Preparation of Profit and Loss Account, Balance Sheet and Cash Flow Statement

Module 1 showed how a raw transaction becomes a ledger balance. This module covers what has to happen between the trial balance and the published statements: the adjustment entries that turn a cash record into a true and fair one, and then the mechanics of the three statements themselves. It closes with the two forms of ownership accounting that are unique to partnerships and companies.

2.1 Adjustment Entries

Adjustment entries are required to reflect the true and fair view of the financial statements. They account for accrued income and expenses, and for deferred revenues or expenses. They may relate to the income and expenses of the profit and loss account, or to the assets and liabilities of the balance sheet.

The four-bucket map

Memory hook: every adjustment entry touches one profit and loss account and one balance sheet account. If both sides of your entry are in the same statement, check it again.

Accrued interest income

Firms invest surplus cash in government securities and fixed deposits. Those instruments typically pay interest half-yearly, on 30 June and 31 December, but the firm's accounting period ends on 31 March. Interest earned from 1 January to 31 March has not reached the bank account. Under the accrual system it still belongs to this period.

Interest Accrued is a representative personal account, effectively a loan the business has given to others, so it is an asset and is debited. Interest Income is a nominal account, credited under "credit all incomes and gains".

Revenue on long-term contracts

A company executing an airport construction or metro rail project takes several years to finish. Income can be recognised in proportion to the progress of the project: if 40% of the work is completed in year 1, 40% of the revenue is recognised in year 1. This is the percentage of completion method, and it is the subject of Module 4. Without it, income would be badly understated during the project's life.

Prepaid expenses

An insurance premium of Rs. 12 lakhs is paid in October for a full year running October to September. The books close on 31 December, so only three months of expense belongs to this year and nine months must be carried forward.

Step 1, October of year 1, the original payment.

Step 2, 31 December of year 1, the adjustment.

Step 3, in year 2, releasing the prepayment.

Memory hook: initial entry, adjustment entry, next-year release. Three legs across two years. The adjustment never touches cash; it only moves the expense to the period that consumed it.

Outstanding and accrued expenses

The firm's accounting period runs 1 January to 31 December. The electricity invoice for December, Rs. 10 lakhs, is received on 10 January and paid on 15 January. December's consumption belongs to the current year.

Note that the settlement in January has no effect on next year's profit. It reduces a liability and reduces cash, both balance sheet items.

Provisions: bad debts, warranty and gratuity

The matching concept requires expenses to be accounted against the related revenue. Where the exact amount is unknown but estimable, a provision is created.

Provision for doubtful debts. The estimated amount customers may fail to pay is Rs. 20 lakhs.

Provision for warranty. The estimated warranty claim is Rs. 20 lakhs in year 1. In year 2 the service engineer replaces a component worth Rs. 5,000 against a customer's claim.

Common trap: the year 2 entry has no impact on year 2's profit. It reduces the provision (a liability) and reduces stores (an asset). The expense was already taken in year 1, which is the whole point of creating the provision. Charging the Rs. 5,000 to expense again in year 2 would double count it.

Provision for gratuity. The company must estimate the gratuity payable as each employee completes a further year of service and provide for it annually.

Gratuity expense is reported in the profit and loss account; provision for gratuity is reported as a liability in the balance sheet.

Inventory consumption

Raw materials issued to production are not tracked transaction by transaction. One adjustment at period end reconciles the stores ledger to the physical count.

Given: opening stock 10 lakhs, purchases 400 lakhs, closing stock 30 lakhs.

Answer: Rs. 380 lakhs.

Depreciation

Depreciation reflects the decline in the value of tangible fixed assets through usage, wear and tear or obsolescence. The example uses straight-line depreciation at 10% a year for a machine with a 10-year useful life.

The accumulated depreciation roll-forward

Balance sheet presentation: the machine is shown at its original cost, with accumulated depreciation shown separately as a deduction, arriving at the net book value. The gross figure is never overwritten.

Amortisation works identically for intangible assets with a limited life such as patents, copyrights and spectrum licences. A 20-year spectrum licence is amortised at 5% per year: Amortisation Expense debit, Accumulated Amortisation credit (or a direct credit to the intangible asset account).

