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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-5
ACCOUNTING CYCLE/PROCESS
(Continued)
Preparing Balance Sheet from Trial Balance: We have assumed that the first month i.e. July was
taken up in setting up of the business and no business activity as such took place in this month. It means
there were no Revenues & Expenses and hence no Income Statement. Preparing Balance Sheet from
Trial balance: involves re-arranging of items or Accounts in the Trial Balance. What is done is that
Assets are taken on the left side and liabilities and owner's equity on the right. This is the Account Form
of Balance Sheet. Alternate form is Report Form in which Assets are written above and liabilities and
owner's equity are written below.
Balance Sheet
Khizr Property dealer
For the month of July 2006
Liabilities & Owner's Equity
Assets
Rs.
Rs.
Cash
22,500
Accounts Payable
23,400
Accounts Receivable
9,500
Khizr, Capital (owner's equity)
180,000
Land
130,000
Building
36,000
Office Equipment
5,400
Total
203,400
Total
203,400
It is to be seen that each of the 7 transactions during July, changed the Accounting Equation, and
hence each gave rise to new balance sheet. The question may arise as to why make journal & ledger
entries. The answer is that we have to have reasonable time-period at the end of which balance sheet
may be prepared. This time-period is Accounting Period which is usually one year. And during this
period individual transactions occurring daily are journalized and ledgerised i.e. posted in ledgers.
Assets are economic resources that are owned by a business and are expected to benefit future
operations. In most cases, the benefit to future operations comes in the form of positive future cash
flows. The positive future cash flows may come directly as the asset is converted into cash (collection of
a receivables) or indirectly as the asset is used in operating the business to create other assets that result
in positive future cash flows (building & land used to manufacture a product for sale). Assets may have
definite physical form such as building, machinery or stock. On the other hand, some assets exist not in
physical or tangible form, but in the form of valuable legal claims or right. Examples are accounts
receivables, investment in govt. bonds and patent rights etc.
Liabilities are debts and obligations of the business. The person or organization to which the debt is
owed is called creditors. All businesses have liabilities; even the most successful companies' purchase
stocks, supplies and receive services on credit. The liabilities arising from such purchases are called
Accounts payable.
Rule of Debit and Credit for Assets and Liabilities
Assets (increase in assets is debit and decrease in asset is credit)
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Financial Statement Analysis-FIN621
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Liabilities (Increase in liability is credit and decrease in liability is debit)
Classification of Assets:
There are two types of assets:
1. Tangible Assets which have physical existence and can be seen or touched. It includes Fixed as
well as Current assets.
2. Intangible assets which have no physical existence like goodwill, patents and s etc.
·
Fixed Assets ­ Are the assets of permanent nature that a business acquires, such as plant,
machinery, building, furniture, vehicles etc. Fixed assets are subject to depreciation.
·
Long Term Assets ­These are the assets of the business that are receivable after twelve
months of the balance sheet date. For example, if business has invested some money for two
years in any saving scheme or has purchased saving certificates for more than one year, it is a
long term asset.
·
Current Assets ­ Are the receivables that are expected to be received within one year of the
balance sheet date. Debtors, closing stock & all accrued incomes are the examples of Current
Assets because these are expected to be received within one accounting period from the
balance sheet date.
The year, in which long term asset is expected to be received, long term asset is transferred to
current assets in that year.
Classification of Liabilities
Capital ­ is the funds invested by the owners of the business. Business has a liability to return these
funds to the owner. We know that for the purpose of accounting, business is treated separately from its
owners. This is known as Separate Entity Concept i.e. Business is a separate entity. Therefore, if the
owner gives something (can be in form of Cash or Some other Asset) to the business then the business,
not only has to return the amount to the owner but it also has to give some return on that money. That is
why we treat Capital (Owners Funds) as a Liability.
Profit & Loss Account ­ The net balance of the profit and loss account i.e. either profit or loss also
belongs to the owners.
While explaining capital we said that the business has to give return to the owners. Now if the business
is managed successfully, then this return would be a Favorable figure (Profit). This return will,
therefore, be added to the Owners' investment.
On the other hand, if the business is not managed successfully then this return would be an un-favorable
figure (Loss). It will, therefore, be deducted from the Owners' Investment.
