UNIT

04 Financial Statements

Names of Sub-Units

Introduction to Financial Statements, the Concept of Different Financial Statements, the Concept of
Outstanding Expenses, Treatment of Closing Stock, Tax Provision, Dividend and Reserves, Finding
Earning per Share (EPS).

Overview
This unit begins by meaning of financial statements, it discusses the different financial statements.
The unit explains the treatment of closing stock. It also discusses the dividend and reserves, finding
Earning per Share (EPS).

Learning Objectives

In this unit, you will learn to:

 Explain the meaning of a financial statement
 Discuss the major characteristics of financial statements
 State the scope of financial statements
 Describe the concept of the profit and loss (P&L) account
 Detail upon the concept of the balance sheet
JGI JAIN
DEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

Learning Outcomes

At the end of this unit, you would:

 Assess the meaning of a financial statement
 Examine the concept of outstanding expenses
 Analyse the treatment of closing stock
 Evaluate the outstanding expenses

4.1 INTRODUCTION
A financial statement refers to a formal and written record of all the financial activities and conditions of
an organisation, entity or a person. Financial statements contain a structured, organised, and detailed
summary of all the business processes. These determine the financial condition (whether organisation
is profitable or not) and the strengths and weaknesses of a business at the end of an accounting period.
Financial statements are prepared with the help of the trial balance that is prepared with the help of
ledgers.
There are three major types of financial statements—Profit & Loss (P&L) Account, Balance Sheet and
Cash Flow Statement.
The profit and loss account or the income statement shows the revenues and expenses of a company
during a particular period. It indicates how revenues are transferred into net income. The main objective
of the profit and loss statement is to show managers and investors whether the company has made
money or lost money during a reported period.
The balance sheet refers to the summary of the fiscal balances of a business organisation. In the balance
sheet, the assets, liabilities and owner’s equity are listed as of a specific date, such as the end of a fiscal
year. Very often financial accounts describe the balance sheet as a “snapshot of a company’s financial
condition”. The balance sheet is the only financial statement that applies to a single point in time in the
business’s calendar year. Financial statement analysis provides a pathway to measure this element of
risk and it is a technique that features past performance of the organisation and can be measured in
terms of liquidity, profitability, growth potential, efficiency, etc. It focuses on the significant relations hip
between financial statements.

4.2 DIFFERENT FINANCIAL STATEMENTS

The primary aim of investing money in a business is to earn profit. An organisation needs to periodically
evaluate profits earned and losses incurred and its financial standing on a given date. There are
different users of accounting information and all of them have different requirements. The information
requirements of different users can be fulfilled by preparing final accounts or financial statements.
Financial statements provide information regarding the profit earned and the losses suffered by a
business. A financial statement is an official record of all financial transactions of an organisation for
a particular period. It reflects the financial position (or financial health) and the performance of the
organisation. Under a financial statement, the profit and loss account reflects the financial performance
of the organisation while the balance sheet reflects the financial position or financial health of the
organisation.
According to Section 2 (40) of the Indian Companies Act, 2013, a financial statement in relation to a
company includes the balance sheet as at the end of the financial year; the profit and loss account; the

40
UNIT 04: Financial Statements JGI JAIN
DEEMED-TO-BE UNI VE RSI TY

cash flow statement for the financial year; the statement of changes in equity; and any explanatory
notes annexed to, or forming part of, any document referred to in the above-mentioned financial
statements. However, the financial statement with respect to a One Person Company, a small company
and a dormant company may not include the cash flow statement.
A business owner would be interested in knowing whether his/her business is running at a profit or
incurring loss, the actual financial position of the business, etc. The main aim of financial statements is
to inform the owner about the progress of his/her business and the financial position at the right time
and in the right manner.
Apart from these three financial statements, a fourth statement is the statement of changes in
equity. In a business, the sole purpose of investing money is earning profits. The financial position of
an organisation is determined by evaluating the profit earned or loss suffered by an organisation. In
addition, different users of accounting need different accounting information. Financial statements are
created to fulfil these requirements. Financial statements provide information regarding total profit
earned or loss suffered, i.e., the net income and the distribution of income. The preparation of financial
statements is the final step in the accounting cycle.

