In order to prepare financial statements, we have to follow the format provided by international accounting standards and based on those formats we have to prepare the income statement and the statement of financial position.
Income statements show the profitability of the business as to how much profits are made by the business and through what sources and how much expenses are incurred by what means. All expenses and all incomes or revenues of the business in an accounting period are always transferred to the income statement. If revenues are greater than expenses profits will be made whereas if expenses are higher than revenues, losses will occur.
Statements of financial position shows the details of assets, liabilities and capital on a certain date and helps in identifying the financial position of the business. They are also referred to as Balance sheet.
Assets = Liabilities + Capital
Net Sales – Cost of Sales = Gross Profit
Gross Profit + Other incomes – Expenses = Net Profit/(loss)
Working Capital = Current Assets – Current Liabilities
Owner’s Capital = Equity = Total Assets – Total Liabilities = Non-current assets + current assets – current liabilities – non-current liabilities
Capital employed = non-current assets + current assets – current liabilities = Total Assets – current liabilities = non-current assets + Working Capital = Owners Capital + Non-current Liabilities.
NOTE: It is extremely important to follow the format of income statement and statement of financial statement of financial position provided by the IAS. Current Assets in statement of financial position will always be recorded in reverse order of liquidity. Liquidity is the ability of the business to convert its assets into cash so cash is the most liquid asset followed by the bank, followed by prepayments and accrued income, followed by receivables and the least liquid asset is inventory because until and unless inventory is sold it cannot be converted into cash.
ADVANTAGES AND DISADVANTAGES OF OPERATING AS A SOLE TRADER:
|Owner keeps all profits ||Unlimited Liability of the owner|
|Low startup costs||Limited Capital can be raised|
|Operations are simple with high privacy||High decision-making responsibility|
|Flexibility in legal and operational structures||Limited business life|
IMPORTANCE OF PREPARING INCOME STATEMENT AND FINANCIAL STATEMENT:
These statements help the business determine revenues, expenses and information about profitability timely. The timely updates help investors and management make operational and financial decisions accordingly. The classifications also help separate business and personal expenses and revenues which help in managerial decision making in cases of expansion or downsizing. All these statements help in analysis for managers or owner.
DIFFERENCE BETWEEN TRADING AND SERVICE BUSINESS:
Trading businesses are such that buy goods to be resold to its customers, their inventories consist of goods to be resold whereas the service business do not have tangible inventories, they generate revenues from the services that they offer to their customers. For example: Law and Accounting firms. While preparing income statements for service firms, the revenue is documented as service revenue. Only Profit and loss accounts are included in a service business only. Trading account are not included for service business.
FINANCIAL STATEMENTS OF A SOLE TRADER WITH ADJUSTMENTS:
Financial statements refer to the income statement and statement of financial position. Although financial statements are prepared at the end of the accounting period, but they are published 3 months later. Any changes or additional information occurring during these 3 months are called Adjustments which need to be incorporated into the financial statement before they are published.
1. If a new business is started or commenced, its opening inventory would not exist.
2. Closing inventory is never recorded in the trail balance because inventory is counted after Accounting year has ended and we do not prepare the T Account of inventory. It is counted using techniques of inventory valuation.
3. Whenever the owner withdraws anything from the business for personal use it is referred to as Drawings. If the owner withdraws cash it is called Cash Drawings. The double entry to record Cash Drawings are:
If the owner withdraws non-current assets, it is referred to as non-current asset drawings and the double entries are:
Non-Current Asset Cr
If the owner withdraws inventory it is called Stock Drawings or Inventory Drawings and the double entries to record stock Drawings are:
4. If an inventory is damaged, destroyed, lost or robbed then it is an expense of the business and if no insurance claim is accepted against it then the double entries to record this stock loss are:
Income statement Dr
If the inventory loss is covered by insurance and the full insurance claim is accepted against it when the insurance claim will be treated as current assets and the double entries will be:
Insurance Claim Dr
If a partial insurance claim is accepted, then the part of insurance claim which is accepted will be treated as current assets and the part of insurance claim which is not accepted will be treated as expense of the business and hence the double entries are:
Insurance Claim Dr
Income Summary Cr
5. Expenses are divided into two categories: expenses associated to purchases and expenses associated to Sales. Expenses associated to purchases are all those expenses which part of cost of goods are sold and hence are included in trading section of income statement. Examples of expenses associated to purchases are: carriage inwards. Freight charges, custom duties, packaging, wages for preparation of goods for sale and so on. Expenses associated to sales are all those expenses which are part of day to day running cost of business and hence are included in the expense section of Income Statement and thus is part of Profit and Loss account.