·
Long Term Liabilities ­ These are the liabilities that will become payable after a period of
more than one year of the balance sheet date. For example, if business has taken a loan from
bank or any third person and it is payable after three years, it will be treated as a long term
liability for the business.
·
Current Liabilities ­ These are the obligations of the business that are payable within
twelve months of the balance sheet date. Creditors and all accrued expenses are the examples
of current liabilities of the business because business is expected to pay these back within one
accounting period.
The year in which long term liability is to be paid back, long term liability is transferred to
current liability in that year.
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Financial Statement Analysis-FIN621
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Balance Sheet
It is a position statement that shows the standing of the organization in Monetary Terms at a Specific
Time.
Unlike Profit and Loss that shows the performance of the entity over a period of time, the Balance Sheet
shows the Financial State of Affairs of the entity at a given date. Balance sheet is the summarized
analysis in a `T' form of all assets and liabilities of the entity, with liabilities listed on left hand side and
assets on right hand side. Asset is any owned physical object (tangible asset) or a right (intangible asset)
having economic value to the owner. Liability is an obligation of the business to deliver goods or to
provide a benefit in future.
Format of Balance Sheet (Account Form)
Name of the Entity
Balance Sheet
As At-------
Liabilities
Amount
Assets
Amount
Rs.
Rs.
Fixes Assets
75000
Capital
100000
Long Term Assets
20000
115000
Add  Profit
and
loss
Account
Current assets
80000
50000
15000
10000
Long Term Liabilities
Current liabilities
Total
175000
Total
175000
Format of Balance Sheet (Report Form)
Name of the Entity
Balance Sheet
As At-------
PARTICULARS
Amount
Amount
Rs.
Rs.
ASSETS
75000
Fixes Assets
20000
Long Term Assets
80000
Current Assets
Total
175000
LIABILITIES
Capital
100000
115000
Profit
15000
50000
Long Term Liabilities
10000
Current Liabilities
Total
175000
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Financial Statement Analysis-FIN621
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Illustration # 1
The following is the Trial Balance extracted from the books of Naeem & Sons as on 30/06/2007.
Prepare a profit & loss account & balance sheet for the year ended June 30, 2007.
Particulars
Dr.
Cr.
Sales
100,000
Purchases
45,000
purchase return
3,000
Salaries
12,000
Rent
5,000
Debtors
25,000
Creditors
16,000
Capital
368,000
Plant & machinery
400,000
Grand Total
487,000
487,000
Financial Statements
·
Different reports generated from the books of accounts to provide information to the relevant
persons.
·
Every business is carried out to make profit. If it is not run successfully, it will sustain loss. The
calculation of such profit & loss is probably the most important objective of the accounting
function. Such information is acquired from "Financial Statements".
·
Financial Statements are the end product of the whole accounting process. These show us the
profitability of the business concern and the financial position of the entity at a specified date.
·
The most commonly used Financial Statements are `profit & loss account' `balance sheet' &
`cash flow statement'.
Income & Expenditure Vs Profit & Loss Account
·
Income and Expenditure Account is used for Non-Profit Organizations like Trusts, NGOs while
·
Profit and Loss Account is used for Commercial organizations like limited companies.
Profit & Loss Account
·
Profit & Loss account is an account that summarizes the profitability of the organization for a
specific accounting period.
·
Profit & Loss account has two parts:
First part is called Trading account in which Gross Profit is calculated. Gross profit is the
o
excess of sales over cost of goods sold in an accounting period. In trading concern, cost of
goods sold is the cost of goods consumed plus any other charge paid in bringing the goods in
salable condition. For example, if business purchased certain items for resale purpose and any
expense is paid in respect of carriage or bringing the goods in store (transportation charges).
These will also be grouped under the heading of `cost of goods sold' and will become part of its
price. In manufacturing concern, cost of goods sold comprises of purchase of raw material plus
wages paid to staff employed for converting this raw material into finished goods plus any other
expense in this connection.
2nd part is called Profit & Loss account in which Net Profit is calculated. Net Profit is what is
o
left of the gross profit after deducting all other expenses of the organization in a specific time
period.