4.2.1 Preparation of Statement of Profit and Loss

The profit and loss account is prepared so as to ascertain the net profit earned and the net loss suffered
by a business over a given accounting period. Therefore, this statement depicts the financial position
of the business. In other words, the profit and loss account is a statement that shows expenditures,
revenues and net income of a company. The company’s profit and loss account is a brief description
of the company’s revenue, expenses and net profit (or net loss) for any particular period. It may be
produced on a monthly, quarterly, bi-annually or annual basis. In most cases, it is produced on an annual
basis along with other financial statements. The profit and loss account is a statement that reflects the
company’s financial performance to its investors, management and other interested parties.
In simple words, the profit and loss account is the explanation of the company’s profitability over a
particular period. Let us now discuss the components of the profit and loss account which are given as
follows:
 Revenue: Revenue is the total amount of money received by a business entity after selling its products
or services. Generally, revenue is also known as sales revenue or net sales, and it can be calculated
by deducting sales return, discounts and allowances from total sales. It is recorded at the top of the
income statement and because of this it is also known as ‘top line’.
 Cost of Goods Sold (COGS): The COGS includes all direct costs involved in the process of production.
For example, the costs raw material, labour, factory overheads, depreciation on plant and machinery,
etc.
 Gross profit or gross loss: It is the difference between the revenue received and the cost of goods
sold for a particular period.
 Operating expenses: Operating expenses are the expenses that a business entity has to bear in day-
to-day business operations. For example, amortisation of intangible assets, advertising and sales
expenses, research and development, rent of building, etc.
 Administrative expenses: Administrative expenses are those expenses that are not directly related
with the process of production. These expenses are related to management and supporting activities
of a business organisation. For example, depreciation on corporate office building, salary of top-level

41
JGI JAIN
DEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

managers, legal charges, functional cost of the HR department, functional cost of IT department,
functional cost of the finance department, etc.
 Operating income: The operating income can be calculated by deducting operating and
administrative expenses from gross profit. It is also known as Earnings before Interest and Taxes
(EBIT).
 Other income: The other income is the income that is non-operational in nature and is not generated
on the basis of core operations of a business. For example, the rent received from the in -house
canteen contractor of a factory.
 Other expenses: Other expenses are those expenses that are not related to the core operations of a
business enterprise and these expenses do not contribute anything to the process of production. For
example, income tax paid to the government, interest paid for borrowings, etc.
 Net profit or net loss: It can be calculated by deducting all expenses from revenue. It is recorded at
the end of the income statement and because of this it is also known as ‘bottom line’. Net profit/loss
is also known as ‘accounting profit/loss’ because many non-cash transactions such as amortisation,
depreciation, etc. are included under it. All the above items appear in the debit or credit side of the
profit and loss account. The items that appear on the debit side of the profit and loss account are as
follows:
Expenses incurred in a business: This is divided into two parts:
 Direct expenses: These are recorded in the income statement.
 Indirect expenses: These are recorded on the debit side. Indirect expenses are further categorised
as follows:
 Selling expenses: These include all expenses relating to sales such as carriage outwards, travelling
expenses, advertising, distribution costs, etc.
 Office expenses: These include all expenses incurred on running an office such as office salaries,
rent, tax, postage, stationery, etc.
 Maintenance expenses: These include all expenses related to the maintenance of assets such as
repairs and renewals, depreciation, etc.
 Financial expenses: These include all expenses related to interest paid on loan, discount allowed,
etc. The items that appear on the credit side of the profit and loss account are as follows:
 Gross profit
 Other gains and incomes of the business such as interest received, rent received, discounts earned
and commission earned.

