Chapter Notes

Stakeholders and their Information Requirements

In business, a stakeholder is any person or group associated with the company. Their "stake" or interest can be financial (like an owner or a bank that gave a loan) or non-financial (like the government or a customer). These stakeholders, also called users, need meaningful information to make informed decisions.

Users of accounting information are broadly classified into two groups:

1. Internal Users: People inside the business, such as owners and managers.
2. External Users: People outside the business, such as banks, the government, or potential investors.

Different stakeholders have different goals, so they need different types of information.

• Owners (Internal): They invest money to grow their wealth. They want to know how much profit the business made and the current value of its assets and liabilities.
• Managers (Internal): They manage the business on behalf of the owners. Financial statements act like a report card, showing them the company's profitability and financial position.
• Government (External): As a regulator, the government ensures that the rights of all stakeholders are protected. It is also interested in profitability to levy taxes correctly.
• Prospective Owners (External): People considering investing in the business. They look at past profits and financial position to predict future performance.
• Banks (External): When a bank lends money, it is concerned about the safety of its principal and receiving interest payments on time. It looks at the company's profits as an assurance that the loan will be repaid. Banks also care about liquidity—how many assets are in the form of cash or can be quickly converted to cash.

Distinction between Capital and Revenue

One of the most important distinctions in accounting is between capital and revenue items. This separation is crucial because it determines where an item appears in the financial statements.

• Revenue items are recorded in the Trading and Profit and Loss Account.
• Capital items are recorded in the Balance Sheet.

Getting this distinction wrong leads to incorrect profit calculations and a misleading view of the company's financial health.

Expenditure

An expenditure is any payment made by a business for a purpose other than settling a pre-existing debt. The key question to ask is: how long will the business benefit from this expenditure?

Revenue Expenditure

If the benefit of an expenditure lasts for only the current accounting period (usually one year), it is a revenue expenditure. These are recurring costs related to the day-to-day running of the business.

• Purpose: To maintain the existing earning capacity of the business.
• Examples: Paying salaries, rent, or buying raw materials.
• Accounting Treatment: It is treated as an expense for the current year and is shown on the debit side of the Trading and Profit and Loss Account.

Capital Expenditure

If the benefit of an expenditure extends for more than one accounting period, it is a capital expenditure. These are typically non-recurring expenses made to acquire or improve long-term assets.

• Purpose: To increase the earning capacity of the business.
• Examples: Buying machinery, constructing a building, or adding an extension to a factory.
• Accounting Treatment: It is recorded as an asset on the Balance Sheet. The cost is then gradually charged as an expense (called depreciation) over the useful life of the asset.

Deferred Revenue Expenditure

Sometimes, a heavy revenue expenditure is incurred whose benefit is expected to last for more than one year, but it doesn't create a physical asset. This is called deferred revenue expenditure.

• Example: A massive advertising campaign to launch a new product. The benefit of this campaign might last for three to four years.
• Accounting Treatment: Similar to a capital expenditure, the total cost is written off over the period of its expected benefit.

Receipts

Just like expenditures, receipts are also classified as either capital or revenue.

• Capital Receipts: These are receipts that create an obligation to return the money or result from the sale of a fixed asset. They are not part of the normal course of business.
  • Examples: A loan taken from a bank (creates a liability), additional capital invested by the owner (creates an obligation to the owner), or money received from selling old machinery.
• Revenue Receipts: These are receipts from the normal, day-to-day activities of the business and do not create an obligation to return the money.
  • Examples: Money from the sale of goods, commission received, or interest earned on investments.

Importance of Distinction between Capital and Revenue

Correctly classifying items as capital or revenue is essential for several reasons:

• Accurate Profit Calculation: If a revenue expense (like repairs) is incorrectly treated as a capital expense (added to machinery), the expenses for the year will be understated, and the profit will be overstated. The reverse is also true.
• True and Fair View: Incorrect classification distorts both the Profit and Loss Account and the Balance Sheet, meaning they do not present a true and fair view of the business's performance and position.
• Taxation: Capital profits and revenue profits are often taxed differently, so a proper distinction is necessary for legal compliance.

