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

Introduction to Financial Statement Preparation

Financial statements are summaries of financial transactions. This module covers the preparation of three principal statements: the Profit and Loss Account (also called the Income Statement), the Balance Sheet, and the Cash Flow Statement.

Before preparing these statements, accountants record adjustment entries to reflect real‑world timing differences and other complexities. This extends the simplified approach of Module 1, where the first two statements were produced directly from a small set of raw transactions.

The Three Statements

• Profit and Loss Account (Income Statement)
• Balance Sheet
• Cash Flow Statement

Role of Adjustment Entries

• Adjustment entries are made after recording raw transactions but before finalising the financial statements.
• They ensure that revenues and expenses are recognised in the correct accounting period and that assets and liabilities are stated accurately.

Exam tip: Omitting adjustment entries is a common source of errors – always verify that necessary adjustments (e.g., accruals, prepayments) have been applied before presenting the final statements.

Key takeaways

• The three key financial statements are the Profit and Loss Account, Balance Sheet, and Cash Flow Statement.
• Financial statements summarise transactions; in practice, adjustment entries are required first.
• Module 2 builds on Module 1 by incorporating adjustment entries into the preparation process.

Adjusting Entries for Financial Statements

Financial statements must present a true and fair view of a business. This requires adjustment entries — year-end entries that recognise revenues and expenses incurred during the period but not yet recorded because supporting documents (invoices, bank statements) are absent. Without them, expenses are understated and profit overstated. Under double-entry bookkeeping, every adjustment affects both the profit and loss account (income statement) and the balance sheet.

Adjustments fall into three broad categories: income-side, expense-side, and asset-side entries.

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Income-Side Adjustments

Accrued Interest Income

Firms with surplus cash invest in bonds or fixed deposits that pay interest semi-annually (e.g., 30 Sept, 31 Dec). If the accounting year ends 31 March, the period Jan–Mar interest has been earned but not yet received; no bank statement entry exists.

Adjustment entry (no supporting document):

• Dr Interest Accrued (balance sheet, asset) – amount
• Cr Interest Income (profit and loss account, income)

Interest Accrued is an asset; Interest Income is credited to reflect revenue earned.

Revenue Recognition: Percentage of Completion Method

For long-term contracts (e.g., airport construction, metro rail), waiting until completion would delay revenue recognition for years. Accountants may use the percentage of completion method: if 40% of the work is completed in year one, 40% of total contract revenue is recognised. No invoice exists — an adjustment entry records the earned revenue. (Other revenue recognition methods are discussed in a later module.)

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Expense-Side Adjustments

Prepaid Expenses (Prepaid Insurance)

Insurance premium paid in advance covers a period that straddles two accounting years. Example: ₹12 lakh premium paid 1 Oct for one year (Oct–Sep). Accounting year ends 31 Dec. Only three months’ expense (Oct–Dec) belongs to the current year; nine months relate to the next year.

Three-entry method (starting from full-expense recording):

1. 1 Oct – Payment entry:

   • Dr Insurance Expense ₹12,00,000
   • Cr Cash/Bank ₹12,00,000 (Entire amount debited to expense)

2. 31 Dec – Adjustment entry:

   • Dr Prepaid Insurance (asset) ₹9,00,000
   • Cr Insurance Expense ₹9,00,000 (Reduces expense to ₹3,00,000; ₹9,00,000 reclassified as prepaid)

3. Next year (1 Oct onward) – Reversal entry:

   • Dr Insurance Expense ₹9,00,000
   • Cr Prepaid Insurance ₹9,00,000 (Moves prepaid amount to expense in the correct period)

Alternative approach: split at payment:

• Dr Prepaid Insurance ₹9,00,000
• Dr Insurance Expense ₹3,00,000
• Cr Cash/Bank ₹12,00,000

No year-end adjustment needed in the current year; the next year requires a reversal to move the prepaid balance to expense.

Exam tip: Prepaid insurance always appears as a current asset on the balance sheet. Failing to adjust overstates expenses in the payment year and understates them in the following year.

Outstanding Expenses (Electricity Bill)

Expenses incurred in the period but billed later. Example: December electricity consumption is billed on 10 January of the next year (₹10,00,000). The year ends 31 Dec.

Adjustment entry (recorded in late January when bill is known):

• Dr Electricity Expense ₹10,00,000
• Cr Outstanding Electricity Expense (liability) ₹10,00,000

Payment on 15 Jan:

• Dr Outstanding Electricity Expense ₹10,00,000
• Cr Cash/Bank ₹10,00,000 (Liability settled; no further impact on profit)

Provisions for Bad Debts and Warranty Expenses

Estimated expenses with no exact amount. The matching concept requires that revenues of a period bear all related costs, even if those costs are realised later.

• Bad debts: customers may not pay. Estimate based on past experience.
• Warranty expenses: products sold with a warranty; future repairs are likely.

Adjustment entry:

• Dr Bad Debt Expense / Warranty Expense ₹20,00,000 (estimated)
• Cr Provision for Doubtful Debts / Provision for Warranty (liability) ₹20,00,000

When the actual expense occurs (e.g., warranty repair costing ₹5,000):

• Dr Provision for Warranty ₹5,000
• Cr Stores (or Cash) ₹5,000 (Only the provision account and balance sheet are affected; profit and loss of the future period is untouched.)

Provision for Gratuity

The Payment of Gratuity Act requires paying 15 days’ salary for each year of service at retirement. Matching concept demands that each year’s revenue bears the gratuity cost earned by employees that year.

Yearly adjustment entry (estimation):

• Dr Gratuity Expense
• Cr Provision for Gratuity (liability)

At retirement:

• Dr Provision for Gratuity
• Cr Cash/Bank (No impact on the year’s profit and loss account.)