Particulars Note Figures as at the Figures as at the

No. end of the current end of the previous
reporting period reporting period
I. Revenue from operations XXX XXX
II. Other Income XXX XXX
III. Total Revenue (I+II) XXX XXX
IV. Expenses:
Cost of materials consumed XXX XXX

42
UNIT 04: Financial Statements JGI JAIN
DEEMED-TO-BE UNI VE RSI TY

Particulars Note Figures as at the Figures as at the

No. end of the current end of the previous
reporting period reporting period
Purchases of Stock-in-Trade
Changes in inventories of finished XXX XXX
goods work-in-progress and
stock-in-trade
Employee benefits expense
Finance costs
Depreciation and amortisation
expense
Other expenses
Total Expenses XXX XXX
V. Profit before exceptional and XXX XXX
extraordinary items and tax (III-
IV)
VI. Exceptional items XXX XXX
VII. Profit before extraordinary items XXX XXX
and tax (V-VI)
VIII. Extraordinary items XXX XXX
IX. Profit before tax (VII-VIII) XXX XXX
X. Tax Expense:
1. Current Tax XXX XXX XXX
2. Deferred Tax XXX XXX XXX
XI. Profit/(Loss) for the period from XXX XXX
continuing operations
XII. Profit/(Loss) from discontinuing XXX XXX
operations
XIII. Tax expense of discontinuing XXX XXX
operations
XIV. Profit/(Loss) from discontinuing XXX XXX
operations (after tax)
XV. Profit/(Loss) for the period XXX XXX
XVI. Earnings per equity share:
1. Basic XXX XXX XXX
2. Diluted XXX XXX XXX

4.2.2 Preparation of Balance Sheet

In simple words, a balance sheet refers to a statement that summarises and presents the financial
position of an organisation on any given date. It shows assets and liabilities of the organisation. The
main aim of preparing a balance sheet is to determine the exact financial position of the organisation.
In a balance sheet, the debit balances are reflected by the assets and credit balances are reflected by
the liabilities. A number of steps are involved in preparing a balance sheet. The first step is transferring

43
JGI JAIN
DEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

all nominal accounts in the trial balance to the trading and profit and loss account. Next, the personal
accounts of customers are grouped under the heading of sundry debtors, the entities from whom the
amounts of sold goods and services are due.
Similarly, we need to group all balances of suppliers under the single heading of sundry creditors, the
entities to whom the organisation owes money or payment. In the end, the real and personal accounts
are grouped as assets and liabilities and are arranged in a proper way. The resultant statement obtained
is called the balance sheet. The American Institute of Certified Public Accountants defines the balance
sheet as “A tabular statement of summary of balances (debits and credits) carried forward after an
actual constructive closing of books of account and kept according to the principles of accounting.”
In the balance sheet, assets are represented on the right side and liabilities are shown on the left side.
It is also known as the statement of sources of funds and application of funds. The financial position
of the organisation includes its economic resources (assets), economic obligations (liabilities), and the
owner’s equity. As discussed in the previous chapters, a balance sheet is the detailed summary of the
basic accounting equation
Assets = Liabilities + Owner’s Equity
“The format of a financial statement prescribed in Schedule III of the Companies Act, 2013 is applicable
for all companies” voluntarily from April 1, 2015 and mandatorily from April 01, 2016. As per Schedule
III, the vertical format has now been permitted for the balance sheet. The balance sheet should include
the following items and in the order:
Name ot the Company.........................
Balance Sheet as at...........................
(Rupees in. ....... )

Particulars Note Figures as at the Figures as at the

No. end of the current end of the previous
reporting period reporting period
1 2 3 4
I. Equity and liabilities
1. Shareholders’ funds
a. Share capital
b. Reserves and surplus
c. Money received against share warrants
2. Share application money pending
allotment
3. Non-current liabilities
a. Long-term borrowings
b. Deferred tax liabilities (Net)
c. Other long-term liabilities
d. Long-term provisions

