Balance Sheet and Profit and Loss Account
In this series of articles we will also talk about:
1. Balance sheet explained
2. Trading Account and Profit and Loss
3. Final Account Adjustments
Previously, in discussing the basic accounting equation, it was noted that A – L = P, where A represents the assets (ownership and possession) owned by the business; L represents liabilities (claims against the business from creditors) and P represents the owner’s funds (equity) in the business.
Income Accounting Concept
The concept of ‘income’ is different to economists and accountants. Economists’ concept of income is that of ‘real income’, that is, the increase in real terms of property funds between two moments.
In accounting, the term income is known as ‘net profit’. It was said before:
Sales – Cost of Marketing = Gross Profit and Gross Profit – Expenses of Doing Business = Net Profit
In other words, Income – Expenses = Net Profit.
These terms are explained below:
Returned
It is the monetary value of products sold or services provided to customers during the period. It is the result of sales services and sources such as interest, dividends and commissions, etc. For example, the sales affected by the business and the charge made for the services provided by the business constitute income. However, not all cash receipts may be returned.
Therefore, the borrowed money gives rise to the receipt of cash, but does not constitute income. Similarly, the additional contributed capital increases the owner’s funds, but it is not income.
Expenses/Cost of (doing business)
Expenses incurred by the company to earn income are called expenses or costs of doing business. Examples of expenses are raw materials consumed, wages, rent, depreciation, advertising, etc.
Cash vs. accrual basis of accounting (or accrual)
Small businesses, individual professionals, and non-commercial businesses generally adopt cash accounting. Under this system, income is considered earned only when it is received in cash and expenses are considered incurred only when actually paid. Therefore, under this system, the profit or loss of an accounting period is the difference between the income received and the expenses paid. Although the cash basis of accounting is simple (no adjustment required), it loses its comparability.
On an accrual basis, all income is credited to the period in which it was earned, regardless of whether or not it was received. Likewise, all expenses are charged to the period in which they are incurred, regardless of whether they are paid or not. It is a scientific basis of accounting, although a bit difficult.
Coincidence concept. It requires that the expenses correspond to the income of the corresponding accounting period. So, we need to determine what is the revenue earned during a particular accounting period and the expenses incurred to earn this revenue.
It is the concept of consistency that justifies accrual accounting.
Accruals and deferrals
Accounting is expected to measure or determine the net income of the business during the accounting period. Normally it is the calendar year (from January 1 to December 31) but in other cases it can be the fiscal year (from April 1 to March 31) or any other period according to the convention of the business community in the area.
The combined impact of the reconciliation concept and the accounting period concept in accounting has led to accruals and deferrals.
Accumulated or pending expenses
It is the term that denotes that an expense has been incurred during the accounting period but has not been paid in cash, for example, salary, rent, salary, etc. due but not paid.
Deferred or prepaid expenses
It is the term that denotes that the cash payment has been made “in advance, but the full benefit of this payment has not been reaped in the current accounting period, for example, Insurance paid in advance.
Earned or pending income
It is the term that denotes that the income has been obtained but the cash against it has not been received. Income due but not received has been accrued, for example, interest on investments, etc.
Earnings deferred or received in advance
It is the term that denotes income that has been received (in cash) in advance but has not been earned so far, for example, rent received in advance. All accruals and deferrals are not adjusted at the end of the accounting period (period-end adjustments) to find out the company’s income for the period under review. The procedure to determine (i) the income of the business and (ii) the financial situation is described in detail below:
In fact, these are the two most important of many accounting goals. To know the profits obtained by him, he prepares an operations and loss account and to know the financial position of his business on the last day of the financial year, he prepares a balance sheet.
Such accounts are called ‘Final Accounts’. The preparation of the final accounts is the final step of the accounting cycle. In fact, the final accounts include various accounts (i) Manufacturing/Production Account, (ii) Trading Account, (iii) Profit and Loss Account and (iv) Balance Sheet.
Practically the balance is a statement of account but for accounting purposes here it is treated as part of the vital accounts.
The preparation of all or any of the above accounts depends on the nature of the business that the business in question carries on. In the case of a manufacturing company, the manufacturing account, trading account, profit and loss account, and balance sheet form the parts of the ending accounts, while in the case of trading company, all other accounts are prepared with the exception of the manufacturing account. Each of these accounts provides specific vital information for the entrepreneur to help control and organize business activities in a better way.
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