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Asset-Side Adjustments

Material Consumption (Inventory Adjustment)

Opening stock + purchases − closing stock = material consumed. Example:

• Opening stock: ₹10,00,000
• Purchases: ₹4,00,00,000
• Closing stock (per storekeeper): ₹30,00,000

$\text{Consumption} = 10,00,000 + 4,00,00,000 - 30,00,000 = 3,80,00,000$

Adjustment entry:

• Dr Material Consumed (expense) ₹3,80,00,000
• Cr Materials (inventory) ₹3,80,00,000

Depreciation (Tangible Assets)

A machine costing ₹1,00,00,000 is used for production. Its value declines over its useful life (say 10 years). At year-end, the accountant reduces asset value by 10%:

Straight-line depreciation:

• Dr Depreciation Expense ₹10,00,000
• Cr Accumulated Depreciation (contra asset) ₹10,00,000

The balance sheet shows:

• Machine (cost) ₹1,00,00,000
• Less: Accumulated Depreciation ₹10,00,000
• Net book value ₹90,00,000

In year two, the same entry adds ₹10,00,000 to accumulated depreciation (total ₹20,00,000; net book value ₹80,00,000). The original cost remains unchanged in the machine account.

Amortisation (Intangible Assets)

A spectrum licence paid for 20 years is an intangible asset. Each year its value is reduced by 5% (straight-line). The entry mirrors depreciation:

• Dr Amortisation Expense
• Cr Accumulated Amortisation (contra asset)

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Key Takeaways

• Adjustment entries are mandatory for a true and fair view — they match revenues and expenses to the correct accounting period.
• Income adjustments accrue earned but not yet received income (e.g., interest) or recognise revenue on long-term contracts (percentage of completion).
• Expense adjustments handle prepayments (assets), outstanding expenses (liabilities), and provisions for future costs (bad debts, warranties, gratuity).
• Asset adjustments correct inventory, depreciation (tangible), and amortisation (intangible) using contra accounts.
• The matching concept is the underlying principle: all expenses related to a period’s revenue must be recognised in that period, even if actual payment occurs later.
• Failing to adjust overstates profit and misrepresents the balance sheet.

Adjustments Related to Liabilities

Adjustment entries for the liability side of the balance sheet ensure that obligations are stated at their true present value. Key liability-related adjustments include foreign currency loans, dividends, and revaluation of financial assets under new accounting standards.

Foreign Currency Loans: Exchange Rate Changes

When a loan is taken in a foreign currency, it is recorded at the exchange rate on the borrowing date. However, if the exchange rate changes before the balance sheet date, the liability must be restated to reflect the current rate – even though the repayment is far in the future. Ignoring the change would understate liabilities.

Example

• Borrow $1 million at 4% interest, repayable after 10 years.

• Exchange rate on borrowing date: 1 USD = ₹80.

• Initial entry: Cash & Bank Dr ₹80 million Foreign Currency Loan Cr ₹80 million

• At financial statement date, 1 USD = ₹90 (Indian rupee depreciated).

• The liability is now effectively ₹90 million – an increase of ₹10 million.

• Adjustment entry: Foreign Currency Expenses Dr ₹10 million Foreign Currency Loan Cr ₹10 million

Exam tip: The increase in liability is treated as an expense (foreign exchange loss) in the profit and loss account. Do not forecast future rates; adjust only for changes that have already occurred.

Key takeaways

• Liabilities in foreign currency must be revalued at the closing rate.
• A depreciation of the domestic currency increases the liability (and vice versa).
• The corresponding debit goes to an expense (exchange loss) in the P&L.
• Similar adjustments apply to receivables (e.g., export invoices).

Dividend Declared but Not Yet Paid

Dividends create a liability at the point of declaration by the Board, subject to shareholder approval. Two entries are needed:

• The liability “Dividend Payable” appears under current liabilities until paid.
• The dividend is charged to retained earnings (not to the current year’s P&L).

Key takeaways

• Dividend liability arises on the date of Board resolution, not on payment date.
• The debit reduces retained earnings (equity), not the profit of the year.

Fair Value of Financial Assets (Investments)

New accounting standards require that financial assets held for investment be revalued to their market value at each balance sheet date. The treatment depends on the holding period:

• Long-term holdings – changes go directly to equity via Fair Value Through Other Comprehensive Income (FVTOCI).
• Short-term/trading holdings – changes go through the profit and loss account via Fair Value Through Profit and Loss (FVTPL).

Example – Investment in SBI shares

• Cost: ₹100 lakhs. Current market value: ₹108 lakhs.
• Initial entry: SBI Investment A/c Dr ₹100 lakhs Cash & Bank Cr ₹100 lakhs

Case 1: Long-term investment Adjustment entry: SBI Investment A/c Dr ₹8 lakhs Fair Value Through Other Comprehensive Income (FVTOCI) Cr ₹8 lakhs

• FVTOCI is an equity account (part of “Other Equity”).
• The ₹8 lakhs notional gain is added directly to equity, bypassing the P&L.

Case 2: Short-term (trading) investment Adjustment entry: SBI Investment A/c Dr ₹8 lakhs Fair Value Through Profit and Loss (FVTPL) Cr ₹8 lakhs

• FVTPL flows through the P&L, increasing net profit for the year.
• The increased profit then adds to equity (retained earnings).

Decision flow for notional gain/loss

Key differences: FVTOCI vs FVTPL

Exam tip: The acronyms FVTOCI and FVTPL are commonly tested. Remember: OCI = equity route; P&L = income route. Both end up in equity, but only FVTPL affects reported profit.

Key takeaways

• All financial assets must now be marked-to-market at year-end.
• Long-term: notional changes → OCI (no effect on P&L).
• Short-term: notional changes → P&L (affects net profit).
• “Other Equity” on the balance sheet includes both retained earnings and OCI reserves.

Why Adjustment Entries Matter

Adjustment entries (for outstanding expenses, provisions, depreciation, accrued revenues, and the above liabilities) are essential to present a true and fair view of the financial position. They ensure that:

• All expenses incurred to earn revenue are recorded.
• Liabilities are stated at current, realistic amounts.
• Assets are measured at their recoverable or fair values.