Foreign currency liability revaluation

When a company borrows or buys in a foreign currency, movements in the exchange rate change the rupee value of the liability. The liability is restated at the closing rate and the difference goes to the profit and loss account.

Given: an imported invoice of USD 100,000 recorded at Rs. 80 per dollar, so Rs. 80 lakhs. On 31 March the dollar quotes at Rs. 84 and the invoice is still unpaid.

Answer: an expense of Rs. 4 lakhs and a creditor balance increased to Rs. 84 lakhs.

Dividend payable

When a dividend is declared, the liability is recorded even before the cash goes out.

Note that the debit goes to retained earnings, not to an expense account. A dividend is a distribution of profit, not a cost of earning it.

Revaluing financial assets: FVTOCI and FVTPL

Under current accounting standards, financial assets must be revalued to fair value even if they have not been sold. Notional gains and losses must be recognised. Where the gain lands depends on the nature of the holding.

Memory hook: long term to equity, short term to the income statement.

Worked entry. A company makes a long-term investment of Rs. 100 lakhs in State Bank of India shares. On the balance sheet date the market value is Rs. 108 lakhs.

Answer: the investment is carried at Rs. 108 lakhs and Rs. 8 lakhs is added to other equity, with no effect on reported profit.

"Equity" on the balance sheet therefore includes share capital, accumulated profits or losses and other equity components such as the FVTOCI reserve.

2.2 Preparation of the Income Statement

• Purpose: shows a business's financial performance over a period. It is the summary of all the nominal accounts.
• Process: summarise revenue and expense transactions. Revenue items are listed first (sales, other income, interest income), followed by expenses (raw materials, salaries, utilities, depreciation, interest).
• Profit before tax = total income less total expenses.
• Net income (profit after tax) = profit before tax less taxes.

Illustrative format (Rs.)

The Sales Book specimen

The income statement needs summarised sales, purchases and other figures. Subsidiary books supply them. The Sales Book gives the details of all credit sales during a period, and only its total is posted.

Each row of the sales book obeys one identity.

For Mahesh & Co., $250 + 15 - 20 + 10 = 255$. The column totals obey the same identity: $930 + 50 - 80 + 50 = 950$.

Profit and Loss Appropriation Account

• Purpose: shows how net income is distributed between dividends and retained earnings or reserves. It is the link between the income statement and the balance sheet, and it maintains a running positive balance in retained earnings.
• Components: opening balance (retained earnings brought forward), net income for the year, dividends, transfer to general reserve, and the closing balance carried forward.

The closing balance of 20 becomes the opening balance of the next period, which is what gives retained earnings its continuity across years.

2.3 Preparation of the Balance Sheet

• Purpose: the balance sheet shows a company's financial position (assets, liabilities and equity) at a specific point in time, unlike the income statement which covers a period. It is a snapshot of the company's wealth, and can be read as a Statement of Wealth.
• Sources and application of capital: the sources side shows where the capital came from (equity, loans, creditors). The application side shows how it was used (assets).
• Relation to the income statement: the income statement summarises the nominal accounts. Those accounts are closed at period end and the net profit or loss is transferred into the equity section of the balance sheet.
• Structure:
  • Sources of capital: equity share capital, retained earnings, long-term borrowings and other liabilities.
  • Application of capital: fixed assets or non-current assets (land, buildings, machinery, computers, furniture, and intangibles such as software and patents), and current assets (inventories, trade receivables, cash and cash equivalents). Accounting rules require fixed assets to be reported as non-current assets.
• Adjustment entries: the balance sheet is prepared after incorporating adjustment entries such as depreciation and provision for bad debts. These are what make the view true and fair.

