Financial Statements - I 9
Y ou have learnt that financial accounting is a
well-defined sequential activity which begins
with Journal (Journalising), Ledger (Posting), and
LEARNING OBJECTIVES preparation of Trial Balance (Balancing and
After studying this chapter, Summarisation at the first stage). In the present
you will be able to : chapter, we will take up the next step, namely,
• state the nature of the preparation of financial statements, and discuss the
financial statements;
types of information requirements of various
• identify the various
stakeholders and their stakeholders, the distinction between capital and
information require- revenue items and its importance and the nature
ments; of financial statements and the preparation thereof.
• distinguish between
the capital and reve- 9.1 Stakeholders and their
nue expenditure and
receipts; Information Requirements
• explain the concept of Recall from chapter I (Financial Accounting Part I)
trading and profit and
loss account and its
that the objective of business is to communicate
preparation; the meaningful information to various stakeholders
• State the nature of in the business so that they can make informed
gross profit, net profit decisions. A stakeholder is any person associated
and operating profit;
with the business. The stakes of various
• describe the concept of
balance sheet and its stakeholders can be monetary or non-monetary. The
preparation; stakes can be active or passive; or can be direct or
• explain grouping and indirect. The owner and persons advancing loan to
marshalling of assets the business would have monetary stake. The
and liabilities;
government, consumer or a researcher will have
• prepare profit and loss
account and balance non-monetary stake in the business. The
sheet of a sole prop- stakeholders are also called users who are normally
rietory firm; and classified as internal and external depending upon
• make an opening whether they are inside the business or outside the
entry.
business. All users have different objectives for
2022-23
,320 Accountancy
joining business and consequently different types of information requirements
from it. In nutshell, the various users have diverse financial information
requirements from the business.
For example we have classified the following into the category of internal
and external users specifying their objectives and consequent information
requirements.
Name Internal/ Objective for participating Accounting Information requirements
External in business
users
Current Internal To make investment in the Likes to know extent of profit in the
owners business and wealth grow. last accounting period, current
position of the assets/liabilities of the
business.
Manager Internal For a career. They essenti- Accounting information in the form
ally act as the agent of of financial statements is like their
owners (their employers). report card and they are interested
in information about both profits and
financial position.
Government External Its role is regulatory and Its concerns are that the rights of all
tries to lay down the rules stakeholders are protected. Since the
in the best public interest. government levies taxes on the
business, they are interested in
information about profitability in
particular besides lot of other
information.
Prospective External He is expecting to make He is interested in information about
owner investments in the business past profits and financial position as
with a view to make his indicative of likely future performance.
investment and wealth grow.
Bank External Bank is interested in safety Bank is interested in adequacy of
of the principal as well as profits only as an assurance of the
the periodic return return of principal and interest back
(interest). in time. Bank is equally concerned
about the form in which the assets
are held by the business. When more
assets are held in cash or near cash
form, the aspect is knnown as
liquidity.
Fig. 9.1 : Analysis of various users of accounting information
2022-23
,Financial Statements - I 321
Box 1
Accounting Process (up to Trial balance) :
1. Identify the transactions, which that are recorded.
2. Record transactions in journal. Only those transactions are recorded which are
measured in money terms. The system followed for recording is called double entry
system whereby two aspects (debit and credit) of every transaction are recorded.
Repeated transactions of same nature are recorded in subsidiary books, also called
special journals. Instead of recording all transactions in journal, they are recorded in
subsidiary books and the journal proper. For example, the business would record all
credit sales in sales book and all credit purchases in purchases book. The other
examples of subsidiary books are return inwards book, return outwards book. An
other important special book is cash book, in which all cash and bank transactions
are recorded. The entries, which are not recorded in any of these books, are recorded
in a residual journal called journal proper.
3. The entries appearing in the above books are posted in the respective accounts in the ledger.
4. The accounts are balanced and listed in a statement called trial balance. If the total
amounts of debit and credit balances agree, accounts are taken as free from
arithmetical errors.
5. The trial balance forms the basis for making the financial statements, i.e. trading
and profit and loss account and balance sheet.
9.2 Distinction between Capital and Revenue
A very important distinction in accounting is between capital and revenue items.
The distinction has important implications for making of the trading and profit
and loss account and balance sheet. The revenue items form part of the trading
and profit and loss account, the capital items help in the preparation of a balance
sheet.