Key takeaways (overall section)

• Foreign currency loans: revalue liability at closing rate; record exchange loss/gain.
• Dividend payable: record liability on declaration, reduce retained earnings.
• Financial assets: revalue to market; treat notional gain/loss via OCI (long-term) or P&L (short-term).
• Adjustment entries bridge the gap between cash‑based records and accrual‑based financial statements.

Income Statement (Statement of Profit and Loss)

The Income Statement summarises a company’s revenues and expenses over a period. It answers: did the core business generate a profit or a loss? It is built directly from the revenue and expense columns of the accounting equation (the adjustment entries).

Also called Profit and Loss Account or Statement of Profit and Loss. It is the first step in preparing financial statements after all transactions for the period are summarised.

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Structure of the Income Statement

The statement lists revenues first (following a fixed sequence), then expenses, and finally computes profit.

Revenue Side (in order)

1. Revenue from sale of products or services (core revenue) – e.g. for a sugar company, revenue from sugar.
2. Other operating revenue – e.g. revenue from by‑products like molasses (sugar companies).
3. Other income – e.g. interest income, profit on sale of used assets (listed last).

The sum of all three categories is called Total Income.

Expense Side (in order)

Expenses are listed in a prescribed sequence, moving from core operations to indirect costs:

Profit Calculation

$\text{Profit Before Tax (PBT)} = \text{Total Income} - \text{Sum of all Expenses}$

$\text{Profit After Tax (PAT) (or Net Income)} = \text{PBT} - \text{Tax Expense}$

Tax is estimated based on applicable tax rate.

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Key Concepts in Expense Calculation

• Freight inward: transport cost to bring materials into the business (part of raw material cost). Freight outward: transport cost to send goods to customers (selling expense).
• Raw material consumed: $\text{Material Consumed} = \text{Opening Stock} + \text{Purchases} - \text{Closing Stock}$ The closing stock balance is obtained from the stores department at period‑end.
• Number of raw materials varies by industry: Sugar company → one main raw material (sugarcane). Paint/pharma → few. Automobile → hundreds of components → elaborate stores accounting.

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Profit and Loss Appropriation Account

This account links the Income Statement to the Balance Sheet. It shows how the net profit for the year is distributed or retained, ensuring continuity in the books (the account always has a positive closing balance or is closed).

The closing balance is shown under Reserves and Surplus (also called Other Equity) in the Balance Sheet, alongside the General Reserve.

Exam tip: The Profit & Loss Appropriation Account is not part of the Income Statement; it is a bridge to the Balance Sheet. The phrase “appropriation” means allocation of profit.

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Worked Example

A company’s Income Statement shows Profit After Tax = ₹70 lacs. Opening balance of Profit & Loss Appropriation Account = ₹40 lacs (retained from prior years).

If instead ₹80 lacs were transferred to General Reserve, the closing balance would be zero and the account would be closed – but accountants usually avoid this to keep the account open.

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Key Takeaways

• The Income Statement lists revenue items first (core → other operating → other income), then expenses (material → salaries → utilities → selling & admin → depreciation → interest).
• Profit Before Tax = Total Income – Total Expenses; deduct tax to get Net Income.
• Raw material consumed is calculated as Opening Stock + Purchases – Closing Stock.
• Profit and Loss Appropriation Account shows distribution of PAT: dividends and transfers to reserves. Its closing balance is part of Other Equity on the Balance Sheet.
• The General Reserve is an internal re‑classification – cash remains with the company.
• A zero closing balance is possible but unusual; accountants prefer a positive carryover.

Preparation of Balance Sheet

The balance sheet is a snapshot of a company's financial position on a specific date. While the profit and loss account (income statement) measures performance over a period (quarterly or annually), the balance sheet shows wealth at a point in time. It answers: Where did the capital come from, and where has it been put to use?

The balance sheet restates the fundamental accounting identity:

$\text{Assets} = \text{Liabilities} + \text{Equity}$

This equation is the scaffold: one side lists what the business owns (assets), the other side lists how those assets were financed (sources of capital — from owners and lenders).

Relationship with the Profit and Loss Account

Structure of the Balance Sheet

The balance sheet has two sides that must always balance:

1. Sources of Capital (Liabilities + Equity)

• Equity share capital – money contributed by owners.
• Retained earnings (profit retained in the business) – accumulated past profits not distributed.
• Loans – borrowings from banks or other lenders.
• Other liabilities – amounts owed to suppliers of goods/services on credit.

Intuition: Every asset must be financed either by owners (equity) or by outsiders (liabilities). The total of all sources equals the total assets.

2. Application of Capital (Assets)

Assets are classified into:

• Fixed assets (also called non-current assets under modern financial reporting standards) – used over the long term to produce goods or deliver services.
  • Tangible: land, building, machinery, computers, furniture.
  • Intangible: software, patents (legal rights to produce a product or process).
• Current assets – short-term resources (e.g., cash, inventory, receivables).

Adjustment Entries Before Preparation

The balance sheet is prepared after all adjustment entries have been recorded in the profit and loss account. Two key adjustments highlighted:

• Depreciation – systematic allocation of a fixed asset's cost over its useful life. Reduces the asset's value on the balance sheet and is an expense in the P&L.
• Provision for doubtful debts – an estimate of accounts receivable that may not be collected. Created as a contra-asset (reduces receivables) and recorded as an expense.

These adjustments ensure the balance sheet reflects a true and fair view of financial position.

The Balancing Principle

After all entries (including adjustments) are posted, the total of the sources of capital side must equal the total of the application of capital side. This equality is the core of double-entry bookkeeping and acts as a built-in check for accuracy.

Exam tip: Always check the accounting equation after posting adjustments. A common trap is forgetting to transfer net profit to retained earnings — this breaks the balance. Also, depreciation and provision for doubtful debts are non-cash adjustments that affect both the income statement and balance sheet.

