Module – 3

Module 3 (Unit -3.1)

Meaning of Financial Statements
Financial statements are basically report and depict financial and accounting information
relating to businesses. A company’s management uses it to communicate with external
stakeholders. These include shareholders, tax authorities, regulatory bodies, investors,
creditors, etc.
Objectives of Financial Statements
The financial statements are prepared with the purpose to determine the financial standing of a
business entity by measuring three main variables: profitability, liquidity, and solvency.
• Profitability is the ability of a business to make profit. After paying all the business expenses
out of the sales revenue for a particular accounting period, is the entity still able to make a
profit?
• Liquidity is the ability of a business to pay current obligations without disrupting normal
operations. It is the ability to pay regular bills without having to sell off assets needed to operate
the business. In short, being liquid means having enough cash to pay the bills.
• Solvency is the ability of a business to pay all its debts if the business were liquidated, or sold
out. A solvent business must have more assets than it has debt.
These variables are shown in the revenue generated by business (profit & loss statement), the
movement of cash in various business activities and balance cash available (cash-flow
statement), and the net worth of the business (balance sheet).
Users of Financial Statements
Internal and External Users
The users may be classified into internal and external users.
Internal users refer to managers who use accounting information in making decisions related
to the company's operations.
External users, on the other hand, are not involved in the operations of the company but hold
some financial interest. The external users may be classified further into users
with direct financial interest – owners, investors, creditors; and users with indirect financial
interest – government, employees, customers and the others.
1. Owners and investors
Stockholders of corporations need financial information to help them make decisions on what
to do with their investments (shares of stock), i.e. hold, sell, or buy more.
Prospective investors need information to assess the company's potential for success and
profitability. In the same way, small business owners need financial information to determine
if the business is profitable and whether to continue, improve or drop it.
2. Management
In small businesses, management may include the owners. In huge organizations, however,
management is usually made up of hired professionals who are entrusted with the responsibility
of operating the business or a part of the business. They act as agents of the owners.
The managers, whether owners or hired, regularly face economic decisions – How much
supplies will we purchase? Do we have enough cash? How much did we make last year? Did
we meet our targets? All those, and many other questions and business decisions, require
analysis of accounting information.
3. Lenders
Lenders of funds such as banks, financial institutions, and bondholders, are interested in the
company’s ability to pay liabilities upon maturity (solvency).
4. Trade creditors or suppliers
Like lenders, trade creditors or suppliers are interested in the company’s ability to pay
obligations when they become due. They are nonetheless especially interested in the
company's liquidity – its ability to pay short-term obligations.
5. Government
Governing bodies of the state, especially the tax authorities, are interested in an entity's
financial information for taxation and regulatory purposes. Taxes are computed based on the
results of operations and other tax bases. In general, the state would like to know how much
the taxpayer makes to determine the tax due thereon.
6. Employees
Employees are interested in the company’s profitability and stability. They are after the ability
of the company to pay salaries and provide employee benefits. They may also be interested in
its financial position and performance to assess possibilities of company expansion, and with
it, career development opportunities.
7. Customers
When there is a long-term involvement or contract between the company and its customers,
the customers become interested in the company’s ability to continue its existence and maintain
stability of operations. This need is also heightened in cases where the customers depend upon
the entity.
For example, a distributor (reseller), the customer in this case, is dependent upon the
manufacturing company from which it purchases the items it resells.
8. General Public
Anyone outside the company such as researchers, students, analysts and others could be
interested in the financial statements of a company for some valid reason – be it for personal
research, industry and sector analyses, school report, or simply to satisfy one's curiosity.
Meaning of Trading Accounts
A trading account is used to record the sale and purchase of goods/services. This temporary
account closes at the end of each accounting period. The purpose of the trading account is to
show the gross profit or gross loss made in a particular time period.
List of items in a Trading Account
Opening Stock – The unsold stock remaining from the previous accounting period is the
opening stock of the current accounting period. Depending on the type of industry, it can
include raw materials, unfinished products, and finished goods.
It is typically listed on a company’s trial balance and appears on the debit side of a trading
account. A new business’s first year of operation does not include opening inventory.
Purchase and Purchase Returns – Goods and services bought for resale are collectively
termed “purchases” for the business. It is a ledger account that records the cost of goods and
services that a business purchases on credit. It has a debit balance and includes both cash &
credit purchases.
It is important to note that the purchase account does not include the cost of assets purchased
for use in the business, such as machinery or furniture.
In the event that the goods are returned for any reason, it is considered a purchase return or
a return outwards. Such accounts have a credit balance.
