NCERT Solutions For Class 12 Accountancy Chapter 5
Financial Statements of a Company

Financial statements are the basic and formal annual reports through which the corporate management communicates financial information to its owners and various external parties. These normally refer to the Balance Sheet and the Statement of Profit and Loss of a company.

The following points explain the nature of financial statements:

1. Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such cash, bank, trade receivables, fixed assets etc. are taken as per the figures recorded in accounting books.
2. Accounting Conventions: Certain accounting conventions are followed while preparing financial statements. The convention of valuing inventory at cost or market price whichever is lower is followed. The valuing of assets at cost less depreciation principle for balance sheet purpose is followed. The convention of materiality is followed in dealing in dealing with small items like pens, postage stamps, staplers etc. The use of accounting conventions makes financial statements comparable, simple and realistic.
3. Postulates: Financial statements are prepared on certain basic assumptions known as postulates such as going concern postulate, money measurement postulate, realisation postulate etc. Going concern postulate assumes that the enterprise is treated as a going concern and exists for a longer period of time. While preparing statement of profit and loss the revenue is included in sales of the year in which the sale was undertaken even though the sale price may be received in the next year. The assumption is known as realisation postulate.
4. Personal Judgements: Facts and figures presented through financial statements are based on personal opinion, estimates and judgements. The depreciation is provided taking into consideration the useful economic life of the asset. Provisions for doubtful debts are made on estimates and personal judgement. Personal opinion, judgements and estimates are made while preparing financial statements to avoid any possibility of over statement of assets and liabilities, income and expenditure, keeping in mind the convention of conservatism.

1. Shareholders: They want to know about the profitability and future prospects of the business enterprise. The required information is available from the financial statements.
2. Creditors: They want to ensure themselves, whether their funds are safe and secured and the business is capable of making payment of interest regularly and also return as per agreement.
3. Government: Financial statements help government in determining tax liability. The government is also capable of ascertaining the economic development of the country.
4. Investors: They would like to know, how far their previous investment has been safe and how much new investment will be safer and secured.

The primary objective of financial statements is to assist the users in their decision making. The specific objectives include the following:

1. To provide information about economic resources and obligations of a business.
2. To provide information about the earning capacity of the business.
3. To judge the effectiveness of management.

Following are the important limitations of financial statements:

1. Financial statements are prepared on the basis of historical cost. Hence they do not reflect current situation.
2. Vital information is missing in the financial statements like information relating to loss of markets, cessation of agreements, etc. which have vital bearing on the enterprise.
3. Accounting is done on the basis of certain conventions. Some of the assets may not realise the stated values, as they are shown in the Balance Sheet at the unexpired cost.

Balance Sheet (Extract)

Notes to Accounts:

Balance Sheet as on….

Notes to Accounts:

The process of preparing income statement (or statement of profit and loss) is given below in chronological order:

1. Prepare a trial balance on the basis of the balances of various accounts in the ledger.
2. Record Revenue from Operations i.e. sales less returns.
3. Add other incomes to Revenue from Operations to ascertain Total Revenue.
4. Deduct total expenses of the company from Total Revenue to ascertain profit before tax.
5. Deduct tax paid by the company from profit before tax to ascertain profit or loss for the period.

The process of preparing Balance Sheet of a company is as follows:

1. The Balance Sheet of a company is prepared in two parts ‘Equities and Liabilities’ and ‘Assets’.
2. Under the head ‘Equities and Liabilities’, Shareholders’ Funds, Share Application Money Pending Allotment, Non-current Liabilities and Current Liabilities are recorded.
3. Under the head Assets, Non-current Assets and Current Assets are recorded.
4. At the end total of two heads is ascertained, which must be equal.

1. Recorded Facts: Financial statements are prepared on the basis of facts in the form of cost data recorded in accounting books. The original cost or historical cost is the basis of recording transactions. The figures of various accounts such cash, bank, trade receivables, fixed assets etc. are taken as per the figures recorded in accounting books.
2. Accounting Conventions: Certain accounting conventions are followed while preparing financial statements. The convention of valuing inventory at cost or market price whichever is lower is followed. The valuing of assets at cost less depreciation principle for balance sheet purpose is followed. The convention of materiality is followed in dealing in dealing with small items like pens, postage stamps, staplers etc. The use of accounting conventions makes financial statements comparable, simple and realistic.
3. Postulates: Financial statements are prepared on certain basic assumptions known as postulates such as going concern postulate, money measurement postulate, realisation postulate etc. Going concern postulate assumes that the enterprise is treated as a going concern and exists for a longer period of time. While preparing statement of profit and loss the revenue is included in sales of the year in which the sale was undertaken even though the sale price may be received in the next year. The assumption is known as realisation postulate.
4. Personal Judgements: Facts and figures presented through financial statements are based on personal opinion, estimates and judgements. The depreciation is provided taking into consideration the useful economic life of the asset. Provisions for doubtful debts are made on estimates and personal judgement. Personal opinion, judgements and estimates are made while preparing financial statements to avoid any possibility of over statement of assets and liabilities, income and expenditure, keeping in mind the convention of conservatism.

1. Shareholders: They want to know about the profitability and future prospects of the business enterprise. The required information is available from the financial statements.
2. Management: The management needs information regarding profitability, operational efficiency, and financial soundness of the business, so that weak points of the business may be identified and effective measures can be taken.
3. Creditors: They want to ensure themselves, whether their funds are safe and secured and the business is capable of making payment of interest regularly and also return as per agreement.
4. Government: Financial statements help government in determining tax liability. The government is also capable of ascertaining the economic development of the country.
5. Investors: They would like to know, how far their previous investment has been safe and how much new investment will be safer and secured.
6. Employees: They get increment and bonus on the basis of their productivity and profitability of the business.