Worked Example

Record adjustment entries, then prepare an income statement and balance sheet. The process flow is:

Key takeaways

• The balance sheet shows financial position on one date; the profit and loss account shows performance over a period.
• Two sides: sources of capital (equity and liabilities) and application of capital (assets). They must be equal.
• Fixed assets include tangible (land, building, machine) and intangible (patents, software) – now called non-current assets.
• Adjustments like depreciation and provision for doubtful debts are critical before finalising the balance sheet.
• The balance sheet is built from real and personal accounts; the income statement from nominal accounts.
• Every asset is financed by some source — the accounting equation is the foundation.

Cash Flow Statement

The Cash Flow Statement summarizes all cash and bank transactions of a firm over a period. While the Profit & Loss Account measures accrual-based profit, the Cash Flow Statement shows actual cash inflows and outflows. It answers: Where did cash come from, and where did it go? Accounting regulations in many countries (including India) mandate its presentation.

Cash and bank transactions are grouped into three broad activities:

The sum of cash flows from the three activities gives the net cash flow for the period.

$$\text{Opening Cash Balance} + \text{Net Cash Flow} = \text{Closing Cash Balance}$$

Accountants verify that the closing cash balance matches the bank statement.

Direct vs. Indirect Method

• Direct method: Uses the cash and bank account to list operating cash receipts and payments directly.
• Indirect method: Derives operating cash flow by adjusting net profit (from the Income Statement) for non‑cash items and changes in working capital (from the Balance Sheet). This method reconciles accrual profit with cash flow.

Exam tip: The indirect method is more common in practice because it starts from net profit, which is already known. Direct method requires detailed cash account information.

Key takeaways

• Cash flow statement classifies transactions into operating, investing, and financing activities.
• Operating cash flow is expected positive for a profitable company; investing cash flow is often negative for growing firms.
• Net cash flow = sum of the three activities; verifies the change in cash balance.
• Two preparation methods: direct (cash account) and indirect (Income Statement + Balance Sheet).

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Adjustments Before Preparing Financial Statements: Example (Alpha and Company)

This example illustrates how adjustment entries are recorded and then used to prepare the Profit & Loss Account, Balance Sheet, and (ultimately) the Cash Flow Statement. The data are for a three‑month period (January–March) of a newly formed company.

Company Setup and Transactions

• Incorporation: Alpha and Company is promoted by young graduates.
• Capital: Equity ₹200 lakh; Loan ₹300 lakh.
• Factory: Paid deposit ₹10 lakh and monthly rent ₹2 lakh (rent payable on 5th of next month).
• Assets: Machinery and other factory assets ₹350 lakh; later, quality control equipment ₹50 lakh.
• Purchases: Materials worth ₹600 lakh on credit; paid ₹400 lakh to suppliers.
• Sales: Total credit sales ₹1,200 lakh; customers paid ₹900 lakh.
• Expenses paid:
  • Salary: ₹5 lakh per month (paid on 7th of following month)
  • Electricity: ₹5 lakh for each of the first two months (paid on 10th of following month); third month bill ₹3 lakh (unpaid)
  • Other operating expenses: ₹20 lakh paid
• Closing inventory: Materials worth ₹30 lakh remain in stores.
• Bad debts estimate: 2% of receivables may become bad debts.
• Depreciation: Equipment and other assets depreciated at 10% (straight‑line basis assumed).
• Fixed deposit: ₹300 lakh invested; interest ₹3 lakh earned (not due until June).
• Loan interest: ₹9 lakh accrued for the three‑month period (payable in June).
• Import: Materials worth $100,000 on credit; rate \text{Rs. }80/$ → recorded at ₹80 lakh. On March 31, rate is ₹84/$ (unrecorded exchange loss of ₹4 lakh).
• Tax liability: Estimated at ₹150 lakh.

Adjustment Entries Required

The following adjustments must be recorded before financial statements are finalised:

Exam tip: Watch for the difference between paid and incurred expenses. Adjustments recognise expenses/revenues in the correct period even if cash has not moved. Also note that depreciation is a non‑cash charge; it reduces profit but does not affect cash flow.

From Adjustments to Financial Statements

After posting all adjustment entries:

1. Prepare an Adjusted Trial Balance.
2. Profit & Loss Account is drawn up: revenues (sales + interest income) minus all expenses (purchases adjusted for closing stock, salary, rent, electricity, depreciation, bad debts, forex loss, interest, tax) to arrive at net profit.
3. Balance Sheet is drawn up: assets (cash, debtors net of provision, closing inventory, fixed assets net of depreciation, accrued interest, fixed deposit) and liabilities (creditors – including import payable at new rate, rent payable, salary payable, electricity payable, interest payable, tax payable, loan) and equity (initial capital + retained profit).
4. Prepare the Cash Flow Statement from opening and closing cash balances, net profit, changes in working capital, and investing and financing activities.

The example demonstrates how seemingly separate transactions are linked through adjustments to yield a true and fair view of the firm's financial position and performance.

Key takeaways

• Adjustments ensure that expenses and revenues are recognised in the period they are incurred/earned, not when cash is received/paid.
• Common adjustments include accrued expenses, prepaid items, closing stock, depreciation, bad debts, interest, foreign exchange gains/losses, and tax provisions.
• The adjusted trial balance is the foundation for preparing the Profit & Loss Account and Balance Sheet.
• The Cash Flow Statement is prepared after all adjustments, using either direct or indirect method.

The Example: From Transactions to Financial Statements

This worked example traces the complete accounting cycle for a new company over its first three months (January–March). It demonstrates how raw business events are recorded in the accounting equation, adjusted for accruals and estimates, and then transformed into the three core financial statements: Income Statement (Profit & Loss Account), Balance Sheet, and Cash Flow Statement.

All figures are in lakhs of rupees (₹ lakh = ₹100,000).

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1. Recording Transactions in the Accounting Equation

Each transaction is recorded as a dual entry affecting Assets = Liabilities + Equity. The example begins with the following events:

After recording, the accounting equation balances: total assets = ₹1,278; total liabilities + equity = ₹1,278.