Sales and Sales Return – Goods sold in cash and credit by the business to earn profits are
included under the head “Sales”. It has a credit balance and includes both cash and credit sales.
In the event that a customer returns goods for any reason, it is considered a sales return or
a return inwards. Such accounts have a debit balance.
Direct Expenses – Expenses incurred while purchasing goods till the time they are brought to
a saleable condition are called direct expenses. These are expenses related to the core
business operations of a company. For example – Wages, Carriage Inwards, Power, Freight,
etc.
Closing Stock – The unsold stock in hand at the end of the current accounting period is placed
under the head “closing stock”. It is also known as “inventory” and is shown on the credit side
of a trading account.
It is valued at the end of an accounting period at cost or net realisable value, whichever is lower.
Gross Profit or Gross Loss – After all items of trading are arranged in the prescribed trading
account format. The account must be balanced to determine loss or profit arising from selling
activities.
If sales are higher than purchases, i.e. Credit side is bigger than the Debit side, then the
difference is termed “Gross Profit“. This is then transferred to the Profit & Loss account.
If purchases are higher than sales, i.e. Debit side is bigger than the Credit side, then the
difference is termed “Gross Loss“. This is then transferred to the Profit & Loss account.
Need of Trading Accounts
The purpose of creating a trading account in accounting is to:
• Maintain a record of goods sold and purchased.
• Establish whether the sale of goods resulted in a gross profit or gross loss.
• Provide a basis for the calculation of net profit or loss.
• Provide information that is useful for management accounting.
• Comply with accounting standards and regulations.
• Prepare the basis of the income statement for the accounting period.
Overall, the main purpose of a trading account is to provide a clear and accurate record of the
sales and purchases of goods and to calculate the gross profit or loss on these transactions.
This information is used in the preparation of the income statement and is also used by
management to make decisions about the business.
Creating a trading account is an important part of the accounting process and helps to ensure
the accuracy and completeness of the company’s financial records.
Meaning of Profit & Loss Accounts
Profit and Loss Account is a type of financial statement which reflects the outcome of business
activities during an accounting period (i.e. Profit or loss). Reported income and expenses are
directly related to an organization’s are considered to measure the performance in terms of
profit & loss.
Profit & loss a/c is popularly known as P&L A/c. It is also called as Profit and Loss Statement
or income and expense statement.
Need of Profit & Loss Accounts
• Tracks the Net Profit or Net Loss: The Most important benefit of preparing a profit
and loss account is to track business performance in terms of net profit or net loss.
• Tracks Indirect Expenses: Indirect expenses of a particular period can be easily
tracked and monitored with the help of data provided in a profit and loss account and
thus can help in lowering or minimising the excess expenses, thereby increasing
profitability.
• Helps in Ascertaining the Net Profit Ratios: This statement helps in conducting
financial statement analysis. With the help of net profit, a company may easily
determine the net profit-linked ratios.
• Helps in Decision Making: With the help of profit and loss statements, a comparison
can be done between the current year’s data and the previous year’s data and then
forecasting the future performance and thus helps in making future plans and decision-
making.
Meaning of Balance Sheet
The term balance sheet refers to a financial statement that reports a company's assets, liabilities,
and shareholder equity at a specific point in time. Balance sheets provide the basis for
computing rates of return for investors and evaluating a company's capital structure.
In short, the balance sheet is a financial statement that provides a snapshot of what a company
owns and owes, as well as the amount invested by shareholders. Balance sheets can be used
with other important financial statements to conduct fundamental analysis or calculate financial
ratios.
Need of Balance Sheet
Regardless of the size of a company or industry in which it operates, there are many benefits
of a balance sheet,
Balance sheets determine risk. This financial statement lists everything a company owns and
all of its debt. A company will be able to quickly assess whether it has borrowed too much
money, whether the assets it owns are not liquid enough, or whether it has enough cash on hand
to meet current demands.
Balance sheets are also used to secure capital. A company usually must provide a balance sheet
to a lender in order to secure a business loan. A company must also usually provide a balance
sheet to private investors when attempting to secure private equity funding. In both cases, the
external party wants to assess the financial health of a company, the creditworthiness of the
business, and whether the company will be able to repay its short-term debts.
Managers can opt to use financial ratios to measure the liquidity, profitability, solvency, and
cadence (turnover) of a company using financial ratios, and some financial ratios need numbers
taken from the balance sheet. When analyzed over time or comparatively against competing
companies, managers can better understand ways to improve the financial health of a company.
Last, balance sheets can lure and retain talent. Employees usually prefer knowing their jobs are
secure and that the company they are working for is in good health. For public companies that
must disclose their balance sheet, this requirement gives employees a chance to review how
much cash the company has on hand, whether the company is making smart decisions when
managing debt, and whether they feel the company's financial health is in line with what they
expect from their employer.
Distinction between Trial Balance and Balance Sheet