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Financial Statement Analysis-FIN621
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How to prepare Profit & Loss Account?
·
One way is to write down all the Debit and Credit entries of Income and Expense accounts in
the Profit and Loss Account. But it is not sensible to do so.
·
The other way is that we calculate the net balance or we can say Closing Balance of each
income and expense account. Then we note all the credit balances on the credit side and all the
debit balances on the debit of profit and loss account.
·
If the net balance of profit and loss is Credit (credit side is greater than debit side) it is Profit
and if the net balance is Debit (Debit side is greater than credit side) it is a loss.
Income, Expenditure, And Profit & Loss
·
Income is the value of goods and services earned from the operation of the business. It includes
both cash & credit. For example, if a business entity deals in garments. What it earns from the
sale of garments, is its income. If somebody is rendering services, what he earned from
rendering services is his income.
·
Expenses are the resources and the efforts made to earn the income, translated in monetary
terms. It includes both expenses, i.e., paid and to be paid (payable). Consider the above
mentioned example, if any sum is spent in running the garments business effectively or in
provision of services, is termed as expense.
·
Profit is the excess of income over expenses in a specified accounting period.
Profit= Income-expenses
In the above mentioned example, if the business or the services provider earn Rs. 100,000 & their
expenses are Rs. 75,000. Their profit will be Rs. 25,000 (100,000-75,000).
·  Loss is the excess of expenses over income in a specified period of time. In the above example,
if their expenses are Rs. 100,000 & their income is Rs. 75,000. Their loss will be Rs. 25,000.
Rules of Debit & Credit
·
Increase in expense is Debit
(Dr.)
·
Decrease in expense is credit
(Cr.)
·
Increase in income is credit
(Cr.)
·
Decrease in income is Debit
(Dr.)
Classification of Expenses
·
It has already been mentioned that a separate account is opened for each type of expense.
Therefore, in large business concerns, there may be a large number of accounts in
organization's books
·
. As profit & loss account is a summarized record of the profitability of the organization. So,
similar accounts should be grouped for reporting purposes.
·
The most commonly used groupings of expenses are as follows:
o  Cost of goods sold
o  Administration expenses
o  Selling expenses
o  Financial expenses
·
Cost of goods sold (CGS) is the cost incurred in purchasing or manufacturing the product,
which an organization is selling plus any other expense incurred in bringing the product in
saleable condition. Cost of goods sold contains the following heads of accounts:
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Financial Statement Analysis-FIN621
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Purchase of raw material/goods
o
Wages paid to employees for manufacturing of goods
o
Any tax/freight is paid on purchases
o
Any expense incurred on carriage/transportation of purchased items.
o
·
Administrative expenses are the expenses incurred in running a business effectively. Main
components of this group are:
o  Payment of utility bills
o  Payment of rent
o  Salaries of employees
o  General office expenses
o  Repair & maintenance of office equipment & vehicles.
·
Selling expenses are the expenses incurred directly in connection with the sale of goods. This
head contains:
o  Transportation/carriage of goods sold
o  Tax/freight paid on sale
o  If the expense head `salaries' includes salaries of sales staff then it will be excluded
from salaries & appear under the heading of `selling expenses'.
Financial expenses are the interest paid on bank loan & charges deducted by bank on
o
entity's bank accounts. It includes:
Mark up on loan
o
Bank charges
o
Receipt & Payment Account
A receipt & payment account is the summarized record of actual cash receipts and actual cash payment
of the organization for a given period of time. This is a report that provides cash movement during the
reported period. In other words, it can be defined as the summarized record of the cash book for a
specific period.
Receipt & Payment Vs Profit & Loss Account
Receipt & payment account is the summarized record of actual cash receipts and actual cash
o
payment during the period while profit & loss account also includes Receivable and Payable.
Income & Expenditure Vs Profit & Loss Account
o
These are two similar terms. Only difference between these two terms is that income &
o
expenditure account is prepared for non profit oriented organizations, e.g. Trusts, NGO's,
whereas profit & loss account is prepared in profit oriented organizations, e.g. Limited
companies, Partnership firms etc.
In case of Income and Expenditure account, Surplus/Deficit is to be find and in case of Profit
o
and loss account, profit or loss is to be found.