Exam tip: The matching concept drives adjusting entries — expenses must be recognised in the period they help generate revenue, even if cash hasn’t changed hands (salaries, rent, interest) or if a future loss is probable (bad debts, exchange differences).

Key takeaways

• Every transaction affects at least two accounts; the equation always balances.
• Cash transactions are recorded immediately; non-cash accruals require adjusting entries at period-end.
• Eight adjusting entries appear in this example: inventory consumption, bad debt provision, depreciation, electricity payable, salary payable, rent payable, interest payable/accrued, exchange difference, and tax payable.

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2. The Trial Balance

After posting all transactions (including adjustments), a trial balance lists the closing balance of every account. Accounts are sorted and grouped — contra assets (e.g., accumulated depreciation, provision for doubtful debts) are netted with their related asset on the face of the balance sheet but shown separately in the trial balance.

Trial balance totals (after correction of depreciation to ₹10):

Exchange difference (₹4) increases sundry creditors and appears as an expense.

Key takeaways

• Trial balance proves arithmetic accuracy (debit = credit).
• Some accounts (cash, inventory, sundry debtors, creditors) have multiple entries; the net balance is taken.
• Contra assets are shown as negative balances on the asset side.

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3. Income Statement (Profit & Loss Account)

The income statement summarises revenues and expenses to compute profit after tax.

• Depreciation: 10% p.a. × ₹400 lakh × 3/12 = ₹10 lakh.
• Interest expense: 12% p.a. × ₹300 lakh × 3/12 = ₹9 lakh.
• Bad debt provision: 2% × ₹300 lakh (outstanding debtors) = ₹6 lakh.

Key takeaways

• All revenues earned (whether cash received or not) and all expenses incurred (whether paid or not) are included.
• Adjusting entries for accruals and estimates appear as expenses (e.g., salary payable, bad debts, depreciation).
• Profit after tax (₹405) is added to equity in the balance sheet.

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4. Balance Sheet

The balance sheet presents the financial position at 31 March. Assets are listed in order of liquidity (fixed assets first, cash last). Liabilities are shown after equity.

Liability & Equity Side

• Accumulated depreciation (₹10) and provision for doubtful debts (₹6) are deducted from the related assets on the face of the balance sheet.

Key takeaways

• Equity = contributed capital + retained profits.
• Current liabilities include all payables (salary, electricity, interest, rent, tax, creditors).
• Total assets = total liabilities + equity (always).
• The balance sheet classifies assets and liabilities — but no formal current / non-current split is shown in this example (though loan is long-term, payables are short-term).

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5. Cash Flow Statement (Direct Method)

The cash flow statement summarises actual cash inflows and outflows during the period, classified into three activities:

Detailed Cash Flow Statement

Exam tip: Only actual cash receipts and payments appear in the cash flow statement. The rent deposit (₹10) is an investing outflow, not an operating expense. Likewise, interest received (accrued but not yet received) is excluded; only the ₹900 from customers is shown.

How to interpret cash flow patterns:

• A profitable, growing company usually has positive operating cash flow, positive financing cash flow (raising funds to invest), and negative investing cash flow (buying assets).
• A mature, non-growing company will have positive operating cash flow, negative financing cash flow (repaying debt or paying dividends), and small or negative investing cash flow.

Key takeaways

• Direct method uses actual cash transactions from the cash book.
• Three sections: Operating, Financing, Investing.
• Closing cash matches the cash balance on the balance sheet (₹251).
• Operating cash flow (₹461) is positive — the business is generating cash from its core operations.

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6. Indirect Method – Brief Overview

The indirect method reconstructs operating cash flow from the income statement and balance sheet, without using the cash book.

Example: Cash collected from customers

$\text{Cash collected} = \text{Opening receivables} + \text{Sales} - \text{Closing receivables}$

• Opening receivables: 0 (new company)
• Sales: 1,200
• Closing receivables: 300 (from balance sheet)
• Cash collected: 0 + 1,200 – 300 = 900

Example: Salary paid

$\text{Salary paid} = \text{Salary expense} - \text{Increase in salary payable}$

• Salary expense: 15
• Closing salary payable: 5
• Opening payable: 0
• Salary paid: 15 – 5 = 10

For payments to suppliers, the calculation is more complex because it must account for purchases (from inventory change) and creditor movements. The indirect method is not covered in detail here; the direct method is simpler when a cash book is available.

Exam tip: The indirect method starts with net profit and adjusts for non-cash items (depreciation, bad debts, accruals) and changes in working capital. The direct method lists actual cash flows. Both produce the same operating cash flow total.

Key takeaways

• Indirect method derives operating cash flow without a cash book.
• Requires information from the income statement and balance sheet (opening and closing balances).
• More tedious but useful when cash records are not accessible.

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Summary: The Complete Accounting Cycle

The example walks through the entire process:

1. Record transactions in the accounting equation.
2. Pass adjusting entries to apply matching and conservatism.
3. Prepare trial balance to verify debits = credits.
4. Prepare income statement to compute profit after tax.
5. Prepare balance sheet to show financial position.
6. Prepare cash flow statement to show liquidity.

General relationships:

• Net profit (405) forms part of equity.
• Closing cash (251) is both a balance sheet asset and the final line of the cash flow statement.
• Adjusting entries for revenues (interest receivable) and expenses (payables) flow into the income statement and create corresponding balance sheet items.

Key takeaways (final)

• Eight adjusting entries are essential for accurate period-end reporting.
• The income statement measures performance; the balance sheet measures position; the cash flow statement measures liquidity.
• The accounting equation ($A = L + E$) must hold at every stage.
• Cash flow analysis reveals whether a profitable company is actually generating cash — in this example, it is.

Partnership Accounts

Partnership is a business form where two or more individuals share ownership. While the core accounting (recording transactions, preparing financial statements) is the same as for any business, partnerships have unique transactions: capital contributions, drawings, interest on drawings, profit distribution among partners, and adjustments when a partner is admitted or retires. The entity concept treats the business as separate from the partners—amounts owed by or to partners are distinct from their equity.