9.2.1 Expenditure
Whenever payment and/or incurrence of an outlay are made for a purpose other
than the settlement of an existing liability, it is called expenditure. The
expenditures are incurred with a viewpoint they would give benefits to the
business. The benefit of an expenditure may extend up to one accounting
year or more than one year. If the benefit of expenditure extends up to one
accounting period, it is termed as revenue expenditure. Normally, they are
incurred for the day-to-day conduct of the business. An example can be
payment of salaries, rent, etc. The salaries paid in the current period will not
benefit the business in the next accounting period, as the workers have put
in their efforts in the current accounting period. They will have to be paid the
salaries in the next accounting period as well if they are made to work. If the
benefit of expenditure extends more than one accounting period, it is termed
2022-23
, 322 Accountancy
as capital expenditure. An example can be payment to acquire furniture for use
in the business. Furniture acquired in the current accounting period will give
benefits for many accounting periods to come. The usual examples of capital
expenditure can be payment to acquire fixed assets and/or to make additions/
extensions in the fixed assets.
Following points of distinction between capital expenditure and revenue
expenditure are worth noting :
(a) Capital expenditure increases earning capacity of business whereas
revenue expenditure is incurred to maintain the earning capacity.
(b) Capital expenditure is incurred to acquire fixed assets for operation of
business whereas revenue expenditure is incurred on day-to-day conduct
of business.
(c) Revenue expenditure is generally recurring expenditure and capital
expenditure is non-recurring by nature.
(d) Capital expenditure benefits more than one accounting year whereas
revenue expenditure normally benefits one accounting year.
(e) Capital expenditure (subject to depreciation) is recorded in balance sheet
whereas revenue expenditure (subject to adjustment for outstanding and
prepaid amount) is transferred to trading and profit and loss account.
Sometimes, it becomes difficult to classify the expenditure into revenue or
capital category. In normal usage, the advertising expenditure is termed as
revenue expenditure. The heavy expenditure incurred on advertising is likely to
benefit the business firm for more than one accounting period. Such revenue
expenditures, which are likely to give benefit for more than one accounting period,
are termed as deferred revenue expenditure.
It must be understood that expenditure is a wider term and includes
expenses. Expenditure is any outlay made/incurred by the business firm. The
part of the expenditure, which is perceived to have been used or consumed in
the current year, is termed as expense of the current year.
Revenue expenditure is treated as an expense for the current year and is
shown in trading and profit and loss account. For example, salary paid by the
business firm is treated as an expense of the current year. Capital expenditures
are charged to income statement and are spread over to more than one accounting
period. Hence, furniture of ` 50,000 if expected to be used for 5 years will be
treated as expense @ ` 10,000 per year. The name given for the expense is
depreciation. The treatment of deferred revenue expenditure is same as of capital
expenditure. They are also written-off over their expected period of benefit.
2022-23
Y ou have learnt that financial accounting is a
well-defined sequential activity which begins
with Journal (Journalising), Ledger (Posting), and
LEARNING OBJECTIVES preparation of Trial Balance (Balancing and
After studying this chapter, Summarisation at the first stage). In the present
you will be able to : chapter, we will take up the next step, namely,
• state the nature of the preparation of financial statements, and discuss the
financial statements;
types of information requirements of various
• identify the various
stakeholders and their stakeholders, the distinction between capital and
information require- revenue items and its importance and the nature
ments; of financial statements and the preparation thereof.
• distinguish between
the capital and reve- 9.1 Stakeholders and their
nue expenditure and
receipts; Information Requirements
• explain the concept of Recall from chapter I (Financial Accounting Part I)
trading and profit and
loss account and its
that the objective of business is to communicate
preparation; the meaningful information to various stakeholders
• State the nature of in the business so that they can make informed
gross profit, net profit decisions. A stakeholder is any person associated
and operating profit;
with the business. The stakes of various
• describe the concept of
balance sheet and its stakeholders can be monetary or non-monetary. The
preparation; stakes can be active or passive; or can be direct or
• explain grouping and indirect. The owner and persons advancing loan to
marshalling of assets the business would have monetary stake. The
and liabilities;
government, consumer or a researcher will have
• prepare profit and loss
account and balance non-monetary stake in the business. The
sheet of a sole prop- stakeholders are also called users who are normally
rietory firm; and classified as internal and external depending upon
• make an opening whether they are inside the business or outside the
entry.
business. All users have different objectives for
2022-23
,320 Accountancy
joining business and consequently different types of information requirements
from it. In nutshell, the various users have diverse financial information
requirements from the business.
For example we have classified the following into the category of internal
and external users specifying their objectives and consequent information
requirements.
Name Internal/ Objective for participating Accounting Information requirements
External in business
users
Current Internal To make investment in the Likes to know extent of profit in the
owners business and wealth grow. last accounting period, current
position of the assets/liabilities of the
business.
Manager Internal For a career. They essenti- Accounting information in the form
ally act as the agent of of financial statements is like their
owners (their employers). report card and they are interested
in information about both profits and
financial position.
Government External Its role is regulatory and Its concerns are that the rights of all
tries to lay down the rules stakeholders are protected. Since the
in the best public interest. government levies taxes on the
business, they are interested in
information about profitability in
particular besides lot of other
information.
