What are Final Accounts?

Final Accounts consists of

• Trading Account
• Profit and Loss Account
• Balance Sheet

Trading Account

It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS LOSS arising as a result of trading activities of a business.

According to J.R.Batliboi:-

‘The Trading Account shows the results of buying and selling of goods. In preparing, this account, the general establishment charges are ignored and only the transactions in goods are included’

Importance of Trading Account

Trading Account is prepared for the following reasons

• To know the Gross Profit or Gross loss arising due to trading activities of the business.
• To find out the direct expenses incurred by the business for the goods sold during the year.
• Find out how much closing stock is left as compared to previous years and thus find out the performance of the business.
• Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss and to assess the performance of the business and take corrective measures, if needed.

Preparation of Trading Account

The following items usually appear in a Trading Account

Sales turnover

Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales returns (Return inwards).

Opening Stock

The closing stock of the previous accounting year is taken as the Opening stock for the present year. If there is no Opening Stock then no entry is made.  Opening stock is derived by balancing the Stock Account and bringing down its balance to the next period.

Purchases

Purchases include all the Cash and Credit purchases of goods made by the business during the year.
Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net Purchases.

Direct Expenses

• Wages e.g. Warehouse worker wages.
• Carriage Inwards i.e. the cost of transport of goods to the trading place. The expense is usually borne by the buyer.
• Duty on purchases, for example, Import duty or excise duty.

Closing Stock

All the goods which remain unsold at the end of the year are known as ‘Closing stock’.
The closing is stock is valued at Cost price or Market price, whichever is lower.
The reason for taking the lower value of the two is in accordance with the ‘Prudence Principle’.
Normally, ‘Closing stock’ is given outside the Trial Balance.  This is so because its valuation is made after the accounts have been closed.

Note: Sometimes, the ‘Closing Stock’ may be given inside the Trail Balance. This means that the entry to incorporate the closing stock in the books has already been passed and it has already been deducted from the Purchases Account. In this case, ‘Closing Stock’ will not be shown in the Trading Account will only appear in the Asset side of Balance Sheet’.

Cost of goods sold

This means the finding the cost of only those goods which have been sold during the year. It can be calculated as follows:

(Net Purchases+Opening Stock) - Closing Stock

Example

On 31st December 2007, the books of XYZ show the following balances:

Closing Stock was valued at $400

Solution

download 'example handout'

For Closing Entries related to Trading Account Click here.

Profit and Loss Account

According to Prof. Carter: 

‘A Profit and Loss Account is an account into which all gains and losses are collected, in order to ascertain the excess of gains over the losses or vice-versa’.

Why Profit and loss account is made?

• To find out the Net Profit or Net Loss
• Compare the net profit of the business with previous years and to assess the performance of the business.
• Find out the amount of overheads of a business.

Items appearing on a Profit and Loss account

Any Incomes or gains

Any income or gains of the business from sources other than sales are recorded on the Credit side of Profit and loss account.

Gross Profit or Loss

It is transferred to the P/L account from the Trading Account. Gross Profit is transferred to the Debit side whereas Gross Loss is transferred to the Credit side.

Office and Administrative expenses

Example include salaries, office rent, lighting, stationery etc.

Selling and Distribution expenses

Include advertising expense, commission, carriage outwards, bad-debts etc.

Miscellaneous expenses

Such as, interest on loan, interest on capital, depreciation etc.

For Closing Entries related to Profit and Loss Account Click here.

Balance Sheet

Balance Sheet is a statement which shows the financial position of the business on a particular day.

According to A. Palmer

“The Balance Sheet is a statement at a particular date showing on one side the trader’s property and possessions and on the other hand the liabilities”.

Thus we can say that

• Balance sheet is a statement not an account.
• It is prepared to show the financial position of the business.
• It records all the assets and liabilities of the business.
• It shows the financial position on a particular day not for a period of time.

Need and Importance of Preparing a Balance Sheet

A Balance Sheet serves the following purposes:

• The true financial position of the business can be ascertained at a particular point of time.
• Reveals the amount of assets owned by the business for example machinery, cash, debtors and so on.
• Show the liabilities of the business such as total creditors, share capital etc.
• To adjudge weather the firm is solvent or not.
• Opening entries for the next financial year are based on the Balance Sheet of the previous year.