Capital and Current Accounts

Each partner has a Capital Account (permanent equity) and a Current Account (temporary equity for drawings and interest). The current account records amounts the partner withdraws for personal use and any interest charged on those drawings. A positive current account balance is receivable from the partner (asset). Partners may close the current account into the capital account if they choose not to repay the drawings.

Recording Initial Contributions, Drawings, and Interest

Example:

• Ram contributes ₹20 lakh, Krishna contributes ₹30 lakh cash. Capital accounts credited accordingly.
• Sales: ₹300 lakh cash. Revenue ₹300 lakh.
• Expenses: ₹250 lakh cash. Expense ₹250 lakh.
• Drawings: Ram ₹5 lakh, Krishna ₹10 lakh. These are debited to their respective current accounts (assets).
• Interest on drawings: Ram ₹30,000 (0.3 lakh), Krishna ₹50,000 (0.5 lakh). Interest income for the business; also increase current accounts receivable.

After these entries, the trial balance shows:

• Cash: ₹85 lakh (50 in + 300 – 250 – 5 – 10)
• Ram’s current account: ₹5.3 lakh receivable
• Krishna’s current account: ₹10.5 lakh receivable
• Ram’s capital: ₹20 lakh
• Krishna’s capital: ₹30 lakh
• Revenue: ₹300 lakh (sales) + 0.8 lakh (interest) = ₹300.8 lakh
• Expenses: ₹250 lakh
• Profit: ₹50.8 lakh

Profit Distribution

Profit is distributed according to the profit sharing ratio agreed by partners. Here, Ram gets 40%, Krishna 60% (based on capital contributions).

$\text{Ram's share} = 50.8 \times 0.40 = 20.32 \text{ lakh}$ $\text{Krishna's share} = 50.8 \times 0.60 = 30.48 \text{ lakh}$

This profit is transferred from the Profit & Loss account to the partners’ capital accounts.

Post‑distribution capital accounts:

• Ram: ₹20 + ₹20.32 = ₹40.32 lakh
• Krishna: ₹30 + ₹30.48 = ₹60.48 lakh

Key takeaways

• Partnerships maintain separate Capital (permanent) and Current (temporary) accounts for each partner.
• Drawings are recorded as assets (receivable from partners), and interest on drawings is income for the business.
• Profit is shared in the agreed ratio (e.g., based on capital contributions).
• Always apply the entity concept: the business is distinct from its owners.

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Admission of a Partner

When a new partner joins an existing profitable business, the business is worth more than the original capital contributed. The goodwill of the business—the intangible value due to its earning power—must be valued and shared among existing partners. The new partner pays a premium (additional capital) to acquire a stake, and the old partners sacrifice part of their profit share.

Goodwill Valuation

Goodwill is often estimated using a multiplier on historical profits:

$\text{Goodwill} = \text{Average historical profit} \times \text{multiplier}$

In the example, after one year:

• Profit = ₹50 lakh (excluding interest income from drawings, as it is not operational profit)
• Multiplier = 3
• Goodwill = 50 × 3 = ₹150 lakh

This goodwill is allocated to existing partners in their old profit sharing ratio (Ram 40%, Krishna 60%):

• Ram: 150 × 0.40 = ₹60 lakh
• Krishna: 150 × 0.60 = ₹90 lakh

Accounting Entry for Goodwill

Goodwill (asset)        Dr  150 lakh
   To Ram’s Capital A/c         60 lakh
   To Krishna’s Capital A/c     90 lakh

(New partner Rahul does not share in this goodwill; it belongs to the original partners.)

New Partner’s Contribution and New Profit Sharing Ratio

Rahul contributes ₹50 lakh cash, credited to his capital account.

Capital balances after goodwill and new capital:

• Ram: ₹20 (initial) + ₹20.32 (profit) + ₹60 (goodwill) = ₹100.32 lakh
• Krishna: ₹30 + ₹30.48 + ₹90 = ₹150.48 lakh
• Rahul: ₹50 lakh
• Total capital: ₹300.8 lakh

The new profit sharing ratio is based on these capital balances:

$\text{Ram} = \frac{100.32}{300.8} \approx 33.35\%$ $\text{Krishna} = \frac{150.48}{300.8} \approx 50.03\%$ $\text{Rahul} = \frac{50}{300.8} \approx 16.62\%$

This ratio is used for future profit distribution (not recorded in books, only used at year‑end).

Exam tip: Goodwill is a notional asset created only in the books on admission or retirement. It is allocated to existing partners in their old ratio. The new partner’s capital is added, and the new ratio is computed from the updated capital balances.

Key takeaways

• Goodwill = average profit × agreed multiplier.
• On admission, goodwill is credited to existing partners’ capital accounts in the old profit‑sharing ratio.
• New partner contributes capital but does not share in past goodwill.
• New profit sharing ratio = proportion of each partner’s updated capital to total capital.

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Retirement of a Partner

When a partner retires, the business must be revalued again. Goodwill is recalculated based on the latest profit performance. The retiring partner’s capital account is settled (paid out), and the remaining partners adjust their goodwill and profit‑sharing ratio.

Goodwill Revaluation on Retirement

Assume Ram retires after three years. Profits: Year 1 = ₹50 lakh, Year 2 = ₹80 lakh, Year 3 = ₹140 lakh. Partners agree to value goodwill at 5 times the average profit of three years:

$\text{Average profit} = \frac{50 + 80 + 140}{3} = 90 \text{ lakh}$ $\text{Goodwill} = 90 \times 5 = \textbf{\text{Rs. }450 lakh}$

The existing goodwill (₹150 lakh from admission) is now outdated. The increase of ₹300 lakh must be recognized and shared among all three partners (including the retiring partner) in their current profit‑sharing ratio (33.33% Ram, 50% Krishna, 16.67% Rahul).