2.4 The Cash Flow Statement

• Purpose: summarises all cash and bank transactions during a period. Required by accounting regulations in many countries, India included.
• Categories:
  • Operating activities: cash sales, collections from credit customers, payments to suppliers and employees, payments for electricity, repairs, advertisement, selling and distribution, and taxes paid. For a profit-making company this is positive.
  • Investing activities: purchase of fixed assets and intangibles (outflow), sale of used assets (inflow), interest income and dividend income (inflow). For a growing firm this is negative.
  • Financing activities: raising equity or debt (inflow), repaying loans, repurchasing shares, paying interest and dividends (outflows). Firms reward capital suppliers through interest and dividends, so those payments sit here.

The accountant verifies that the closing cash balance derived from the cash flow statement equals the closing balance on the bank statement.

Direct and indirect method

Common trap: this course teaches and examines the direct method only. The lecturer states outright that a full indirect-method reconciliation starting from profit before tax will be skipped, because it adds no insight when the cash book is available. Do not import a textbook indirect-method template into an answer here.

The one indirect-style derivation the course does demonstrate is how a single line can be recovered without the cash book:

and likewise for an expense line:

Reading the signature of a business

Reading just the three signs tells you whether a business is profitable, whether it is growing and whether it is expanding, which is why the cash flow statement is far simpler to interpret than the other two statements.

2.5 Comprehensive Exercise: Alpha & Co

This is the module's anchor problem. It runs the whole chain: record the transactions, pass the adjustment entries, and prepare all three statements. All figures are in Rs. lakhs and the period is 1 January to 31 March (three months).

The facts

• A group of young graduates promoted Alpha & Co on 1 January to produce and supply an electronic component to automobile manufacturers.
• They invested 200 as equity and raised a 300 loan.
• An industrial shed was allotted requiring a deposit of 10 and monthly rent of 2, payable on the 5th of the following month.
• Machinery and other fixed assets were bought for 350; quality control equipment for a further 50.
• Materials worth 600 were purchased on credit and used to assemble the component. 400 was paid to suppliers.
• Salary is 5 per month, paid on the 7th of the following month.
• Electricity is paid on the 10th of the following month. The bill for the first two months was 5 in total and was paid. The third month's bill of 3 is unpaid.
• Other operating expenses of 20 were paid.
• The stores manager reports material worth 30 in stores on the last day of the third month.
• Sales for the three months were 1,200, all on credit. Customers paid 900. Industry norms suggest about 2% of receivables may turn bad.
• Equipment and other assets are depreciated at 10% per annum.
• Surplus cash is periodically placed in fixed deposits; at 31 March the total is 300. The bank pays interest at the end of June and December. The accountant estimates 3 of interest earned but not due.
• Loan interest is payable on 30 June; the accountant estimates 9 for the three months.
• Imported material was invoiced at USD 100,000, recorded at Rs. 80 per dollar, so 80. Payment is due 8 May. On 31 March the dollar quotes at Rs. 84.
• The accountant estimates the tax liability at 150.

The adjustment entries

Common trap: the depreciation rate of 10% is annual. The business has only existed for three months, so the charge is $400 \times 10\% \times 0.25 = 10$, not 40. Getting this wrong throws out the profit, the fixed asset carrying value and the balance sheet total at once.

Profit and Loss Account for the three months ended 31 March

Answer: profit after tax is Rs. 405 lakhs.

Note how each expense is built from an accrual, not from cash: salary is $5 \times 3 = 15$ although only 10 was paid; rent is $2 \times 3 = 6$ although only 4 was paid; electricity is $5 + 3 = 8$ although only 5 was paid.

Balance Sheet as at 31 March

Answer: the balance sheet totals Rs. 1,278 lakhs on each side.

Sundry creditors are purchases 600 less payments 400, giving 200, restated upward by the exchange difference of 4. Receivables are sales 1,200 less collections 900, giving 300, shown net of the 6 provision.

Cash Flow Statement for the three months ended 31 March (direct method)

Answer: closing cash is Rs. 251 lakhs, which agrees with the cash figure in the balance sheet.

That cross-check between the closing cash on the cash flow statement and the cash line on the balance sheet is the standard proof that the whole set is internally consistent.

Common trap: the rent deposit of 10 is an investing outflow, not an operating one. It is a refundable asset, not an expense. Classifying it as operating would report cash from operations of 451 instead of 461. The closing cash total is unaffected, but the interpretation of the business changes.

