[FAQs] on Final Accounts

The following are the limitations of financial statements:-

1. Historical Cost

The financial statements are prepared on the basis of historical cost, i.e. current market value of the fixed asset is not taken into consideration. The value of the fixed asset continues to decrease with the passage of time, but the effect of these subsequent changes in price is not taken into account. The Balance Sheet loses its significance since it does not take into consideration the economic realities of the business organization. Thus, heavy reliance on historical cost makes the financial statements misleading & irrelevant for decision-making.

2. Perpetual Continuity & Periodical Account

Financial statements are prepared at the end of the year but the accounting records are maintained on the going concern assumption (i.e. the business shall continue to exist forever).

As a result, many items of capital expenditure are distributed over a number of beneficial years arbitrarily which may lead to incorrect preparation of financial statements.

3. Strengths & Weaknesses

The assets which can be expressed in terms of money are recorded in the financial statements of a company. The strengths & weaknesses of the business are not taken into consideration while preparing the Balance Sheet. For example: services, skills & loyalty of the employees are also important for the business, but these are not shown in the Balance Sheet. Thus, it should be kept in mind while judging the company’s financial position, that many non-monetary strengths will not be reflected in the Balance Sheet.

4. Intangible assets

A company may have a number of intangible assets that are not recorded in its financial statements, but the expenditure made in regard to those assets are charged to expense.

This policy can drastically affect the reliability of the financial statements of a company.

5. Window Dressing

There is a possibility of fabrication of the financial statements by the management of the company. In such a case, financial statements may not provide true & fair view of the financial position of the company.

6. Different Accounting Policies

The financial statements of different companies are not always comparable, because the entities use different accounting policies.

For example: One company may charge depreciation on straight line method & another on written down value method. When different methods are adopted by different companies for the treatment of a particular item, the results of comparison between such enterprises shall be misleading.

• Trading account shows the profit/loss made on a gross basis that is including only the direct cost of the goods.
• In trading a/c, we credit the trading income like sale and
• Debit the cost of goods sold (opening stock + purchases (-) closing stock).
• Alternatively Opening Stock & purchases is debited & Closing stock is credited to trading account.
• Other direct expenses related to purchase or manufacture of goods like carriage inward, wages, etc. are also debited here.
• Purchase return & Sales returns will be deducted/adjusted from the purchases & sales respectively.
• The balance is known as the gross profit or gross loss, which is transferred to profit and loss a/c.
• Non-corporate entities usually prepares trading a/c so as to know the gross margin available in its sale.
• But at corporate level usually it is not prepared. In those cases the items of trading account gets incorporated in profit & loss account.

• It shows the performance of the entity i.e. profit earned or loss suffered considering all indirect expenses and incomes.
• Gross profit or gross loss from trading account is transferred to P&L a/c.
• Other incomes like discount, interest, etc. are credited.
• Administrative expense, selling and distribution expense, financial expense, income tax, losses, etc. are debited to it.
• The net profit/net loss is transferred to P&L appropriation a/c (if made) otherwise to capital a/c.
• If trading a/c is not prepared then in place of gross profit/gross loss all items of trading a/c will come in P&L a/c itself

Although not necessary, but usually full profit/loss is transferred to proprietor/partners capital account, hence profit & loss account does not appear in balance sheet.

• Balance sheet shows the financial position of the entity as at a particular point of time.
• It shows what and how much entity owns (i.e. its assets) and how much it owes to others (i.e. its liabilities), the balance (i.e. asset – liability) is the owners equity.
• It is not an account, hence does not have debit and credit side.
• On one side assets like fixed assets (building, machinery, furniture, etc.), current assets (like stock, debtors, cash bank balance, advances prepaid and investments, if any) are shown.
• On the other side in addition to owner’s capital and reserves, the outside liabilities like loans taken, creditors, expenses payable etc. are shown.
• The two sides total must be same.
• On the asset side of balance sheet we start with most permanent to least permanent i.e. fixed assets, investments and then current assets. It is known as permanency preference. In case of manufacturer/trader this sequence is followed hence student will see this in all the chapters.
• When asset side starts with most liquid asset to least liquid like cash bank balance and ends with fixed assets is known as liquidity preference generally followed by institutions like banks.
• Liability side is mostly same in all cases we have first owner capital and reserves, then loans and thereafter current liabilities and provisions.