44
UNIT 04: Financial Statements JGI JAIN
DEEMED-TO-BE UNI VE RSI TY

Particulars Note Figures as at the Figures as at the

No. end of the current end of the previous
reporting period reporting period
4. Current liabilities
a. Short-term borrowings
b. Trade payables
c. Other current liabilities
d. Short-term provisions
Total:
II. Assets
1. Non-current assets
a. Fixed Assets
i. Tangible assets
ii. Intangible Assets
iii. Capital work-in-progress
iv. Intangible assets under
development
b. Non-current investments
c. Deferred tax assets (net)
d. Long-term Loan and Advances
e. Other Non-current assets
2. Current assets
a. Current investments
b. Inventories
c. Trade receivables
d. Cash and cash equivalents
e. Short-term loans and advances
f. Other current assets
Total:

4.3 OUTSTANDING EXPENSES

During the usual course of a business, there are expenses that will be incurred during the current
accounting period and are not paid or in other words, there are certain expenses that take place during
the current accounting period but payment for the same are not made, such expenses are called
outstanding expenses.
The outstanding expense is a personal account with a credit balance and is treated as a liability for the
business. It is recorded on the liability side of the balance sheet of a business.
For accounting accuracy, these expenses need to be realised whether they are paid or not. Like the other
expenses incurred by a business, it is also charged against the profit that is obtained for the current
year.

45
JGI JAIN
DEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

4.4 TREATMENT OF CLOSING STOCK

The closing stock implies inventory held at the end of the year. Thus, to derive information relating to
closing stock we maintain a real account by name Closing Stock. It provides data relating to the value
of stock unsold at the end of the accounting period. The value of closing stock is ascertained by physical
verification of stock and its valuation at cost or market price whichever is lower.
Usually, the closing stock does not appear in the Trial Balance when the accounts are being finalized as
the closing stock is ascertained by physical verification, which takes time in bringing up the value. Thus,
it appears as part of adjustment entry, which has to be passed before the preparation of Final Accounts.
If the closing stock is shown in the trial balance it means the adjustment for the closing stock has
already been done and it will be shown as a current asset on the right side of the balance sheet. From
the accounting point of view, aspects covered while preparing the accounts are:
1. Closing Stocks as shown on the Credit Side of Trading Account
2. Closing Stocks as shown on the Asset Side of Balance Sheet

However, if the value of the adjusted purchase (the cost of goods sold) is given then, the trial balance will
show figures of both adjusted purchases account and Closing Stock Account.

4.5 PREPAID EXPENSES

A prepaid expense is a type of asset on the balance sheet that results from a business making advanced
payments for goods or services to be received in the future. Prepaid expenses are initially recorded as
assets, but their value is expensed over time onto the income statement. Unlike conventional expenses,
the business will receive something of value from the prepaid expense over the course of several
accounting periods.

4.6 TAX PROVISION

A tax provision is comprised of two parts: current income tax expense and deferred income tax expense.
A company’s current tax expense is based upon current earnings and the current year’s permanent
and temporary differences. The deferred tax calculation, which focuses on the effects of temporary
differences and other tax attributes over time, is the more complicated part of the provision.

4.7 DIVIDEND AND RESERVES

Dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a
profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Dividends can
provide stable income and raise morale among shareholders.
Dividends must be approved by the shareholders through their voting rights. Although cash dividends
are the most common, dividends can also be issued as shares of stock or other property. Along with
companies, various mutual funds and Exchange-Traded Funds (ETF) also pay dividends.
A dividend is a token reward paid to the shareholders for their investment in a company’s equity, and it
usually originates from the company’s net profits. While the major portion of the profits is kept within
the company as retained earnings—which represent the money to be used for the company’s ongoing
and future business activities—the remainder can be allocated to the shareholders as a dividend. At

46
UNIT 04: Financial Statements JGI JAIN
DEEMED-TO-BE UNI VE RSI TY

times, companies may still make dividend payments even when they don’t make suitable profits. They
may do so to maintain their established track record of making regular dividend payments.

