INTRODUCTION

You, either as an executive or an interested party while dealing with other business firms,
would obviously be interested in knowing their financial health. For the purpose, one
such financial statement usually referred to is Balance Sheet. Balance Sheet has two
sides - liabilities payable and assets owned. The total of these two sides is always equal.
If it is so, how can one judge that the financial health of one business firm/company is
better/more sound than the other? Given innumerable transactions, how does it happen
that two sides of balance sheet always tally? These are myths among beginners of the
subject of Accounting and Finance. The subject matter of this chapter is designed to
provide answers to these and other perplexing questions.
To understand the subject, consider how you deal with money. There is no deep
understanding of accounting is required to know that Cash Inflows are Receipts and Cash
Outflows are Payments; Sales generate Revenues/Incomes; and expenses are incurred to
run the business.
BALANCE SHEET
Balance sheet is a position statement that shows financial position in terms of assets
(resources owned) and liabilities owed (sources of financing the assets). If you have
purchase a Honda City for ₹ 1200,000 on loan. Your status would be that you own an
asset in form of car worth ₹ 1200,000; at the same time you owe a liability to repay a loan
of ₹ 1200,000. Balance stake is a stock statement and reflect the position at a point of
time. Any further even with change the composition of assets and liabilities, however
total of assets and liabilities would remains same.

Example 1.1 Let us assume that a private limited company has been formed (with name
Royal Industries) by a group of 10 friends (each contributing Rs 3 lakh in cash) on Ist
June, in current year. As a result of this transaction, the company’s balance sheet would
appear as follows:
Balance Sheet of Royal Industries as at June 1, Current Year
Liabilities Amount (Rs) Assets Amount (Rs)
Capital 30,00,000 Cash 30,00,000
30,00,000 30,00,000
 Common-sense suggests that cash should appear on assets side. But we are to find
an answer why capital is shown on liabilities side. For accounting purposes, a
company/business firm is considered as an entity separate from its owners/promoters
(known as Principle of Separate Entity). This principle requires that every business
transaction is to be viewed from the perspective of the firm and not from the point of view
of owners. It is for this reason, therefore, that the capital represents liability for the
company (conceptually, company has obligation to pay back to the owners). In absence
of this principle, we shall be constrained to determine true income (or loss) of a business
firm as there will be no record either of capital bought in by the owner(s) or withdrawals
(in cash off and on) made by them.
Let us assume further that out of Rs 30 lakh, Rs 20 lakh is deposited in a bank on
2nd June by Royal Industries. As a result of this transaction, it is imperative that cash
balance will reduce to Rs 10 lakh and new item ‘Bank Balance’ will appear on the assets
side.

Balance Sheet of Royal Industries as at June 2, Current Year

Liabilities Amount (Rs) Assets Amount (Rs)
Capital Rs 30,00,000 Cash 10,00,000
Bank Balance 20,00,000
30,00,000 30,00,000

Assume further the company purchases goods worth Rs 6 lakh against cash
payment on 4th June (Being a new firm, the supplier will not sell on credit; he may not
accept cheque either). Evidently, cash reduces to Rs 4 lakh (Rs 10 lakh – Rs 6 lakh) and a
new asset in the form of ‘Stock of Finished Goods’ would appear in balance sheet.

Balance Sheet of Royal Industries as at June 4, Current Year

Liabilities Amount (Rs) Assets Amount (Rs)
Capital Rs 30,00,000 Cash 4,00,000
Bank Balance 20,00,000
 Stock (Finished Goods) 6,00,000
30,00,000 30,00,000

Do you not find things simple? What happens in our personal life to our cash
balance, the same holds true for the business records. Cash balance gets reduced when it
is spent. Please note that no change has taken place in bank balance (as the firm has
neither deposited into bank nor withdrawn) or in capital account. Two sides of balance
sheet again tally; change is in composition of assets only. This equality will always exist
unless the mistake has been committed by the accountant. In operational terms, it implies
that every business transaction has two fold effects (known as principle of duality /
double entry). The treatment of additional transactions shown in this example will further
re-inforce this contention.
During 5-8th June, Royal Industries has cash sales of Rs 5,00,000 (for goods
costing Rs 4,00,000). Evidently, there is decrease of stock by Rs 4,00,000 (cost price) and
increase in cash by Rs 5,00,000 (selling price). The difference between sales revenue and
cost (that is of Rs 1,00,000) is Profit. As per separate entity concept, profits are payable
to owners and, hence, liabilities of the company.