Though utmost care is taken in the preparation of the financial statements and provide detailed information to the users, they suffer from the following limitations:

1. Do not reflect current situation: The items recorded in the financial statements reflect their original cost i.e. the cost at which they were acquired. Financial statements also fail to record the inflation effect.
2. No qualitative information: Financial statements contain only monetary information but not qualitative information like current economic environment, industrial relation, labour relation, quality of management etc.
3. Biased: Financial statements are based on the personal judgements regarding the use of the methods for charging depreciation, amount of provision for doubtful debts, methods of valuation of inventory etc.
4. Only Summary: Financial statements show aggregate information but not detailed information. Hence they may not be of great help in decision making.
5. Some important information missing: Financial statements do not disclose information relating to loss of markets, and cessation of agreement, which have vital impact on the business.

The importance and significance of financial statements are as follows:

1. Report on stewardship function: Financial statements report the performance of the management to the shareholders. The gaps between the management performance and ownership expectations can be understood with the help of financial statements.
2. Basis for fiscal policies: The financial statements provide the basic input for industrial, taxation and other economic policies of the government.
3. Basis for granting of credit: Credit granting institutions take decisions based on the financial performance of the business.
4. Guide to the value of investment already made: Shareholders of the companies are interested in knowing the status, safety and return on their investment.
5. Basis for prospective investors: Their prime concern in their investment decisions are security and liquidity of their investment with reasonable profitability. Financial statements help the investors to assess long-term and short-term solvency as well as the profitability of the concern.
6. Aids trade associations in helping their members: Trade associations may analyse the financial statements for the purpose of providing service and protection to their members.

i. Current assets are shown on the assets part of the balance sheet. Inventory is shown under the head Current Assets and sub head inventories.
ii. Contingent liability is not recorded in the books of accounts but is disclosed in the notes to accounts for the information of the users. It includes:
Claim against the company not acknowledge as debts;
Proposed Dividend (Current Year).
iii. Shareholders’ funds are shown in the Equity and Liabilities part of the balance sheet. Reserves and Surplus are shown under the head shareholders’ fund.
iv. Fixed Assets are shown under the head Non- Current Assets. Intangible Assets are shown under the head Non- Current Assets and Sub- heads Fixed Assets.
v. Proposed Dividend for the current year is treated as a Contingent Liability and shown in the notes to Accounts.
vi. Non-Current liabilities are shown in the Equity and Liabilities part of the Balance sheet.
vii. Arrears of dividend on cumulative preference shares are sown as ‘Commitments in Notes to Account’.

Balance Sheet

Notes to Accounts:

Balance Sheet

Notes to Accounts:

Note: There is a misprint in the book. The number of equity shares issued must be 50,000 so that both the sides of the Balance Sheet stand equal.

Balance Sheet

Notes to Accounts:

Balance Sheet as at….

Notes to Accounts:

Balance Sheet (Extract)

Notes to Accounts:

PART I

Form of Balance Sheet.

Name of the Company……………………..

Balance Sheet as at …………………………

Equity and Liabilities: It is divided into two parts – liability towards owners, i.e., equity, and liability towards outsiders.

Share Capital: It shows the details of the authorised capital, issued capital and paid-up capital in terms of the number and amount of each type of share, and also the amount of calls in arrears and the forfeited shares.

Reserves and Surplus includes Capital Reserves, Capital Redemption Reserve, Securities Premium Reserve, Debenture Redemption Reserve, Share Options Outstanding Account, Other Reserves (specify the nature and purpose of each reserve and the amount in respect thereof), Surplus, i.e., balance in the Statement of Profit and Loss after appropriations such as dividend, bonus shares etc.

Money received against share warrants: It is a part of the shareholders’ funds. These are instruments issued by a company that are converted into shares at a pre determined price, at a later date.

Non-current liabilities are those liabilities which are not due for payment within the next 12 months.

Current liabilities are those liabilities which are due for payment within the next 12 months.

Assets: These are broadly classified into two types, i.e., non-current assets and current assets.

Non-current Assets: These are assets which are not held with the purpose of selling or converting them into cash, but to improve the earning capacity of a business.

Current Assets: It includes current investments, inventories, trade receivables, cash and cash equivalents, short term loans and advances and other current assets.

Form of Statement of Profit and Loss

Revenue from operations: It includes Net sales, sale of scrap and revenue from services.

Other income: It includes rent received, interest and dividend received and profit on sale of fixed assets or investment.

Cost of materials consumed: It is equal to opening inventory of materials plus net purchases minus closing inventory of materials.

Changes in inventories of finished goods, work-in-progress and stock-in-trade: It is equal to opening inventory minus closing inventory.

Employee benefit expenses: It includes the following:

1. Wages
2. Salaries
3. Staff welfare expenses
4. Contribution to Provident Fund and other staff welfare funds

Depreciation and amortisation expenses: Depreciation refers to amount of tangible assets written off. Amortisation refers to amount of intangible assets written off.

Finance costs: It includes the following:

1. Amount of interest paid by the company on its borrowings.
2. Other borrowing cost which includes discount on issue of debentures and premium payable on redemption of debentures etc.

Other expenses: It includes expenses other than the above six heads of expense. These could be telephone expenses, rent and taxes, selling and distribution expenses, loss on sale of fixed assets or investments, bad debts, cash discount allowed etc.