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Financial Statement Analysis-FIN621
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A sample of Profit and Loss Account
Name of the Entity
Profit and Loss Account
For the period Ending ----
DEBIT
CREDIT
PARTICULARS
AMOUNT
PARTICULARS
AMOUNT
Rs.
Rs.
Cost of sale
60,000
Income
100,000
Gross profit c/d
40,000
(Income ­ cost of sales)
Total
100,000
Total
100,000
Admin expenses
15,000
Gross profit b/d
40,000
Selling expenses
5,000
Financial expenses
5,000
Net profit
15,000
(Gross profit ­ expenses)
Total
40,000
Total
40,000
Calculations of Gross profit and Net profit
Gross profit = Income ­ cost of sales
= 100000-60000
= 40000
Net profit  = Gross profit ­ Expenses
= 40000 ­ (15000+ 5000+5000)
= 15000
A sample of Income Statement
Name of the Entity
Income statement
For the period Ending ----
PARTICULARS
AMOUNT
AMOUNT
Rs.
Rs
Income/Sales/Revenue
100000
Less: Cost of sales
(60000)
Gross profit
40000
Less: Administration expenses
15000
Selling expenses
5000
Financial expenses
5000
(25000)
Net profit
15000
Recognition of Income and Expenditure Account:
Income ­ should be recognized / recorded at the time when goods are sold or services are rendered.
Expenses ­ should be recognized / recorded when benefit relating to that expense has been drawn.
Income Statement and Net Income
Income Statement summarizes operating results of a business by matching revenues with
expenses over the same accounting period.
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Financial Statement Analysis-FIN621
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Net income is the increase in owner's equity resulting from profitable operations of a
business. This is accompanied by increase in total assets, (but not necessarily cash) or decrease in total
liabilities. It may happen that a profitable business may also run short of cash, because the profit that it
earns is tied up in other assets i.e. Accounts Receivables, fixed assets etc or else, it was used in paying
out its obligations like Accounts Payable etc. Net loss is the corresponding decrease in owner's equity.
Elements of Income Statement
Revenues: This is defined as sale price of goods sold and services rendered during an
accounting
period.
Expenses: These constitute Cost to the business of the goods and services used in business operations
during the same accounting period. In other words, these are "cost of doing business". Just as in
Balance Sheet we have sub-elements or sub-Accounts, in Income Statement also there are sub-
elements/sub-Accounts i.e. difference sources of Revenues, different expenses like cost of good sold,
depreciation expenses, interest expense etc.
Accrual Basis of Revenue & Expense Accounting
Revenue Recording is done on Realization Principle. In this case, the date of rendering
services or date of delivery of good sold is considered as the date of earning revenue. For example, if
services are rendered in January and actual receipt of revenue/fee takes place in February i.e. after one
month as per agreement, still the revenue would be recorded in the month of January since it was
"earned" in January.
Expense Recording is done on matching principle. This means that revenues are offset by
all expenses incurred in producing those revenues, pertaining to a particular accounting period. It would
thus be seen that there is cause-and-effect relationship between revenues and expenses. For example,
June salaries are paid in July but these have to be recorded as salaries expense for June. It must also be
noted that Revenue & cash Receipts and Expense & cash payments are different. The two can happen
before, after or during the accounting period.
Dr. & Cr. Rules for Recording Revenues and Expenses are the same as those for Owner's
equity or Capital Account.
Expenses are the costs of the goods and services used up in the process of earning revenue. Examples
include the cost of employee's salaries, advertising, rent, utilities, and the gradual wearing-out
(depreciation) of such assets as buildings, automobiles, and office equipment. All these costs are
necessary to attract and serve customers and here by earn revenue. Expenses are often called the "costs
of doing business" that is, the cost of the various activities necessary to carry on a business.
An expense always causes a decrease in owner's equity. The related changes in the accounting equation
can be either (1) a decrease in assets, or (2) an increase in liabilities. An expense reduces assets if
payment occurs at the time that the expense is incurred. If the expense will not be paid until later, as for
example, the purchase of advertising services on account, the recording of the expense will be
accompanied by an increase in liabilities.
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