Financial Statements

After preparing and agreeing the trial balance, a business creates its financial statements. These are reports that summarize the financial performance and position of the business over a period.

The two main objectives of financial statements are:

1. To present a true and fair view of the financial performance (profit or loss).
2. To present a true and fair view of the financial position (assets and liabilities).

For a sole proprietorship, the financial statements typically consist of:

• Trading and Profit and Loss Account: Also known as the Income Statement, it shows the profit earned or loss incurred during an accounting period.
• Balance Sheet: Also known as the Position Statement, it shows the assets, liabilities, and capital on a specific date.

Trading and Profit and Loss Account

The Trading and Profit and Loss Account is a summary of all revenues and expenses for an accounting period, prepared to determine the final net profit or net loss.

It is an account with two sides:

• Debit Side: All expenses and losses are transferred here from the trial balance.
• Credit Side: All revenues and gains are transferred here from the trial balance.

If the total of the credit side (revenues) is greater than the total of the debit side (expenses), the difference is a profit. If the debit side is greater, the difference is a loss.

Relevant Items in Trading and Profit and Loss Account

Items on the Debit Side (Expenses)

• Opening Stock: The value of goods unsold at the beginning of the year. It's part of the cost of goods sold for the current year.
• Purchases less returns: The net cost of goods bought for resale during the year (both cash and credit), after deducting goods returned to suppliers (purchases return or return outwards).
• Direct Expenses: Costs directly related to purchasing goods or bringing them to a saleable condition. Examples include:
  • Wages: Paid to factory workers involved in production.
  • Carriage Inwards/Freight Inwards: Transport costs incurred to bring purchased goods to the business premises.
  • Fuel, Water, Power: Used in the production process.
• Indirect Expenses: All other business expenses not directly related to production or purchase of goods. Examples include:
  • Salaries: Paid to administrative and sales staff.
  • Rent Paid: For office or godown space.
  • Interest Paid: On loans or overdrafts.
  • Repairs: To maintain assets like machinery or furniture in working condition.

Items on the Credit Side (Revenues/Gains)

• Sales less returns: The net revenue from goods sold during the year (both cash and credit), after deducting goods returned by customers (sales return or return inwards).
• Other Incomes: Revenue earned from sources other than the main business operations. Examples include rent received, interest received, or commission received.

Closing Entries

At the end of the accounting period, closing entries are passed to transfer the balances of all revenue and expense accounts to the Trading and Profit and Loss Account. This process closes these temporary accounts, setting their balance to zero for the next year.

• All direct expense accounts (Opening Stock, Purchases, Wages, etc.) are closed by transferring their balances to the debit side of the Trading Account.
• The Sales account is closed by transferring its balance to the credit side of the Trading Account.
• All indirect expense accounts (Salaries, Rent, Bad Debts, etc.) are closed by transferring their balances to the debit side of the Profit and Loss Account.
• All other income accounts (Commission Received, Interest Received, etc.) are closed by transferring their balances to the credit side of the Profit and Loss Account.

Concept of Gross Profit and Net Profit

The Trading and Profit and Loss Account is prepared in two parts to calculate two different types of profit.

Trading Account and Gross Profit

The first part is the Trading Account. Its purpose is to determine the profit or loss from the core operational activity of buying and selling goods.

• It matches the sales revenue against the direct costs of those sales.
• The result is the Gross Profit or Gross Loss.

Gross Profit = Sales - (Purchases + Direct Expenses)

If sales are greater than the cost of goods sold, the result is a Gross Profit. This gross profit is then transferred to the credit side of the Profit and Loss Account to begin the next stage of calculation.

Profit and Loss Account and Net Profit

The second part is the Profit and Loss Account. It starts with the Gross Profit and then accounts for all other indirect expenses and incomes to find the overall profit or loss for the business.

• The Gross Profit is brought down on the credit side.
• All indirect expenses are debited.
• All other indirect incomes are credited.
• The final balancing figure is the Net Profit or Net Loss.