Trial Balance Balance Sheet

Definition

Trial balance is a statement that is created with Balance sheet is the financial statement which
the intention of recording balances from all the shows the position of the assets and liabilities of
ledger accounts an organisation at a given time point of time

Applied in
The main application of trial balance is to The main application of balance sheet is to
check whether debit balance and credit determine the accuracy of the financial position
balance tally with each other or not of the company

Component of Financial Statement

Not a component of financial statement Is a part of financial statement

Purpose of Creation

It is used for internal users of information It is used for external users of information

Frequency of Recording

Trial balance is recorded monthly, quarterly, Balance sheet is prepared yearly

half-yearly and yearly

Source of data

Data collected from General ledger Data collected from trial balance
Module 3 (Unit -3.2)
Meaning of Financial Statements-With Adjustments
Every company prepares Profit & Loss Account and Trading account (also known as an income
statement) and Balance Sheet statement(position statement) every financial year. The income
statement indicates the net profit and loss status of a company, whereas, the balance sheet
indicates the financial position of the business.
All these statements are provided according to the trial balance record. While preparing these
accounts, it can be noticed that few accounts or transactions are (i) Omitted from the record
book (ii) Sometimes have been recorded wrongly in the book or (iii) Sometimes entered only
one part of the transactions. Entries passed for such financial transactions are known as
adjustment entries.
Objectives and Needs of Adjustments
The major objectives and need for adjustments are as follows:
• To get information about actual Profit or Loss: Through adjustments in the financial
statement, we consider all the accounting items which are relevant to the current
financial year, but not recorded in the books due to any reason. This helps us in getting
the actual profit or loss for the year.
• To know about the real financial position of the business: Adjustments bring many
accounting information related to assets and liabilities, which need attention while
preparing the Balance Sheet. We can only get the accurate financial position of the
company if adjustment entries are passed in the Balance Sheet.
• To rectify the errors found in the books of accounts: Adjustment plays an important
part in rectifying any error which was previously recorded in the books of accounts. As
we all know that we cannot change any previous entry but can only pass a different
entry to register the same effect.
• To complete the incomplete transactions: With the help of adjustment, a rectifying
entry can be passed for any partial or total omission of any accounting item.
• To make provision for depreciation and other such provisions: Often, provisions
are made at the end of the financial year and sometimes even after preparing a financial
statement. With the help of adjustments, we make provisions for depreciation and other
provisions so that any assets or liabilities will not remain undervalued or overvalued.
• To include all incomes, whether received or about to be received: Without including
all the accrued income in the Profit & Loss A/c, it will not show the actual profit or loss
for the year. With the help of adjustments, we try to include all the income of the
financial year, whether it has been received or still accrued. This helps in ascertaining
the actual income of the enterprise.
• To include all the expenses, whether paid or about to be paid: Like Accrued
Income, we also have to include all the expenses of the current financial year, which
have been paid or are still outstanding. This also helps us in ascertaining the actual
profit or loss of the year.
 • To record all such incomes, which have been received in advance: Income received
in advance are those incomes which are unearned but yet received in a financial year.
It shows the profit overvalued for the year because Unearned Income does not belong
to the current year. With the help of adjustments, we cancel those effects by recording
all the incomes, which are received in advance.
• To record all such expenses, which have been paid in advance: Like Income
received in Advance, there are some expenses which are paid in advance. Such
expenses are called prepaid expenses and because of them, the profits for the year go
undervalued. By recording all such expenses which are paid in advance, we aim to get
the actual profit or loss for the year.
Effect of Adjustment
Some points must be considered at the time of adjustment:
• Accounting for items mentioned in the trial balance will be carried out only once i.e.,
in one account only, whether in the Trading A/c, Profit and Loss A/c, or Balance Sheet.
• Accounting for items given outside the trial balance in adjustments will be carried out
