Chapter 9: Financial Statements – 1

Statements that contain financial information about a business which can satisfy the information requirements of internal and external users are known as financial statements. It serves as a source of financial information that caters to the diverse information requirement of users. It is prepared with the purpose of representing a true and fair view of the business.

To do so, it requires the creation of three statements, namely, trading and profit and loss account and balance sheet.

The financial statements are related to gross/net profit or loss, assets and liabilities. The users of information can be the following:

Current owners: These internal users would like to know the profits in the previous accounting period and the current position of the assets and liabilities.

Government: Government is an external user and wants to know the financial position of a business so that stakeholders’ rights are protected.

Prospective owner: These external users would like to know the past profits and financial position and also the future performance of the business to make an informed decision about whether to invest in the business or not.

A journal entry that is made at the end of an accounting period that transfers balances from the temporary accounts to a permanent account is known as closing entries. Some examples are as follows:

1. The purchase returns are closed by transferring the balance to the purchase account, and the following entries are made:

Purchases return A/c

Dr

To Purchases A/c

2. Sales return account is closed by transfer of the balance to the sales account, and entries will be as follows:

Sales A/c

Dr

To Sales return A/c

3. Purchases account closed by transferring to the debit side of trading and P & L Account, and entries will be as follows:

Trading A/c

Dr

To Purchases A/c

4. Sales account closed by transferring the balance to the credit side of trading and P & L account, and entries will be as follows:

Sales A/c

Dr.

To Trading A/c

A balance sheet needs to be prepared due to following reasons:

1. To show the financial position of a business.

2. To show much assets and liabilities a business has.

3. It serves as an information source for internal and external users.

4. It acts as a reference for balances that need to be carried forward.

5. To gather an idea about the liquidity of the firm or business.

6. Helps management in planning and controlling business operations.

Grouping refers to including assets and liabilities of similar nature under a common heading. For example, different types of creditors can be placed in one heading. Similarly, work in progress, raw material and finished goods can be placed.

Marshalling refers to the arranging of assets and liabilities in order of liquidity and permanence.

In order of liquidity: It shows how easily an asset can be converted into cash or a liability can be paid off. The asset examples are arranged as follows:

1. Cash

2. Bank

3. Debtors

In order of permanence: In this system, the most important asset or liability gets the top position in the balance sheet, and the remaining assets are arranged in the reducing level of permanence. For example,

1. Debtors

2. Bank

3. Cash

Similarly, liabilities in order of permanence are as follows:

1. Capital

2. Long-term loan

3. Creditors