Net Profit = Gross Profit + Other Incomes - Indirect Expenses

This final Net Profit (or Net Loss) is then transferred to the Capital Account in the Balance Sheet.

Cost of Goods Sold and Closing Stock

In reality, a business usually has some unsold goods at the end of the year, known as Closing Stock. This stock has not been sold, so its cost should not be matched against this year's revenue. Instead, it is carried forward as an asset to be sold in the next year.

The presence of opening and closing stock modifies how we calculate the cost of goods sold.

Cost of Goods Sold (COGS) = Opening Stock + Net Purchases + Direct Expenses - Closing Stock

Operating Profit (EBIT)

Operating Profit is the profit earned from the normal, core operations of a business. It provides a clearer picture of the company's operational efficiency by excluding incomes and expenses that are purely financial or abnormal in nature. It is often referred to as EBIT (Earnings Before Interest and Tax).

To calculate Operating Profit, you adjust the Net Profit by:

• Adding back non-operating expenses (e.g., interest on loans, loss by fire).
• Subtracting non-operating incomes (e.g., profit on sale of an asset, dividend received).

Operating Profit = Net Profit + Non-Operating Expenses - Non-Operating Incomes

Balance Sheet

The Balance Sheet is a statement that shows the financial position of a business on a specific date. It lists all the assets (what the business owns) and liabilities (what the business owes to outsiders), along with the owner's capital.

It is called a "balance sheet" because the two sides must always be equal, reflecting the fundamental accounting equation:

Assets = Liabilities + Capital

Preparing the Balance Sheet

The Balance Sheet is prepared after the Trading and Profit and Loss Account. It includes all the ledger accounts that were not closed by transferring them to the income statement—namely, assets, liabilities, and capital accounts.

• Liabilities Side (Left): Shows Capital and all liabilities.
• Assets Side (Right): Shows all assets.

Relevant Items in the Balance Sheet

Assets

• Fixed Assets: Assets held for long-term use in the business, not for resale. Examples include land, buildings, machinery, and furniture.
• Current Assets: Assets that are in the form of cash or can be converted into cash within one year. Examples include cash, bank balance, debtors, bills receivable, and closing stock.
• Intangible Assets: Assets that cannot be seen or touched but have value. Examples include goodwill, patents, and trademarks.
• Investments: Funds invested outside the business, such as in government securities or shares of other companies.

Liabilities

• Long-term Liabilities: Liabilities that are payable after more than one year. Example: a long-term bank loan.
• Current Liabilities: Liabilities that are expected to be paid within one year, usually out of current assets. Examples include creditors, bills payable, and bank overdraft.
• Capital: The owner's claim on the assets of the business. It is calculated as the initial amount contributed, plus any additional capital and net profit, minus any drawings and net loss.
• Drawings: The amount of cash or goods withdrawn by the proprietor for personal use. It is shown as a deduction from capital in the Balance Sheet.

Marshalling and Grouping of Assets and Liabilities

To make the Balance Sheet easy to read and understand, its items are arranged in a logical order.

Marshalling refers to arranging assets and liabilities in a specific sequence. There are two common ways to do this:

1. In Order of Liquidity: Items are arranged from most liquid to least liquid. On the asset side, this means starting with cash and ending with fixed assets like buildings. On the liabilities side, it means starting with current liabilities and ending with capital.
2. In Order of Permanence: This is the reverse of the liquidity order. Items are arranged from most permanent to least permanent. On the asset side, this means starting with fixed assets and ending with cash. On the liabilities side, it means starting with capital and ending with current liabilities.

Grouping means putting together items of a similar nature under a common heading. For example, cash, bank, and debtors can be grouped under the heading "Current Assets," while buildings and machinery are grouped under "Non-Current Assets" or "Fixed Assets."

Opening Entry

The balances of all assets, liabilities, and capital shown in the Balance Sheet at the end of one accounting period are carried forward to the next period. At the beginning of the new year, an opening entry is passed in the journal to bring these balances into the new set of books.

This entry involves:

• Debiting all asset accounts.
• Crediting all liability and capital accounts.