Preparing Balance Sheet from Trial Balance

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Financial Statement Analysis-FIN621

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.

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)

Financial Statement Analysis-FIN621

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.

Financial Statement Analysis-FIN621

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.

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

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

Financial Statement Analysis-FIN621

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

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

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

left of the gross profit after deducting all other expenses of the organization in a specific time

period.

Financial Statement Analysis-FIN621

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:

Financial Statement Analysis-FIN621

Purchase of raw material/goods

Wages paid to employees for manufacturing of goods

Any tax/freight is paid on purchases

Any expense incurred on carriage/transportation of purchased items.

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

entity's bank accounts. It includes:

Mark up on loan

Bank charges

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

payment during the period while profit & loss account also includes Receivable and Payable.

Income & Expenditure Vs Profit & Loss Account

These are two similar terms. Only difference between these two terms is that income &

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

and loss account, profit or loss is to be found.

Financial Statement Analysis-FIN621

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.

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

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.

Financial Statement Analysis-FIN621

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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