Prospective External He is expecting to make He is interested in information about
owner investments in the business past profits and financial position as
with a view to make his indicative of likely future performance.
investment and wealth grow.
Bank External Bank is interested in safety Bank is interested in adequacy of
of the principal as well as profits only as an assurance of the
the periodic return return of principal and interest back
(interest). in time. Bank is equally concerned
about the form in which the assets
are held by the business. When more
assets are held in cash or near cash
form, the aspect is knnown as
liquidity.
Fig. 9.1 : Analysis of various users of accounting information
2022-23
,Financial Statements - I 321
Box 1
Accounting Process (up to Trial balance) :
1. Identify the transactions, which that are recorded.
2. Record transactions in journal. Only those transactions are recorded which are
measured in money terms. The system followed for recording is called double entry
system whereby two aspects (debit and credit) of every transaction are recorded.
Repeated transactions of same nature are recorded in subsidiary books, also called
special journals. Instead of recording all transactions in journal, they are recorded in
subsidiary books and the journal proper. For example, the business would record all
credit sales in sales book and all credit purchases in purchases book. The other
examples of subsidiary books are return inwards book, return outwards book. An
other important special book is cash book, in which all cash and bank transactions
are recorded. The entries, which are not recorded in any of these books, are recorded
in a residual journal called journal proper.
3. The entries appearing in the above books are posted in the respective accounts in the ledger.
4. The accounts are balanced and listed in a statement called trial balance. If the total
amounts of debit and credit balances agree, accounts are taken as free from
arithmetical errors.
5. The trial balance forms the basis for making the financial statements, i.e. trading
and profit and loss account and balance sheet.
9.2 Distinction between Capital and Revenue
A very important distinction in accounting is between capital and revenue items.
The distinction has important implications for making of the trading and profit
and loss account and balance sheet. The revenue items form part of the trading
and profit and loss account, the capital items help in the preparation of a balance
sheet.
9.2.1 Expenditure
Whenever payment and/or incurrence of an outlay are made for a purpose other
than the settlement of an existing liability, it is called expenditure. The
expenditures are incurred with a viewpoint they would give benefits to the
business. The benefit of an expenditure may extend up to one accounting
year or more than one year. If the benefit of expenditure extends up to one
accounting period, it is termed as revenue expenditure. Normally, they are
incurred for the day-to-day conduct of the business. An example can be
payment of salaries, rent, etc. The salaries paid in the current period will not
benefit the business in the next accounting period, as the workers have put
in their efforts in the current accounting period. They will have to be paid the
salaries in the next accounting period as well if they are made to work. If the
benefit of expenditure extends more than one accounting period, it is termed
2022-23
, 322 Accountancy
as capital expenditure. An example can be payment to acquire furniture for use
in the business. Furniture acquired in the current accounting period will give
benefits for many accounting periods to come. The usual examples of capital
expenditure can be payment to acquire fixed assets and/or to make additions/
extensions in the fixed assets.
Following points of distinction between capital expenditure and revenue
expenditure are worth noting :
(a) Capital expenditure increases earning capacity of business whereas
revenue expenditure is incurred to maintain the earning capacity.
(b) Capital expenditure is incurred to acquire fixed assets for operation of
business whereas revenue expenditure is incurred on day-to-day conduct
of business.
(c) Revenue expenditure is generally recurring expenditure and capital
expenditure is non-recurring by nature.
(d) Capital expenditure benefits more than one accounting year whereas
revenue expenditure normally benefits one accounting year.
(e) Capital expenditure (subject to depreciation) is recorded in balance sheet
whereas revenue expenditure (subject to adjustment for outstanding and
prepaid amount) is transferred to trading and profit and loss account.
Sometimes, it becomes difficult to classify the expenditure into revenue or
capital category. In normal usage, the advertising expenditure is termed as
revenue expenditure. The heavy expenditure incurred on advertising is likely to
benefit the business firm for more than one accounting period. Such revenue
expenditures, which are likely to give benefit for more than one accounting period,
are termed as deferred revenue expenditure.
It must be understood that expenditure is a wider term and includes
expenses. Expenditure is any outlay made/incurred by the business firm. The
part of the expenditure, which is perceived to have been used or consumed in
the current year, is termed as expense of the current year.
Revenue expenditure is treated as an expense for the current year and is
shown in trading and profit and loss account. For example, salary paid by the
business firm is treated as an expense of the current year. Capital expenditures
are charged to income statement and are spread over to more than one accounting
period. Hence, furniture of ` 50,000 if expected to be used for 5 years will be
treated as expense @ ` 10,000 per year. The name given for the expense is
depreciation. The treatment of deferred revenue expenditure is same as of capital
expenditure. They are also written-off over their expected period of benefit.
2022-23