 Items appearing on a Balance Sheet

Assets

Assets of a business are what it owns. They can be classified as:

Fixed assets:  All those assets which are owned by the business and last for more than an accounting year. Examples include Land, building, machinery, vehicle, furniture and fixtures and the like.

Current assets: It includes all those assets which either in the form of cash or can be easily converted into cash within one accounting period. Current Assets include Cash, Debtors and Stock.

Liabilities

Liabilities represents what the business owes to outside persons other than owners. These liabilities are classified on basis of time period of repayment.

Long term liabilities: These are liabilities which the business owes for more than one accounting period, e.g. long term bank loans, debentures etc.

Current liabilities: These are short term debts of the business that are to be repaid within one accounting period, e.g. creditors and bank overdraft.

Owner’s Equity

Owner’s equity represents what the business owes its owner.

It is equal to total assets minus total liabilities.

Important points regarding Balance Sheet

• The Balance Sheet is not an account but a statement.
• It does not have debit or credit side but has two sections i.e. assets and liabilities.
• The heading of Balance Sheet is ‘as on a particular date’. Thus a Balance Sheet may have different figure on different dates.
• The balances shown in the Balance Sheet act as Opening Balances for the next accounting period.
• Balance Sheet is based on the accounting equation

Assets= Owner’s Equity + Liabilities

Download 'Balance Sheet Format'

Difference between Trial Balance and Balance Sheet

Objective

Trial Balance is prepared to verify the arithmetical accuracy of the books of account whereas Balance Sheet shows the financial position of the business.

Headings

Trial Balance is two sides i.e. Debit and Credit whereas Balance Sheet has Assets and Liabilities.Profit and LossTrial Balance does not show any information about the profit or loss of a business, whereas Balance Sheet records the Profit or Loss of the business.

Closing stock

The valuation of closing stock is not necessary to prepare a Trial Balance whereas Balance Sheet cannot be prepared unless the Closing stock for that particular accounting year is not ascertained.

Types of Accounts

Balances of all types of accounts are recorded in a Trial Balance i.e. Personal, real and nominal. Balance Sheet records balances of personal and real accounts only.

Adjustments

Adjustment for outstanding expenses, prepaid expenses and accrued incomes are not required for the preparation of Trial Balance. A Balance sheet is only complete after all the necessary adjustments are made.

Closing Stock

Closing stock refers to the goods remaining unsold during the year.
They are valued at Cost price or Market Price whichever is lower.

Closing entries

Treatment in Final Accounts

When closing stock is given outside the Trial Balance

It will appear on

• The credit side of the Trading Account
• Under Current Assets in the Balance Sheet.

When closing stock appears inside the Trail Balance

This means that the Closing stocks have already been deducted from the Purchases and thus it will ONLY appear in the Balance Sheet under Current Assets.

Accrued expenses or outstanding expenses

Expenses which have been incurred but not been paid for till the end of the accounting year are known as Accrued expenses or outstanding expenses.
For example,
Total salaries to be paid for the year were $10,000, but by the end of the year $1000 were not paid and will be treated as outstanding salary.

Adjusting Entry

Accounting treatment

Outstanding expense amount is added to that particular expense account in the Profit and loss or Trading Account because it was the expense for that year. (Based on the matching principle)
Outstanding expenses are liabilities for the business. Thus they will appear under the Current Liabilities in the Balance Sheet.

Note: If the Outstanding expense appears in the Trial Balance then it will only be recorded in the Liabilities side of the Balance Sheet.

Prepaid Expenses

All those expenses which are due next year but paid for in advance during the current year are termed as Prepaid Expenses.

Adjustment Entries

Accounting Treatment

The concerned expense will be deducted by the prepaid amount in the Trading Account or Profit & Loss account.
Prepaid expenses are assets for the business thus it will appear under the Current Assets in the Balance Sheet.

Note: If the Prepaid expense is given inside the Trial Balance, then the prepaid expense will only appear in the Current Asset of the Balance Sheet.

Depreciation

Depreciation is the fall in the value of fixed assets over a period of time.

Adjustment Entries

Accounting Treatment

Depreciation amount is entered as expense on the Debit Side of Profit and Loss account.

Depreciation is deducted from the value of the concerned asset in the Balance Sheet.

Accrued Income

Incomes which are earned during the year but not received till the end of the accounting year are termed as Accrued Income / Earned Incomes/ Income Receivable.

