff salaries, building rent, repairs, insurance, electricity bill, water & gas
bill, telephone bill, stationery, entertainment etc.

3.2 Selling, Distribution and Marketing Expenses

It is clear from its name that these expenses are incurred to promote the sales, these include but not
restricted to; sales staff wages and commission, advertisement, free sampling, carriage outwards,
discount allowed, bad debts etc.

4 Other Incomes
These are the non-operating incomes. These are the earnings, which are not generated through the
principal activities of the entity, rather these are the earnings through the sources other than sales of
goods or services. These include but not restricted to; rent income, interest income, commission
income, discount received etc.

5 Net Profit
As discussed earlier, the income statement is split into two portions; the first portion shows gross profit
and the second portion shows net profit. In-fact, it is the profit that management of the entity wants to
know through income statement in order to take certain economic decisions.

6 Fixed Assets
These are the assets that are held; for use in production of goods/services or delivery of
goods/services, for renting to others and for administration purpose. These normally provide economic
benefits to the entity for more than one accounting year.

7 Current Assets
These are the assets that are held for trading purposes (means stock for selling purpose) and/or are
expected to be recovered in cash in next twelve months (debtor), and/or are cash in hand and cash at
bank.
8 Owners’ Equity
It is the wealth of owners held by the entity. It includes the amount of capital (personal resources of the
owners invested into the entity) and also the net profit earned/generated by the entity by utilizing
owner’s capital. The amount of drawings is subtracted from it as these were the entity’s resources
distributed to the owners against the expected profit of the entity.

9 Long-Term Loan
It is an obligation on the entity that is expected to be settled after more than one accounting year. It is
the source of finance that is obtained from lenders (financial institutions).

10 Current Liabilities
These are obligations on the entity that are payable within next twelve months. These include but not
restricted to; creditors, bank overdraft and current portion of the long-term loans payable within next
twelve months.
Practice 6.1 – Answer
Entity’s Name
Income Statement
st
For the year ended 31 December 20X9

Rs. Rs.
Sale 40,600
Cost of Goods Sold (Note 1)
Opening stock -
Purchases 28,500
Closing stock (9,960) (18,540)
Gross Profit 22,060

Operating Expenses:
Bad Debts 305
Advertisement 1,506
Telephone Bill 1,615
Stationary 500
Repairs 600
Salaries & Wages 4,850 9,376
Operating Profit/Income 12,684

Other Income
Add: Rent Income 1,000
Net Profit/Income 13,684

Entity’s Name
Balance Sheet
As at 31 December 20X9

Rs. Rs.
Assets
Fixed Assets
Land 28,000
Machinery 12,500
Furniture 5,600 46,100
Current Assets
Stock 9,960
Debtors 7,810 17,770
63,870
Owner’s Equity
Capital 52,154
Add: Net Profit 13,684
Loss: Drawings (7,218) 58,620

Liabilities
Current liabilities
Creditors 5,250
63,870
Exercise Question
Q.1
Esme started in business on 1 January 20X6, by investing Rs.150,000 as capital.
Esme took Rs.100 per week from the business to cover living expenses (drawings), other than for
2 weeks in August when she took $500 per week.
At 31 December 20X6, the assets and liabilities of the business were as follows:
Rs.
Building 45,000
Furniture 75,000
Trade Debtors 2,300
Trade Creditors 10,000
Stock in trade 17,900
Loan payable 500
Cash at bank 1,300

Prepare Balance Sheet of Esme and calculate profit or loss made during the year.

Answer

Assets = Owner’s equity + liabilities

Building 45,000 Capital 150,000 Creditors 10,000

Furniture 75,000 Less Net Loss* (13,000) Loan 500
Stock 17,900 Less Drawings (6,000)
Debtors 2,300
Cash at Bank 1,300
131,000 + 10,500

141,500 = 141,500

*Net Loss is a Balancing Figure

Q. 2
A business has opening inventory of Rs.7,200 and closing inventory of Rs.8,100. Purchases for the year
were Rs.76,500, carriage inward was Rs.50 and carriage outward was Rs.180.

What is the amount of cost of sales?

a) Rs.75,550
b) Rs.75,650
c) Rs.75,830
d) Rs.77,450
Answer
Opening inventory
Add Purchases
Add Carriage inwards
Less Closing inventory

Q. 3
Javed had the following assets and liabilities at the beginning and end of his financial year:
Beginning of the year End of year
Rs. Rs.
Trade payables 18,000 22,000
Inventories 24,000 27,500
Long-term borrowings 15,000 10,000
Property plant and equipment 82,000 86,500
Cash and cash equivalents 2,500 1,500
During the year, Javed withdrew Rs.11,500 in drawings and no capital was introduced.

How much profit did Javed make for the year?

$
Hint: prepare opening and closing balance sheets to calculate owner’s equity balances
and then prepare equation “Op OE + Profit – Drawings = Cl OE
Examination Questions

1. Alia sold some items of inventory for Rs.1,950 in cash, which she had purchased for
Rs.2,622. How are her assets and owner’s equity affected by this transaction of sale?

Assets Owner’s Equity

A. reduced by Rs.672 reduced by Rs.672
B. reduced by Rs.2,622 reduced by Rs.672
C. increased by Rs.672 increased by Rs.2,622
D. increased by Rs.1,950 reduced by Rs.672

Explanation: It’s a loss-making transaction that is reducing inventory by Rs. 2,622 and increasing
cash asset by Rs. 1,950

2. The profit earned by a business in 20X7 was Rs.72,500. The proprietor brought in new
capital of Rs.8,000 during the year and withdrew goods for his private use, which had
cost Rs.2,200.

If owner’s equity at the beginning of the period were Rs.101,700, what was the closing
owner’s equity?

A. Rs.35,000
B. Rs.39,400
C. Rs.168,400
D. Rs.180,000

Explanation: Opening OE 101,700+Fresh Cap 8,000 + Profit 72,500 – Drawings 2,200 = 180,000

3. Hala has set up a new business. The following balances are recorded in her books:

Owner’s equity Rs.5,000

Bank overdraft Rs.10,000
Motor car Rs.6,000
Her only other asset is office furniture. She has no other liabilities.

What is book value of her office furniture?

Explanation: Owners equity 5,000 + Bank OD 10,000 – Motor car 6,000 = Office furniture 9,000