6. If both accruals and prepayments, opening and closing are given in adjustments to final accounts then in order to find the expense figure to be charged to income statement we will apply PAAP method of preparing T Accounts of expenses. If both opening and closing accrued income and pre-received income are given in adjustments to final accounts, then in order to find the income figure earned by the business we have to prepare the T Account of APPA of revenues.
7. If closing prepayments are given in adjustments to final accounts, then the amount of prepayment will be deducted from the expense figure. Given in the trial balance, the amount hence obtained will be charged to income statement as expenses and the amount of prepayment will be recorded as Current Assets.
8. If closing accruals are given in adjustments to final accounts, then the number of accruals will be added to the expense figure given in the trial balance the amount hence obtained will be charged to income statement as expenses and the amount of Accruals will be treated as Current Liabilities.
9. If closing accrued income is given in adjustments to final accounts, then the amount of Accrued income will be added to the income figure given in the trial balance and the amount hence obtained will go to Income Statements as the other incomes and the amount of accrued income will be treated as current assets in statement of financial position.
10. If closing pre-received income or unearned income or advanced income is given in the adjustments then the amount of pre-received income will be deducted from the income figure given in the trial balance and the amount hence obtained will be treated as the other incomes in Income Statement and the amount of pre-received income will be treated as current liabilities in Statement of Financial Position.
11. The amount of expenses and incomes given in the trial balance are expenses paid and revenues received rather than expense incurred, and revenues earned. Hence these figures are to be adjusted when preparing Income Statement.
12. If the rate of interest all known is given than this rate is applicable on the outstanding amount of loan and hence the amount obtained by charging the rate on the loan is the amount of interest incurred which is to be charged in Income Statement as an expense. If the amount of interest given in the trial balance is the interest paid and the difference between interest incurred and interest paid are accrued interest expenses.
13. If premises are sublet, it indicates that part of premises which was taken on rent is given on rent and thus the amount of sublet is considered as an income for the business.
14. If the amount of loan is given in trial balance it will b treated as non-current liabilities. If the adjustment states that part of the loan is to be repaid, then the amount which is to be repaid will be treated as current liabilities. But interest will be charged on the whole outstanding amount whether it will be paid after an accounting period or within an accounting period.
15. If adjustments state that a certain percentage of depreciation is to be changed on the non-current assets and no previous depreciation is given in the trial balance then the rate of depreciation will directly be charged on the cost of the asset and the amount hence obtained will go to Income Statement as an expense and will be deducted from the cost of asset in the Statement of Financial Position.
If the adjustments state that depreciation is to be charged on cost, then it indicates that straight line method of depreciation is to be charged. In order to do so the rate of depreciation will be charges on the cost of asset. The amount hence obtained is depreciation for the year and hence will be charged to Income Statement as an expense. Accumulated Depreciation (i.e. current years depreciation just found and previous years depreciation given in the trial balance) will be transferred to the Statement of Financial Position as deduction from Non-Current Assets.
If the adjustment states that depreciation is to be charged on Reducing Balance Method or Reduced Cost or Net Book Value or Written Down Value then in order to do so we will first deduct previous years depreciation given in the trial balance from the cost of asset, the amount hence obtained is the Net Book Value and is subject to Rate of Depreciation, when this rate of depreciation will be charged on the Net Book Value, the amount obtained would be depreciation for the years and will go to Income Statement as an Expense. Accumulated Depreciation will go to Statement of Financial Position as deduction from Non-Current Asset.
Rate 10% on cost
Previous Depreciation 10,000
10% of 50,000 = 5000 Income Statement
5000 + 10,000 = 15,000 Statement of Financial Position
Cost = 50,000
Rate of Depreciation 10% on Net Book Value
Previous Depreciation 10,000
Previous Depreciation (10,000)
Net Book Value 40,000
10% = 4,000 income statement
16. If bad debt figure is given in the trial balance, then it is an indication that the receivable figure in the trial balance is the net receivable figure and bad debts will be treated as expense of the business.
If the bad debt figure is given in adjustments to final accounts then it is an indication that the receivable figure is not the net receivable figure and in order to find the net receivable figure, we will deduct bad debts from it, the amount hence obtained are Net Debts which are subject to Provision for Bad Debts.