Adjustment Entries

Accounting treatment

Accrued income will be added to the concerned income account in the Profit and Loss account because it the income for that particular year (matching principle)
Accrued incomes are asset for the business and appear under the Current Assets in the Balance Sheet.

Note: If Accrued Incomes appear inside the Trial Balance then it will ONLY appear under the Current Assets in the Balance Sheet.

Unearned Income/Revenue

All incomes or revenues which are received in advance but not earned during the year are treated as unearned revenue. There may be times when a certain income is received in the current year but the whole amount of it does not belong to the current year.

Adjusting Entries

Accounting Treatment

Unearned incomes/revenues are not the actual income for that particular year and thus deducted from that particular revenue account in the Profit and Loss Account.
Unearned incomes/revenues are treated as liability for the business and thus appear under the Current Liabilities in the Balance Sheet.

Note: If unearned income/revenue appears inside the Trial balance then it will ONLY appear under the Liabilities in the Balance Sheet.

Interest on Capital

Usually the owner gets an Interest on his investment the business. According to the principle of separate entity, Capital is considered as Liability for the business and the owner is paid a certain amount of interest on the capital employed.

Accounting Entries

Accounting Treatment in Final Accounts

Interest on Capital is an expense for the business and thus appears on the Debit side of the Profit and Loss account.
It is a gain for the owner and thus it is added to the Capital in the Balance Sheet.

Interest on Drawings

Many times during the operation of business, the owner may take out some cash from the business for his personal use. These withdrawals from the business are considered as Drawings.  Considering the fact that the business is a separate accounting entity, it charges an interest on the drawings to the owner.

Adjusting Entries

Accounting Treatment

Interest on drawings is an income for the business and appears on the Credit side of the Profit and Loss Account.

Interest on drawings is an expense for the proprietor and thus it is deducted from the Capital Account in the Balance Sheet.

Interest on Loan

Interest paid on loans taken by the business is treated as expense and will appear on the Debit side of the Profit and loss account.
Sometimes the interest on loan may not be fully paid and may be outstanding when the final account is prepared. In this case, the Interest on loan account will be debited by the outstanding interest amount.

Adjusting Entries

Accounting treatment

Interest on loan is an expense for the business and appears on the Debit side of the Profit and Loss account.
Interest on loan is a liability for the business and is added to the Loan Account in the Liabilities section of the Balance Sheet.

Writing off Bad Debts

There may be occasions when the business might not be able to collect its debts. This may be due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.

This amount is then written off the books as ‘Bad debts’. It is a loss for the business and thus it is written on the debit side of the Profit and Loss account.

Closing Entry

Accounting Treatment

Bad debts appear on the debit side of the Profit and Loss account because it is a loss.
Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.

Recovery of Bad Debts

 Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus Cash account is debited whereas ‘Recovery of bad debts’ is credited because it a gain.

Accounting Entries

Partial Settlement of Debtors

Sometimes, a business might only be able to recover a part of the debts. This means the rest of the unrecovered debts will be written off as bad debts.

Accounting Entries

Provision for Doubtful Debts

Even after deducting the amount of actual bad-debts from the Debtors, there may still be some debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as an expense against the current period’s revenue.

When Provision for Doubtful Debts is set up for the first time

Accounting Entries

Closing Entries

Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and Loss account

It will be deducted from the Sundry Debtors in the Balance Sheet.

Increasing the Existing Provision for Doubtful Debts

Adjusting Entry

Closing Entry

Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit and Loss Account.

Decreasing the Existing Provision for Doubtful Debts

Adjusting Entry

Closing Entry

Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit and Loss Account.

In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.

Provision for Discount on Debtors

A provision for discounts to debtors who pay early is created in the current year itself.

Accounting Entries

Profit and Loss Account     Dr.
Provision for Discount on Debtors Account
(For provision for discount created on Debtors)

It is shown on the Debit side of the Profit and Loss Account.

Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet.

Note:  Provision for discount on debtors will be deducted after ‘Further bad debts’ and ‘Provision for doubtful debts’ are deducted from the Debtors.

Provision for Discount on Creditors

When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors.

Although the discounts will be earned in the next year, the discounts so earned are an income of the current year. A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.

Accounting Treatment

Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account.

It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.

Provision for Discount on Creditors

When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors.

Although the discounts will be earned in the next year, the discounts so earned are an income of the current year.

A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.

Accounting Treatment

Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account.

It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.