Entry to record increased goodwill:

Goodwill (asset)        Dr  300 lakh
   To Ram’s Capital A/c        100 lakh
   To Krishna’s Capital A/c    150 lakh
   To Rahul’s Capital A/c       50 lakh

Settlement of Retiring Partner

Ram’s capital account balance at retirement (accumulated):

The firm must pay ₹273.33 lakh to Ram. This payment reduces cash and extinguishes his capital.

New Profit Sharing Ratio After Retirement

After Ram retires, only Krishna and Rahul remain. The new profit sharing ratio is the proportion of Krishna’s and Rahul’s capital after all adjustments.

Key takeaways

• On retirement, goodwill is revalued using current/historical profits and a multiplier.
• The increase in goodwill is shared among all current partners in their existing profit‑sharing ratio.
• The retiring partner’s final capital includes initial capital, accumulated profits, and goodwill shares.
• The remaining partners’ capital balances form the basis for the new profit‑sharing ratio.

Exam tip: Goodwill revaluation entries are only made when a partner joins or leaves. The multiplier and profit‑sharing ratio are crucial—check whether the problem uses average profit or last year’s profit, and whether the multiplier is given.

Retirement of a Partner

When a partner leaves the firm (retirement), the partnership must settle the outgoing partner's entire claim. This involves revaluing goodwill (which often has grown as the business matured), distributing any increase among all partners, and then paying the retiring partner. After that, the remaining partners revise their profit-sharing ratio (PSR) based on their updated capital.

The process mirrors admission of a partner – with the key difference that the retiring partner is being bought out, not buying in.

The Retirement Process

1. Revalue goodwill using the agreed method (e.g., average profit × multiplier). Only the incremental goodwill (new value − already recorded goodwill) is recorded to avoid double-counting.
2. Distribute incremental goodwill among all partners (including the retiring one) in the current profit-sharing ratio. This credits each partner's capital with their share of the increase.
3. Compute the retiring partner's total claim = their capital account + current account + share of the revalued goodwill (including the increment).
4. Pay the retiring partner – typically in cash. The firm's cash decreases, and the retiring partner's capital is reduced to zero.
5. Revise the PSR for the remaining partners. One common method: base it on the proportion of their updated capital balances.

Worked Example

Background: Firm has three partners: Ram, Krishna, and Rahul. Their PSR is ≈ 33.35% : 50.03% : 16.62%. At the end of Year 3, Ram retires. The business has been running for 3 years. Goodwill was already recorded at ₹150 lakh (from Year 1).

Step 1 – Goodwill Revaluation Profits for years 1–3: ₹50 lakh, ₹80 lakh, ₹140 lakh.

$\text{Average profit} = \frac{50 + 80 + 140}{3} = 90 \text{ lakh}$

The partners agree to use a multiplier of 5 (up from 3, because the business is older, has more customers and brand value – analogous to a rising P/E ratio in stocks).

$\text{New goodwill} = 90 \times 5 = 450 \text{ lakh}$

$\text{Incremental goodwill} = 450 - 150 = 300 \text{ lakh}$

Step 2 – Distribute Incremental Goodwill in Current PSR

(Figures are rounded; total ₹300 lakh.)

Step 3 – Ram’s Total Claim After distributing all profits of years 2 and 3 and the goodwill increment, Ram’s equity (capital + current account) stands at ₹273.75 lakh. This is the amount the firm must pay him.

Step 4 – Payment Cash before payment: ₹355 lakh. Cash paid to Ram: ₹273.75 lakh. Cash after payment: ₹355 − 273.75 = ₹81.25 lakh. Ram’s capital becomes ₹0.

Step 5 – Revise Profit-Sharing Ratio Remaining partners’ capital balances:

• Krishna: ₹410.62 lakh
• Rahul: ₹136.44 lakh
• Total: ₹547.06 lakh

New PSR (based on capital proportion):

• Krishna: $\frac{410.62}{547.06} \approx 75.06\%$
• Rahul: $\frac{136.44}{547.06} \approx 24.94\%$

Exam tip: The retiring partner’s share of the incremental goodwill must be added to their capital before computing the final payout. A common mistake is to use the old goodwill without revaluing – this understates the retiring partner’s claim.

When is Goodwill Revalued?

Goodwill is not revalued every year. Revaluation occurs only when there is a change in the partnership structure – admission of a new partner or retirement of an existing partner. The multiplier (or valuation method) may change over time as the business matures.

Key Takeaways

• Retirement triggers a full goodwill revaluation; only the incremental portion is recorded.
• The incremental goodwill is distributed to all partners (including the retiring one) in the existing PSR.
• The retiring partner’s total claim = their accumulated capital + current account + share of the revalued goodwill.
• Payment reduces cash; the retiring partner’s capital is eliminated.
• Remaining partners derive a new PSR – often based on the proportion of their updated capital balances.
• Goodwill is not revalued between partner changes – only at admission or retirement.

Company Accounts – Share Capital, Premium, and Forfeiture

In a company form of business, capital is raised by issuing shares to shareholders. Unlike sole proprietorship or partnership, accountants do not maintain individual capital accounts for each owner. Instead, a single Share Capital account aggregates all contributions. Profits are not added to Share Capital; they are recorded separately (e.g., retained earnings). A critical feature unique to companies is the ability to issue shares at a premium – an amount above the face value – and to forfeit shares when shareholders fail to pay calls.

Key Concepts

1. Share Capital vs. Share Premium

• Share Capital: The amount collected equal to the face value (par value) of the shares. It represents the legal capital of the company.
• Share Premium: Any amount collected above the face value. It reflects the extra value investors are willing to pay because the company is performing well or has strong prospects. Share premium is recorded in a separate Share Premium Account (a reserve).

Intuition: If a company’s existing value per share is ₹100 and the face value is ₹10, a new investor must pay ₹90 extra – the premium – to obtain the same ownership stake. This mirrors partnership adjustments (e.g., a new partner contributing more than the proportionate capital).

