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Financial Statements - I
You have learnt that financial accounting is a well-defined sequential activity which begins with Journal (Journalising), Ledger (Posting), and preparation of Trial Balance (Balancing and Summarisation at the first stage). In the present chapter, we will take up the next step, namely, preparation of financial statements, and discuss the types of information requirements of various stakeholders, the distinction between capital and revenue items and its importance and the nature of financial statements and the preparation thereof.
Stakeholders and Their Information Requirements
Recall from chapter I (Financial Accounting Part I) that the objective of business is to communicate the meaningful information to various stakeholders in the business so that they can make informed decisions. A stakeholder is any person associated with the business. The stakes of various stakeholders can be monetary or non-monetary. The stakes can be active or passive; or can be direct or indirect. The owner and persons advancing loan to the business would have monetary stake. The government, consumer or a researcher will have non-monetary stake in the business. The stakeholders are also called users who are normally classified as internal and external depending upon whether they are inside the business or outside the business. All users have different objectives for 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.
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.
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 to more than one accounting period, it is termed 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 correctly demarcate the expenditures into revenue and capital category. In normal usage, the advertising expenditure is termed as revenue expenditure. However, a heavy expenditure on advertising on launching a product is likely to give benefit for more than one accounting period, as people are likely to remember the advertisement for a slightly longer 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 as well as assets. There is a difference between expenditure and expense. 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.
Questions for Practice
1. What are the objectives of preparing financial statements ?
2. What is the purpose of preparing trading and profit and loss account?
3. Explain the concept of cost of goods sold?
4. What is a balance sheet. What are its characteristics?
5. Distinguish between capital and revenue expenditure and state whether the
following statements are items of capital or revenue expenditure :
(a) Expenditure incurred on repairs and whitewashing at the time of purchase of an old building in order to make it usable.
(b) Expenditure incurred to provide one more exit in a cinema hall in compliance with a government order.
(a) Registration fees paid at the time of purchase of a building
(b) Expenditure incurred in the maintenance of a tea garden which will produce tea after four years.
(c) Depreciation charged on a plant.
(d) The expenditure incurred in erecting a platform on which a machine will be fixed.
(e) Advertising expenditure, the benefits of which will last for four years.
6. What is an operating profit?
1. What are financial statements? What information do they provide.
2. What are closing entries? Give four examples of closing entries.
3. Discuss the need of preparing a balance sheet.
4. What is meant by Grouping and Marshalling of assets and liabilities. Explain the ways in which a balance sheet may be marshalled.
Please refer to attached file for NCERT Class 11 Accountancy - Financial Statements I
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