Chapter 1 — Financial Statements — I

The chapter covers the preparation of the trading and profit and loss account and balance sheet for a sole proprietary firm, the information needs of internal and external stakeholders, the distinction between capital and revenue items, and the concepts of gross profit, net profit, and operating profit.

Capital expenditure benefits the business for more than one accounting year and is recorded in the balance sheet, for example the purchase of furniture. Revenue expenditure benefits only the current accounting year and is shown in the trading and profit and loss account, for example salaries and rent.

Revenue expenditures that are likely to benefit the business for more than one accounting period are called deferred revenue expenditure. Heavy advertising expenditure is a common example. Its treatment is the same as capital expenditure — it is written off over its expected period of benefit.

Capital receipts imply an obligation to return the money — such as a loan from a bank or additional capital brought in by the owner — or arise from the sale of a fixed asset. Revenue receipts carry no obligation to return money and are not from the sale of fixed assets, for example sales revenue and interest received on investments.

Gross Profit = Sales – (Purchases + Direct Expenses). It represents the result from the basic operational activities of the business. If purchases and direct expenses exceed sales, the result is a gross loss.

Net Profit = Gross Profit + Other Incomes – Indirect Expenses. The net profit or net loss is then transferred to the capital account in the balance sheet.

Operating profit is the profit earned through normal operations of the business, excluding incomes and expenses of a purely financial nature such as interest, and abnormal items such as loss by fire. It is computed as: Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Incomes.

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock. When there is no opening or closing stock, it equals purchases plus direct expenses. Closing stock does not normally appear in the trial balance and is brought into books with a journal entry debiting Closing Stock Account and crediting Trading Account.

The balance sheet is a statement showing the financial position of the business by summarising its assets and liabilities at a given date. It is prepared after the trading and profit and loss account. Capital and liabilities appear on the left side; assets appear on the right side. The totals of both sides are always equal.

Marshalling refers to arranging assets and liabilities in a particular order — either in order of liquidity (most liquid first) or in order of permanence (most permanent first). Grouping means placing items of similar nature under a common heading, for example grouping cash, bank, debtors, and stock under 'current assets'.

Current assets are those in the form of cash or convertible into cash within a year, such as cash, bank, debtors, and closing stock. Fixed assets are held on a long-term basis and not for resale, such as land, building, plant and machinery, and furniture. Intangible assets cannot be seen or touched; goodwill, patents, and trademarks are examples.

An opening entry is a journal entry made at the beginning of the next accounting period to reopen all accounts shown in the balance sheet. All asset accounts are debited and all liability and capital accounts are credited, transferring the balance sheet figures into the new year's ledger.

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