twice or at two places or in two accounts.
Module 3 (Unit -3.3)
Meaning of Incomplete Records
Accounting records, which are not strictly kept according to double entry system are known as
incomplete records. Many authors describe it as single entry system. However, single entry
system is a misnomer because there is no such system of maintaining accounting records. It is
also not a ‘short cut’ method as an alternative to double entry system. It is rather a mechanism
of maintaining records whereby some transactions are recorded with proper debits and credits
while in case of others, either one sided or no entry is made. Normally, under this system
records of cash and personal accounts of debtors and creditors are properly maintained, while
the information relating to assets, liabilities, expenses and revenues is partially recorded.
Hence, these are usually referred as incomplete records.
Features of Incomplete Records
In complete records may be due to partial recording of transactions as is the case with small
shopkeepers such as grocers and vendors. In case of large sized organisations, the accounting
records may be rendered to the state of incompleteness due to natural calamity, theft or fire.
The features of incomplete records are as under :
(a) It is an unsystematic method of recording transactions.
(b) Generally, records for cash transactions and personal accounts are properly maintained and
there is no information regarding revenue and/ or gains, expenses and/or losses, assets and
liabilities.
(c) Personal transactions of owners may also be recorded in the cash book.
(d) Different organisations maintain records according to their convenience and needs, and
their accounts are not comparable due to lack of uniformity.
(e) To ascertain profit or loss or for obtaining any other information, necessary figures can be
collected only from the original vouchers such as sales invoice or purchase invoice, etc. Thus,
dependence on original vouchers is inevitable.
(f) The profit or loss for the year cannot be ascertained under this system with high degree of
accuracy as only an estimate of the profit earned or loss incurred can be made. The balance
sheet also may not reflect the complete and true position of assets and liabilities.
Reasons of Incompleteness and its Limitations
It is observed, that many businessmen keep incomplete records because of the following
reasons :
(a) This system can be adopted by people who do not have the proper knowledge of accounting
principles;
(b) It is an inexpensive mode of maintaining records. Cost involved is low as specialised
accountants are not appointed by the organisations;
(c) Time consumed in maintaining records is less as only a few books are maintained;
 (d) It is a convenient mode of maintaining records as the owner may record only important
transactions according to the need of the business.
However, the mechanism of incomplete records suffers from a number of limitations. This is
due to the basic nature of this mechanism. Broadly speaking, unless a systematic approach to
maintenance of records is followed, reliable financial statements cannot be prepared.
The limitations of incomplete records are as follows :
(a) As double entry system is not followed, a trial balance cannot be prepared and accuracy of
accounts cannot be ensured.
(b) Correct ascertainment and evaluation of financial result of business operations can not be
made.
(c) Analysis of profitability, liquidity and solvency of the business cannot be done. This may
cause a problem in raising funds from outsiders and planning future business activities.
(d) The owners face great difficulty in filing an insurance claim with an insurance company in
case of loss of inventory by fire or theft.
(e) It becomes difficult to convince the income tax authorities about the reliability of the
computed income.
Ascertainment of Profit or Loss Every business firm wishes to ascertain the results of its
operations to assess its efficiency and success and failures. This gives rise to the need for
preparing the financial statements to disclose:
(a) the profit made or loss sustained by the firm during a given period; and
(b) the amount of assets and liabilities as at the closing date of the accounting period. Therefore,
the problem faced in this situation is how to use the available information in the incomplete
records to ascertain the profit or loss for the particular accounting year and to determine the
financial position of a entity as at the end of the year.
This can be done in two ways :
1. Preparing the Statement of Affairs as at the beginning and as at the end of the accounting
period, called statement of affairs or net worth method.
2. Preparing Trading and Profit and Loss Account and the Balance Sheet by putting the
accounting records in proper order, called conversion method.
Difference between Double Entry System and Incomplete Records
The difference between incomplete records and double-entry systems are as follows:

INCOMPLETE RECORDS DOUBLE-ENTRY SYSTEM

Trading, profit and loss account, and the balance sheet Trading, profit and loss accounts, and balance sheets
cannot be prepared. can be prepared.
This method is suitable for small-scale business units This method is suitable for large-scale business units
where the owners can directly control the affairs of the where the owners cannot directly control the affairs of
business. the business.

Personal transactions of the owner get mixed up with Personal transactions of the owner are kept separate
business transactions from business transactions.

Both aspects of each transaction are not recorded. Both aspects of each transaction are recorded.

Only personal accounts are kept and in some cases, a

Personal, real, and nominal accounts are kept fully.
cash account is maintained.

Difference between Balance Sheet and Statement of Affairs

Statement of Affairs Balance Sheet

1. Shows the financial position of a company at a 1. Shows the financial position of a company at
specific point in time a specific point in time

2. Includes both assets and liabilities 2. Includes both assets and liabilities

3. Emphasizes current assets and current liabilities 3. Emphasizes long-term assets and liabilities

4. Provides information on cash flow 4. Provides information on the liquidity of the

company

5. May include a statement of income and expenses 5. Does not include a statement of income and
expenses

6. May provide information on the company's 6. Provides information on the company's assets
operations and performance and liabilities

7. May be more comprehensive than a balance sheet 7. Focuses more on the company's net worth

8. May be prepared for a specific purpose such as a 8. Is a standard financial statement that is
loan application prepared on a regular basis
Module 3 (Unit -3.4)
Meaning of Accounts for Not-For-Profit Organizations
Not-for-Profit Organisations are the establishments that are for utilised for the welfare of the
community and are set up as charitable associations which operate without any motive for
profit. Their primary objective is to provide service to a specific class or the public. Usually,
they do not produce, buy or sell commodities and may not have credit transactions.
Therefore, they need not manage many books of account (as the trading entities do) and Trading
and Profit & Loss Account. The funds raised by such establishments are credited to the general
fund or capital fund. The major sources of their income usually are subscriptions from their
member’s donations, income from investments, grants-in-aid etc.
The main aim of maintaining records in such establishments is to meet the statutory necessities
and assist them in exercising control over the consumption of their funds. They also have to
prepare the financial statements during the closure of each accounting period (usually a
financial year) and determine their income and expenditure and the financial condition and
submit them to the statutory authority known as Registrar of Societies.

The primary characteristics of such establishments are :