Balance sheet is a point of time statement, when stated as at 31.3.2006 it means as at close of that date i.e. after considering all transactions of that day.

Even though balance sheet does not have debit and credit side, student should remember that asset side represent debit and capital and liability side represent credit. It will help in correctly preparing final accounts.

Generally, Mercantile/accrual system is followed, as it is the proper and complete system to measure the performance of entity. In your syllabus every where this is considered. Under this system, incomes are recognized when these are earned irrespective of whether amount is received or not. Similarly expenses are recognized when these are incurred or accrued irrespective of whether amount is paid or not. As a result we have to make adjustment for expenses outstanding (payable), prepaid, income outstanding (receivable) and advance-received etc.

• A manufacturing concern may prepare Manufacturing a/c to ascertain cost of goods manufactured.
• Raw material consumed (Op. stock + Purchases – Closing stock), carriage inward, wages, power, depreciation of factory building, machinery, etc. and other manufacturing (factory) expense are debited to it.
• Opening WIP stock is debited and closing WIP stock credited.
• Balance is the cost of goods manufactured and is then transferred to trading account.
• When manufacturing a/c is not prepared, these items will come in trading a/c. Sometimes depreciation a/c may be directly taken to P&L a/c instead of trading a/c.
• Manufacturing a/c is also a period statement.

• Trial balance is a statement containing the balances of all accounts as at the end of certain period usually classified into debit and credit.
• The total of debit and credit side must tally because whole accounting is done by double entry principle, otherwise it indicates arithmetical inaccuracies.
• It has balance of expenses, incomes, assets and liabilities.
• With the help of trial balance and adjustments the final accounts are prepared.
• All expenses and incomes will go into Manufacturing, Trading, P&L and P&L app. a/c depending upon its nature and all assets and liabilities will go into balance sheet.

• Provision means

1. “any amount written off or retained by way of providing for depreciation, renewal or diminution in value of assets, or
2. retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy”.

• Provision is a present liability which by its nature requires a significant amount of estimation.
• The following are examples of amount retained in the business out of earning for different purposes that are described as provisions.

1. 1. Amount provided for meeting claims/liabilities which are admissible in principle but the amount whereof has not been ascertained.
   2. Amount provided for payment of taxes still to be assessed.
   3. Amount set aside for writing off bad debts or for discounts.

• The term ‘reserve’ is not defined in Part-III of Schedule III except negatively in the sense that profit retained in the business not having any of the attributes of a ‘provision’ is to be treated as a reserve.
• Also provisions in excess of the amount considered necessary for the purposes these were originally made, are to be considered as reserves.
• It is thus evident that provisions are a charge against profits, while reserve is an appropriation of profits.
• Reserve are accumulated profits hence part of owners equity, provision are in the nature of liability due to outsiders.
• Provision will be debited to P&L a/c and reserve to P&L appropriation A/c when created.

• Capital reserve is any reserve, which is not free for distribution as dividend.
• Revenue reserve shall mean any reserve other than capital reserve.
• Following are the examples of capital reserve.

Profit/Reserve which are credited to capital reserve account

1. 1. Profit prior to incorporation (as per GAAP)
   2. Profit on re-issue of forfeited shares
   3. Debenture premium (as per GAAP)
   4. Profit on redemption of debenture/shares (as per GAAP)
   5. Profit on buyback of shares (as per GAAP)
   6. Profit on acquisition of business (as per AS-14)
   7. Balance of reconstruction account (as per GAAP).

Profit of capital nature not distributable but kept in separate accounts

1. Share premium/Securities premium a/c
2. Capital redemption reserve/share buyback reserve a/c
3. Revaluation reserve (as per AS-10)

Reserve which are not distributable for the time being (Created under the provisions of Income-tax Act)

1. 1. Investment allowance reserve
   2. Export allowance reserve
   3. Shipping reserve
   4. Export project reserve

Free reserves/Revenue reserve is a reserve, which is available for distribution as dividend like:

1. 1. Profit & loss account balance
   2. General reserve
   3. Dividend equalisation reserve
   4. Profit on disposal of fixed assets/investments.