Reserves
A reserve is retained earnings secured by a company to strengthen a company’s financial position, clear
debt & credits, buy fixed assets, company expansion, legal requirements, investment and other plans.
These are usually done to save the cash from being used for other purposes. Reserve funds do not have
any legal restrictions so that the company can use them for any purpose.
Reserves are divided into two types:
1. Revenue Reserves
2. Capital Reserves

4.8 FINDING EARNING PER SHARE (EPS)

Earnings per Share (EPS) is calculated by determining a company›s net profit and allocating that to
each outstanding share of common stock
Earnings per share value is calculated as net income (also known as profits or earnings) divided by
available shares. A more refined calculation adjusts the numerator and denominator for shares that
could be created through options, convertible debt, or warrants. The numerator of the equation is also
more relevant if it is adjusted for continuing operations.
To calculate a company’s EPS, the balance sheet and income statement are used to find the period-end
number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It
is more accurate to use a weighted average number of common shares over the reporting term because
the number of shares can change over time.

Conclusion 4.9 CONCLUSION

 A financial statement refers to a formal and written record of all the financial activities and conditions
of an organisation, entity or a person. Financial statements contain a structured, organised, and
detailed summary of all the business processes.
 The profit and loss account or the income statement shows the revenues and expenses of a company
during a particular period.
 The balance sheet refers to the summary of the fiscal balances of a business organisation. In the
balance sheet, the assets, liabilities and owner’s equity are listed as of a specific date, such as the
end of a fiscal year.
 The primary aim of investing money in a business is to earn profit. An organisation needs to
periodically evaluate profits earned and losses incurred and its financial standing on a given date.
 The profit and loss account is prepared so as to ascertain the net profit earned and the net loss
suffered by a business over a given accounting period.
 In simple words, a balance sheet refers to a statement that summarises and pr esents the financial
position of an organisation on any given date.
 During the usual course of a business, there are expenses that will be incurred during the current
accounting period.

47
JGI JAIN
DEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

 The closing stock implies inventory held at the end of the year.
 A prepaid expense is a type of asset on the balance sheet that results from a business making
advanced payments for goods or services to be received in the future.
 A tax provision is comprised of two parts: current income tax expense and deferred income tax
expense.
 A dividend is a distribution of profits by a corporation to its shareholders.
 Earnings per share (EPS) is calculated by determining a company›s net profit and allocating that to
each outstanding share of common stock

4.10 GLOSSARY

 Accounting Standards Board: The board consisting of accounting professionals to develop and
implement various accounting guidelines.
 Bottom Line: The net profit of an organisation.
 Carriage outward: The shipping and handling costs incurred by a company that is shipping goods
to a customer.
 Depreciation: The reduction in the value of an asset over time due to wear and tear.
 Sales commission: The amount of commission received by a person depending on the level of sales
obtained by him/her.

4.11 CASE STUDY: SATYAM COMPUTERS LIMITED – BUSINESS ACCOUNTING

FRAUD
Case Objective
The case study explains the impact of fradulent financial reporting on an organisation and its
stakeholders.
Satyam Computer Services Limited was among the leading organisations in the outsourced IT services
industry in India. The organisation was established in 1987 in Hyderabad by Ramalinga Raju. Satyam
Computer Services Limited began with 20 employees and developed rapidly as a global IT company.
The company was engaged in providing IT and Business Process Outsourcing services across various
sectors. Between 2003-2008, Satyam Computer grew considerably and generated USD $467 million from
its total sales. By March 2008, Satyam Computer had grown to USD $2.1 billion. It booked an annual
compound growth rate of 35% in that time period.
Satyam was a Level I enterprise as it had a turnover above `50 crores. This implied that it was compulsory
for Satyam to comply all accounting standards. These accounting standards improve the credibility
and reliability of financial statements, determine managerial accountability, assist accountants and
auditors, and enable ease of understanding. However, there have been several frauds in India’s corporate
history due to lack of compliance to these standards and inefficient corporate governance.
On January 7, 2009, Ramalinga Raju revealed in a letter addressed to Satyam Computers Limited’s Board
of Directors that he had been involved in manipulating the company’s accountin g figures for several
years. Ramalinga Raju declared that he had overstated the company’s assets on Satyam’s balance sheet
by $1.47 billion. He revealed that about $1.04 billion worth of bank loans and cash that Satyam claimed
to own did not exist. Besides, Satyam Computers had underreported its liabilities on the balance sheet