• Such establishments are established for furnishing service to a particular group or
public at a larger picture such as recreation, education, sports, health care and others
without any deliberation of creed, caste and colour. Its sole objective is to provide
service at free of cost or at nominal cost and not to earn profits
• These are established and organised as charitable societies/trusts and subscribers to
such establishments are known as members
• Their phenomenons are normally regulated by a managing/executive committee
selected by its members
• The principal sources of income of such organisations are:
o Subscriptions from members
o Legacies
o Grant-in-aid
o Donations
o Income from investments, etc.
Difference between Profit Seeking Organization and Not-For-Profit Organization
BASIS FOR PROFIT ORGANIZATION NON-PROFIT
COMPARISON ORGANIZATION
Meaning A legal entity, which operates for A non-profit organization is a
earning profit for the owner, is legal entity, which operates for
known as For-profit or Profit serving the society as a whole.
organization.
Motive Profit motive Service Motive
Form of Sole proprietorship, Partnership Club, Trust, Public hospitals,
organization firm or company society, etc.
Management Sole proprietor, partners or Trustees, committees or
directors, as the case may be. governing bodies.
Source of revenue Sale of goods and services. Donation, subscription,
membership fee etc.
Commenced Capital contributed by the owners. Funds from donation,
through subscription, government grant
and so on.
Financial Income statement, Balance Sheet Receipt & Payment A/c,
Statement and Cash flow statement Income & Expenditure A/c and
Balance Sheet.
Money earned over Profit, is transferred to capital Surplus is transferred to capital
and above account. fund.
Module 3 (Unit -3.5)
Meaning of Financial Statement Analysis
Financial statement analysis is the process of analyzing a company’s financial statements for
decision-making purposes. External stakeholders use it to understand the overall health of an
organization and to evaluate financial performance and business value. Internal constituents
use it as a monitoring tool for managing the finances.
Importance of Financial Statement Analysis
(i) To assess the earning capacity or profitability of the firm.
(ii) To assess the operational efficiency and managerial effectiveness.
(iii) To assess the short term as well as long term solvency position of the firm.
(iv) To identify the reasons for change in profitability and financial position of the firm
(v) To make inter-firm comparison.
(vi) To make forecasts about future prospects of the firm.
(vii) To assess the progress of the firm over a period of time.
(viii) To help in decision making and control.
(ix) To guide or determine the dividend action.
(x) To provide important information for granting credit.
Parties Interested in Financial Analysis:
The following parties are interested in the analysis of financial statements:
(1) Investors
(2) Management.
(3) Creditors or suppliers.
(4) Bankers and financial institutions.
(5) Employees.
(6) Government.
(7) Trade associations.
(8) Stock exchanges.
(9) Economists and researchers.
(10) Taxation authorities
Limitations of Financial Statement Analysis:
Financial analysis is a powerful mechanism of determining financial strengths and weaknesses
of a firm. But, the analysis is based on the information available in the financial statements.
Thus, the financial analysis suffers from serious inherent limitations of financial statements.
The financial analyst has also to be careful about the impact of price level changes, window-
dressing of financial statements, changes in accounting policies of a firm, accounting concepts
and conventions, and personal judgment , etc.
Some of the important limitations of financial analysis are, however, summed up as
below:
(i) It is only a study of interim reports
(ii) Financial analysis is based upon only monetary information and non-monetary factors are
ignored.
(iii) It does not consider changes in price levels.
(iv) As the financial statements are prepared on the basis of a going concern, it does not give
exact position. Thus accounting concepts and conventions cause a serious limitation to
financial analysis.
(v) Changes in accounting procedure by a firm may often make financial analysis misleading.
(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation
and draw his own conclusions. Different people may interpret the same analysis in different
ways.
Techniques of Financial Statement Analysis
Ratio Analysis
Ratio analysis refers to the analysis of various pieces of financial information in the financial
statements of a business. They are mainly used by external analysts to determine various
aspects of a business, such as its profitability, liquidity, and solvency.
Analysts rely on current and past financial statements to obtain data to evaluate the financial
performance of a company. They use the data to determine if a company’s financial health is
on an upward or downward trend and to draw comparisons to other competing firms.
Uses of Ratio Analysis
1. Comparisons
One of the uses of ratio analysis is to compare a company’s financial performance to similar
firms in the industry to understand the company’s position in the market. Obtaining financial
ratios, such as Price/Earnings, from known competitors and comparing it to the company’s
ratios can help management identify market gaps and examine its competitive advantages,
strengths, and weaknesses. The management can then use the information to formulate
decisions that aim to improve the company’s position in the market.
2. Trend line
Companies can also use ratios to see if there is a trend in financial performance. Established
companies collect data from the financial statements over a large number of reporting periods.
The trend obtained can be used to predict the direction of future financial performance, and
also identify any expected financial turbulence that would not be possible to predict using ratios
for a single reporting period.
3. Operational efficiency
The management of a company can also use financial ratio analysis to determine the degree of
efficiency in the management of assets and liabilities. Inefficient use of assets such as motor
vehicles, land, and building results in unnecessary expenses that ought to be
eliminated. Financial ratios can also help to determine if the financial resources are over- or
under-utilized.
Comparative Analysis
Comparative financial statements present the same company’s financial statements for one
or two successive periods in side-by-side columns. The calculation of dollar changes or
percentage changes in the statement items or totals is horizontal analysis. This analysis detects
changes in a company’s performance and highlights trends.
Horizontal analysis is called horizontal because we look at one account at a time across time.
We can perform this type of analysis on the balance sheet or the income statement.