The percentage of provision for bad debts will always be charged on the net receivable figure and the amount hence obtained is called Current year Provision which will be charged as Deduction from Receivables. If there is no previous provision given in the trial balance, then the same amount will also be charged to Income Statement as Expenses.
If previous provision for bad debts is given in the trial balance, then it will be deducted from the current years provision. If the answer is positive it is called increase in provision and if the answer is negative it is called increase in provision. Increase in provision is an expense for the business and decrease in provision is an income for the business.
17. If the accounting treatment of provision for Discount Allowed is exactly same as Provision for Doubtful Debts even in adjustments to final accounts.
18. If you are required to prepare financial statements for the half year then all other things will remain intact except for current years depreciation which will be halved.
19. If you are required to prepare financial statement for a quarter, then all other things will remain intact except current years depreciation which will be divided by four.
20. If financial statements are to be prepared for a month, then then all other things will remain intact except current years depreciation which will be divided by 12.
21. Stationery is the only thing in accounting which is Current Asset as well as Expense of the business. The amount of stationery used during the years is an expense while the amount of stationery left unused is Current Assets.
22. If an asset is bought on hire purchase or lease, then the total cost of asset will be treated as Non-Current Asset and the amount paid will already be deducted from bank and the amount not yet paid will be treated as liability.
23. If disposal is written in the trial balance, then we must check whether it is written on the debit side or the credit side. If it is written on the credit side, it is gain on disposal.
24. When the owner gives loan to the business it will not be treated as capital instead it will be treated just like any other Non-Current Liability whose interest will be charged normally as an expense. If it is included in error as capital, then we will deduct the amount of loan from capital and add it to the long-term liabilities.
25. If the business has given loan to the owner or an employee or anyone else, then it is the asset of the business and it will come between Non-Current Asset and Current Asset in Statement of Financial Position.
26. If an asset disposal account is given in adjustment to final accounts, then usually it is made incorrectly, and we need to correct the errors in it. Usually gain or loss on disposal is omitted from it because of which the value of asset is recorded incorrectly and hence depreciation is calculated.
27. Goods sent on sale or return basis should not be treated as sales instead it should be added to closing inventory at cost. If it is already included as sales, then the double entry to correct it will be:
(at selling point)
Whereas, it should be added to closing inventory at cost.
STATEMENT OF FINANCIAL POSITION:
John was in business as a soft drinks supplier and the following balances were extracted from his books on 30 June 2012:
|Capital at 1 January 2012||12,430 |
|Delivery Vehicles, at cost||9,000 |
|Provision for Depreciation on Delivery Vehicles at 1 January 2012||1,200 |
|Crates and Pallets, at book value 1 January 2012||1,000 |
|Stock at 1 January 2012||1,830|
|Wages and Salaries||15,100|
|Rent and Rates||1,550 |
|Vehicle Expenses||2,400 |
|Bad Debt written off||310|
|Balance at Bank||2,105 |
You are required to prepare the Trading and Profit and Loss Accounts for the half year ended at 30 June 2012 and the balance sheet at the date/
The following information is to be taken into account:
(a) Stock at 30 June 2012 was valued at $2,250
(b) Depreciation at the rate of 20% per annum on cost is to be charged on the Delivery Vehicles.
(c) During the half year, goods for re-sale costing $1,130 were destroyed by the fire and this claim has been agreed with the insurance company although it has not been paid or entered in West’s Books. These goods were not included in the stock valuation given in (a)
(d) A provision for bad debts is to be made equal to 2.5% of debtors, excluding the amount due from the insurance company.
(e) The rent and rates ($1,550) include payment of Rates $300 for the half year to 30 September 2012
(f) An amount of $240 was outstanding for Wages due
(g) Crates and Pallets were re-valued at $700 at 30 June 2012.
W1: Closing Inventory 2250
W2: Delivery Van: 9000
Depreciation @ 20%, 1800 x 6/12 = 900 – Income statement
900+1200=2100 – Statement of Financial Position
Insurance Claim 1130
Less: Insurance claim (1130)
37,820 – Income statement
W4: Receivables 4200
Provision for Bad Debt 2.5% 105
W5: 300/6 x 3 = 150 – Prepayment
Rent and Rate 1550
Less Prepayment (150) = 1400 – Income statement
W6: wages 15,100
Add: Accruals 420 = 15520 – Income statement