Balance Sheet of Royal Industries as at June 8, Current Year

Liabilities Amount (Rs) Assets Amount (Rs)
Capital Rs 30,00,000 Cash 9,00,000
Profits 1,00,000 Bank Balance 20,00,000
Stock (Finished Goods) 2,00,000
31,00,000 31,00,000

Let us suppose further that the company decides to venture into its own
manufacturing activity. For the purpose, the company buys a small industrial shed
(Building) for Rs 8 lakh and machinery for Rs 10 lakh. The payment is made through
cheque on 15th June. As a result, the balance sheet would be (please try on your own to
draw it) as follows:
Balance Sheet of Royal Industries as at June 15, Current Year
Liabilities Amount (Rs) Assets Amount
(Rs)
Capital Rs 30,00,000 Cash 9,00,000
Profits 1,00,000 Bank Balance 2,00,000
Stock (Finished Goods) 2,00,000
Building/Shed 8,00,000
Machinery 10,00,000
31,00,000 31,00,000

It is important to note that composition of balance sheet undergoes change with

every business transaction (not necessarily in terms of gross total). Thus, in a way,
balance sheet is a snapshot of financial position (in terms of assets owned and liabilities
owed) of a firm at a particular point of time, say as at June 15; it is valid for that
reference date/day only; its position is bound to change on the following day as soon as a
new business transaction takes place.
Now assume that Royal Industries is relatively known entity and suppliers of
goods/raw materials are willing to transact business on credit basis. It purchases raw
material worth Rs 3 lakh from Reliable Suppliers on credit (on 18th June). This
transaction will be recorded in the name of ‘Stock (Raw Materials)’ on the assets side and
since the sum is payable after the expiry of credit period (say 30 days) to Reliable
Suppliers (at a subsequent date), will be shown on liabilities side and two sides will tally
as per principle of duality. (Please try to prepare balance sheet on your own).
Let us expand example further. Company is optimistic of business growth. To
finance expansion, it estimates additional requirement of Rs 10 lakh; it negotiates 14%
loan (for 3 years) from State Financial Corporation against the mortgage of building and
machinery and obtains cheque on 25th June.

Balance Sheet of Royal Industries as at June 25, Current Year

Liabilities Amount (Rs) Assets Amount (Rs)
Capital 30,00,000 Cash 9,00,000
Profits 1,00,000 Bank Balance* 12,00,000
Reliable Suppliers (Creditors)*** 3,00,000 Stock (Finished Goods) 2,00,000
14% Loan 10,00,000 Stock (Raw Material) 3,00,000
Building** 8,00,000
Machinery** 10,00,000
44,00,000 44,00,000
* Is higher by the sum received from State Financial Corporation
**Ownership continues with Royal Industries.
*** As the sum is payable, Reliable Suppliers are creditors.
This balance sheet is the most comprehensive we have drawn hitherto. It indicates
that the firm owns assets worth Rs 44 lakh and there are two sources of financing these
assets, namely, owners (Rs 31 lakh) and outsiders (creditors and lenders (Rs 13 lakh).
Being so, another useful way of visualising balance sheet is that it is a statement of
Sources (from where finances have been raised) and Resources (in which money has
been invested). Evidently, sources (being payable) are liabilities and resources (being the
ownership of firm) are assets.
In Accounting, liabilities can be bifurcated into two broad categories: (i) internal
liabilities (more commonly known as Owners’ equities = Capital + Profits) and (ii)
external liabilities (consisting of contribution made by creditors and lenders towards
financing assets of a firm).
Accordingly, there can be more than one way of presenting two sides of balance
sheet. Three plausible ways conceived in this regard are as follows:

(1) Liabilities = Assets (1.1)

(2) Sources = Resources (1.2)
(3) Owners’ equity* + Liabilities** = Assets (1.3)
* means stake/claims of owners in assets.
** obviously representing external obligations or external equities.

Likewise, a business transaction can assume the shape in any one of the four possible
ways:

(1) Increase in Liability, followed by increase in Asset.

 (2) Decrease in Liability, followed by decrease in Asset.
(3) Increase in one Liability and decrease in another Liability.
(4) Increase in one Asset and decrease in another Asset.