Reading the signature: operating positive, financing positive, investing heavily negative. That is the classic profile of a growth company in its first year.

2.6 Partnership Accounting

Capital account and current account

Partnership accounting differs from company accounting in one main respect: each partner has a named account rather than a collective share capital account.

Memory hook: the current account sits on the asset side because of the entity concept. The firm is a separate entity from the partners, so money a partner has taken out for personal use is genuinely a receivable from an outsider until it is settled or transferred to capital. Partners may decide to close the current account by transferring its balance into the capital account if they do not intend to repay it.

Base case: Ram and Krishna

Ram and Krishna contribute capital of 20 and 30 and agree to share profit 40:60. Sales are 300 and expenses including taxes are 250. All sales are cash sales and all expenses are paid. Ram withdraws 5 and Krishna 10 during the year, and all drawings are charged interest at 12% per annum. The accountant computes the interest chargeable at Rs. 30,000 on Ram's drawings and Rs. 50,000 on Krishna's, that is 0.30 and 0.50 in lakhs.

Interest on drawings is a charge on the partner and therefore an income of the firm.

Check: cash is $20 + 30 + 300 - 250 - 5 - 10 = 85$. Total assets are cash 85 plus current accounts receivable 15.80, giving 100.80, which equals total partners' capital of 100.80.

Admission of a partner

After one year Ram and Krishna decide to expand. Their friend Rahul contributes Rs. 50 lakhs. All three agree to revalue the business to determine the new profit-sharing ratio.

The value of a business depends on its future profitability, and historical profitability is the available proxy. Accountants generally apply a multiplier to historical profit to value goodwill. The partners agree on a multiplier of 3.

Given: first-year revenue 300, expenses 250, profit 50, multiplier 3.

Goodwill belongs to the existing partners, who built it, and is shared in their old profit-sharing ratio of 40:60. The amount each originally contributed is irrelevant to this split.

The new profit-sharing ratio is then derived from the balances in the capital accounts, not negotiated separately.

Answer: the new ratio is 33.33 : 50 : 16.67.

Common trap: the course computes this table on the base profit of 50, shared 20 and 30. If the interest on drawings of 0.80 is also brought in, the capital balances become 100.32, 150.48 and 50, and the ratio becomes 33.35 : 50.03 : 16.62. The difference is immaterial and the course rounds to 33.33 : 50 : 16.67, but be able to say why the two figures differ.

Note also that the profit-sharing ratio never appears in the accounting books. It is applied only when the year's profit is distributed.

Note what the course does not teach here: there is no sacrificing ratio, no gaining ratio and no Revaluation Account. Goodwill is valued by the profit-multiplier method only, and new ratios come from capital balances.

Retirement of a partner

Mr. Ram wants to retire after three years. Profits were 50, 80 and 140. All revenues and expenses are realised in cash. The partners agree that goodwill is 5 times the average profit of the three years.

Goodwill of 150 is already on the books from the admission, so only the increase is distributed.

The increment is shared in the existing ratio, that is the ratio established when Rahul joined.

Ram's payout. His capital account is built up from five layers.

Answer: the firm must pay Ram Rs. 273.33 lakhs. Ram settles his current account balance separately. The firm then works out a fresh profit-sharing ratio for Krishna and Rahul from their remaining capital balances.

Goodwill in context

Goodwill is an intangible asset that represents the value of a business beyond its physical assets and liabilities. It often reflects elements like brand reputation, customer loyalty, employee relationships and intellectual property, which contribute to future earnings but are not easily quantifiable.

In accounting, goodwill typically comes into play when a company is acquired for more than the fair market value of its net assets (assets minus liabilities). The excess amount paid is recorded as goodwill on the balance sheet, recognising that the business has value beyond its tangible assets alone.

In partnership accounting, goodwill also plays a role, especially during changes in the partnership structure.