2. Stages of Share Issue (Example: Alpha Limited)

Alpha Limited, incorporated 1 Jan 2015, had promoter’s capital of ₹50 crore. For expansion, it issued 100 lakh equity shares (face value ₹10, premium ₹90, total ₹100 per share). Payment was collected in three stages:

3. Oversubscription and Refund

Investors applied for 400 lakh shares (4× oversubscribed). The company could only allot 100 lakh shares. The application money (₹5 per share) for the excess 300 lakh shares was returned.

Accounting Using the Accounting Equation

The accounting equation: Assets (Cash) = Liabilities + Equity (Share Capital + Share Premium + Capital Reserve)

Record each transaction step by step:

1. Promoter contribution (₹5,000 lakh = ₹50 crore)

   • Cash +5,000
   • Share Capital +5,000

2. Application money received from public (400 lakh × ₹5 = ₹2,000 lakh)

   • Cash +2,000
   • (Liability for refund appears, but treated as Share Capital for allottees and liability for excess)

3. Allotment of shares to 100 lakh applicants

   • For the 100 lakh allottees: ₹5×100 = ₹500 is recorded as Share Capital (already in from step 2)
   • For the 300 lakh excess: Return ₹1,500 (₹5×300) → Cash –1,500, Liability –1,500

4. Allotment money received (100 lakh × ₹45 = ₹4,500 lakh) – all to Share Premium

   • Cash +4,500
   • Share Premium +4,500

5. First call money received (only 95 lakh shareholders paid ₹50 = ₹4,750 lakh)

   • Cash +4,750
   • Share Capital +475 (95 lakh × ₹5)
   • Share Premium +4,275 (95 lakh × ₹45)

6. Forfeiture of 5 lakh shares (unpaid first call) These shareholders had paid only application (₹5) and allotment (₹45) – total ₹50 per share. They lose the entire amount.

   Remove their contributions:

   • Share Capital –25 (5 lakh × ₹5)
   • Share Premium –225 (5 lakh × ₹45)

   The accounting equation becomes unbalanced by –250. This amount is the gain from forfeiture – money received but shares cancelled. To balance, a new account is created:

   • Capital Reserve +250

7. Final accounting equation after forfeiture:

(Check: 5,950 + 8,550 + 250 = 14,750)

Forfeiture and Reissue

• Forfeiture means the company cancels the shares of defaulting shareholders. No refund.
• The amount forfeited (application + allotment money) is transferred to Capital Reserve – a capital gain not from regular business.
• Forfeited shares can be reissued later. Upon reissue:
  • The face value (₹10 per share) is credited to Share Capital.
  • Any excess over face (premium) goes to Share Premium.

Exam tip: – Forfeiture always creates a Capital Reserve equal to the amount previously paid by the defaulting shareholder (application + allotment). – Share Premium is only recorded when money is actually received above face value. Allotment and call premiums are accounted separately.

Key Takeaways

• Company accounts treat shareholders collectively – one Share Capital account and one Share Premium account.
• Share Premium arises when shares are issued above face value. It is a reserve, not part of legal capital.
• Oversubscription leads to refund of excess application money; only allotted shares’ proceeds are kept.
• Forfeiture cancels shares for non-payment; the amount already received is transferred to Capital Reserve – a capital profit.
• The accounting equation always balances: forfeiture reduces Share Capital and Share Premium, and increases Capital Reserve by the same net amount.
• Reissued shares re-enter the same accounts (Share Capital at face, any premium to Share Premium).

The Need for Adjustment Entries

Before preparing final financial statements, adjustment entries are required to record transactions that have occurred but have not yet been captured in the ledger. Without these entries, the business’s true financial position cannot be known. Adjustments ensure that revenues and expenses are recognised in the correct accounting period (accrual basis) and that assets, liabilities, and equity are accurately stated.

Exam tip: The phrase “without adjustment entries, we will not know the true financial position” is a high‑yield justification – frequently tested in conceptual questions.

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Classification of Adjustment Entries

Adjustment entries are broadly classified into four categories based on the nature of the account affected:

Intuition: Adjustments align book records with economic reality – recognising income earned but not yet received, or expenses incurred but not yet paid.

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Impact of Adjustment Entries

• In most routine cases, the impact on net income and balance sheet values is not significant.
• However, in certain situations (e.g., large unrecorded liabilities, material prepayments), the effect can be significant – and must be handled carefully to avoid misstatement.

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Financial Statement Preparation and Format

Once all transactions are recorded and adjustment entries are passed, the preparation of financial statements becomes straightforward.

• Companies must follow a format provided under the law (e.g., Schedule III of the Companies Act in India).
• Regulators prescribe the format to ensure comparability across different companies.
• The two primary statements covered in this module are the Profit and Loss Account and the Balance Sheet.

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Cash Flow Statement – Direct Method

The module introduces the cash flow statement and focuses on the direct method of preparation.

• The direct method presents operating cash receipts and payments in a straightforward line‑by‑line format.
• It is considered simple and easy to understand relative to the indirect method.

Note: The module does not elaborate on the rules for classifying cash flows or the indirect method – only the direct method format was discussed.

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Important Entries for Partnership Firms and Companies

The module concludes by covering a few essential journal entries specific to:

• Partnership firms (e.g., capital accounts, drawings, interest on capital, profit‑sharing adjustments).
• Company form of organisation (e.g., issue of shares, debentures, payment of dividends, statutory reserves).

These entries build on the adjustment‑entry concepts and extend them to the particular legal structures of partnerships and companies.

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Key takeaways (whole sub‑section)

• Adjustment entries are mandatory to show the true financial position under accrual accounting.
• They affect revenue, expenses, assets, liabilities, and equity – though often with small impact, material cases require attention.
• Financial statements must adhere to a legal format for comparability.
• The cash flow statement using the direct method is simple and was covered in the module.
• Special entries for partnerships and companies were introduced to illustrate how basic adjustments apply in different organisational forms.