48
UNIT 04: Financial Statements JGI JAIN
DEEMED-TO-BE UNI VE RSI TY

and had been involved in overstating its income almost every quarter over the course of several years
in order to meet the expectations of the critics. Satyam overstated quarterly revenues by 75 per cent and
profits by 97 per cent on October 17, 2009. It was also found out that bank accounts were falsified for
inflating the balance sheet with balances that actually never existed. In addition, the income statement
was exaggerated by declaring interest income from fake bank accounts. It was also exposed that the
company owner made 6000 fake salary accounts over the past several years and withdrew the money
after the company deposited it.
The result of the fraudulent accounting and financial reporting affected the company’s stockholders
and creditors. Besides, the investors’ confidence in the capital market was shaken considerably. The
fraud also had an adverse impact on Satyam’s employees who lost their job s and pension fund. The
others that were affected were depositors in Satyam Computers, the company’s underwriters, auditors,
attorneys, and insurers and even trustworthy competitors whose reputations suffered owing to their
association with Satyam. Some of the main points that organisations must remember after the Satyam
Scandal are:
 Investigation of all inaccuracies: The fraud at Satyam started on a small scale initially and grew
up to $276 million. Most accounting frauds start out small with the offender assuming that minute
changes in the financial statements would go unnoticed. Thus, organisations should be aware when
the accounts do not balance or if something seems inaccurate even if it is insignificant.
 Adherence to accounting standards: Organisations should follow a set of guidelines to prepare
and present their financial statements. This helps in bringing consistency in the reporting of
the accounting information. It also ensures transparency, consistency and comparability of the
accounting information by providing uniformity in accounting practices as accountants and
auditors follow the same rules and procedures.
 Role division: Dividing responsibilities across a team of individuals would help in detecting
irregularities or misappropriated funds.

Questions
1. Suppose you are the finance manager at an MNC. What measures will you take to avoid financial
frauds?
(Hint: Periodically tally the books of accounts, check for the bank balance, investigate the unexpected
cash inflows and outflows and check the unbalanced accounts for small and big changes alike.)
2. Briefly explain the Satyam scam and the role played by the board.
(Hint: Prepare a summary by analysing various loopholes in the scandal.)

4.12 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. What is a financial statement?
2. Why profit and loss account is prepared?

49
JGI JAINDEEMED-TO-BE UNI VE RSI TY
Accounting and Finance

3. What is a balance sheet?

4. What are prepaid expenses?

4.13 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. A financial statement refers to a formal and written record of all the financial activities and
conditions of an organisation, entity or person. Financial statements contain a structured, organised
and detailed summary of all the business processes. Refer to Section Different Financial Statements
2. The profit and loss account is prepared so as to ascertain the net profit earned and the net loss
suffered by a business over a given accounting period. Refer to Section Different Financial Statements
3. In simple words, a balance sheet refers to a statement that summarises and presents the financial
position of an organisation on any given date. It shows assets and liabilities of the organisation.
Refer to Section Different Financial Statements
4. A prepaid expense is a type of asset on the balance sheet that results from a business making
advanced payments for goods or services to be received in the future. Refer to Sec tion Prepaid
Expenses

@ 4.14 POST-UNIT READING MATERIAL

 https://corporatefinanceinstitute.com/resources/knowledge/accounting/three -financial-
statements/
 https://www.accountingtools.com/articles/2017/5/10/financial-statements
 https://www.wikiaccounting.com/five-types-of-financial-statements-ifrs/
 https://courses.lumenlearning.com/boundless-finance/chapter/introducing-financial-statements/

4.15 TOPICS FOR DISCUSSION FORUMS

 Discuss with your friends how financial statements work in a company.

50