1. Admission of a new partner. When a new partner joins, the existing partners may decide to recognise goodwill to reflect the value they have built up. This way the new partner can buy in at a fair value, accounting for the reputation, client base and other intangible benefits already established. Goodwill is calculated and shared among the existing partners based on their profit-sharing ratio, then adjusted in the capital accounts.
2. Retirement or death of a partner. When a partner leaves, their share of goodwill must be considered so they are fairly compensated for the value they helped build. Goodwill is credited to the retiring partner's capital account, based on the pre-determined profit-sharing ratio.
3. Revaluation of partnership assets. The partnership may revalue its assets to reflect current market value, which can include goodwill, so that all partners' capital accounts reflect an accurate share of the business's current value.
4. Amortisation or write-off of goodwill. Some partnerships systematically write off goodwill over time; others prefer to adjust it directly when a significant change in value occurs, such as a major change in partnership structure.

Goodwill adjustments ensure that all partners, incoming and outgoing, are treated equitably and that the accounts reflect the firm's true value.

2.7 Company Accounts

The accountant does not maintain an individual capital account for each shareholder. There is a single collective Share Capital account, and profit is never added into it.

• Share capital: the amount raised by issuing shares at face value.
• Share premium: the amount received above face value. It reflects the company's value and growth potential.
• Calls: companies can collect the share capital and premium in instalments, called application money, allotment money and calls.
• Forfeiture: if shareholders do not pay a call, their shares can be forfeited. They lose their investment and the company retains the money already received.

Why a premium exists

The partnership example makes the case cleanly. Krishna contributed Rs. 30 lakhs at the start and received a 50% profit share. Rahul contributed Rs. 50 lakhs a year later and received only 16.67%. If no premium were charged, Rahul should have paid only about Rs. 10 lakhs for a 16.67% stake, and the extra Rs. 40 lakhs is in substance a premium for buying into a business that others had already built. A company formalises the same idea by splitting the issue price into face value and premium.

Alpha Limited worked in accounting-equation form

Alpha Limited was incorporated on 1 January 2015 and the promoter contributed Rs. 50 crore, that is 5,000 lakhs. The company now issues 100 lakh equity shares of face value Rs. 10 at a premium of Rs. 90, so Rs. 100 per share, collected in three stages:

Investors applied for 400 lakh shares, four times the offer. Alpha allotted 100 lakh and refunded the rest. All allottees paid the allotment money. At the first and final call, only 95 lakh shareholders paid; the remaining 5 lakh did not respond even after reminders, and their shares were forfeited.

Check: $5{,}950 + 8{,}550 + 250 = 14{,}750$, which equals the cash total. The equation holds.

Answer: capital reserve on forfeiture is Rs. 250 lakhs and the balance sheet totals Rs. 14,750 lakhs.

Memory hook: the forfeiture gain of 250 goes to capital reserve, never to the profit and loss account. The company did not earn it by selling cement or paint. It arose from a capital transaction with its own shareholders, so it cannot be treated as operating income and cannot be distributed as a dividend.

If the forfeited shares are later reissued, a fresh entry is made at that time: Rs. 10 per share to share capital and any excess to share premium. Reissue is not journalised in this exercise because the company had not decided to reissue.

Note the boundary again: this course records company accounts in accounting-equation form. It does not use a Calls-in-Arrears account, does not use a Share Forfeiture Account as an intermediate step, and does not journalise reissue.

2.8 Revision Glossary

2.9 Module Summary

• Adjustment entries exist so that the statements show a true and fair view. Each pairs one profit and loss item with one balance sheet item, and none of them moves cash.
• The income statement summarises nominal accounts over a period; the balance sheet summarises real and personal accounts at a point in time. The profit after tax is the single link between them.
• The cash flow statement is built with the direct method in this course. Operating, financing and investing signs together give a quick read on whether a business is profitable and growing.
• Alpha & Co ties the whole module together: ten adjustments, PAT 405, a balance sheet of 1,278 each side, operating cash of 461 and closing cash of 251 that agrees with the balance sheet.
• Partnerships use named capital and current accounts; goodwill is valued by a profit multiplier, credited to the existing partners in the old ratio, and new ratios come from the resulting capital balances.
• Companies use one collective share capital account plus a share premium. Money kept on forfeiture is a capital reserve, not income.