Equations 1.1 to 1.3 are more popularly known as Fundamental Accounting Equations.
Being more informative, Accounting Equation 1.3 should be preferred.
Continuing with example of Royal Industries, let us assume that the whole stock
of finished goods (costing Rs 2 lakh) has been sold on 45 days credit (on 27th June) for
Rs 2,60,000 to Solvent Buyers & Company. Consequently, profits will increase by Rs
60,000 (Rs 2,60,000 – Rs 2,00,000); other changes in balance sheet (B/S) will appear as
follows:
Balance Sheet of Royal Industries as at June 27, Current Year.
Owners’ Equity &Liabilities Amount (Rs) Assets Amount (Rs)
Capital 30,00,000 Cash 9,00,000
Profits (Rs 1,00,000 + Rs 60,000) 1,60,000 Bank Balance 12,00,000
Reliable Suppliers (Creditors) 3,00,000 Solvent Buyers & Co. (Debtor)* 2,60,000
14% Loan 10,00,000 Stock (Raw Materials) 3,00,000
Building 8,00,000
Machinery 10,00,000
44,60,000 44,60,000

*As the sum is receivable, Solvent Buyers & Co. is debtor.

During 28-30th June, Royal Industries has incurred (and paid in cash) the following
expenses:
Salaries Rs 30,000
Rent of the shop 10,000
Electricity 2,000
Stationary 2,000
Refreshments 3,000
Telephone, postage and courier charges 1,000
 Miscellaneous expenses 2,000
Total expenses 50,000

As profits are liabilities (as per separate entity concept), by the virtue of the same
principle, expenses (and so the losses) are assets of the firm as they are claims of the
company on owners. Expenses are to be borne by owners. As a matter of fact, profit
figure to be taken in B/S should be net of expenses (and, in practice, it is that way only).
Evidently, profit figure shown in B/S is at inflated value. In accounting, it is
known as gross profit (Selling Price minus Cost of Goods Sold). Since expenses reduce
gross profit, net profit for Royal Industries will be (Rs 1,60,000 – Rs 50,000) Rs
1,10,000.

Balance Sheet of Royal Industries as at June, 30, Current Year

Owners’ Equity &Liabilities Amount (Rs) Assets Amount (Rs)
Capital 30,00,000 Cash (Rs 9,00,000 – Rs 50,000) 8,50,000
Net Profit (Rs 1,60,000 - Rs 50,000) 1,10,000 Bank Balance 12,00,000
Reliable Suppliers (Creditors) 3,00,000 Solvent Buyers & Co. 2,60,000
14% Loan 10,00,000 Stock (Raw Materials) 3,00,000
Buildings 8,00,000
Machinery 10,00,000
44,10,000 44,10,000

Thus, assets consist of cash, bank balance and similar other valuable resources owned by
a business firm (say buildings, machinery) or for which it has a legal right to receive (say
debtors) from others.

PROFIT AND LOSS ACCOUNT

In example related to Royal Industries, the effect of every business transaction
was shown by drawing a ‘new’ balance sheet each time. In practice, it just does not
happen; B/S is not prepared on daily basis (It is drawn after some reasonable period of
time say a month, quarter, half year or a year). Moreover, it is not practical to do so. In a
day, there may be numerous sales transactions; it may not be practically feasible to
determine profit earned (or loss suffered) on each sales transaction. Above all, this modus
operandi destroys the earlier set of data. Whereas the owners and others (in fact,
mandatory for Income tax purposes) will be interested in access to the full set of data,
inter-alia, to comprehend financial health. And, therefore, it is not desirable also.
From the above, it is imperative that there is a need of an account/a statement
which provides full account/description of all the items affecting profit of a business firm.
Such a statement which meets this requirement is known as an Income Statement/Profit
& Loss Account.
Profit & Loss (abbreviated to P&L) Account/Income Statement reports the
revenues and expenses of a firm of an accounting period.
In broad terms, Revenues, as the name suggests, are incomes which mainly accrue
to the firm either by the sale of goods and services or by investing the resources of the
firm outside. In contrast, Expenses are costs incurred in realising/earning revenues. Thus,
P&L Account is concerned with matching of the revenues of a certain specified period
with the expenses of that period; more is the accuracy of this matching procedure/system,
more correct is the income determination. In other words, preparation of profit and loss
account is based on Matching Principle.
Let us attempt to prepare P&L Account of Royal Industries for the month of June.
Since this account represents items related to revenues and expenses of a firm, this
account, obviously is required to have two sides: one revenue side (by convention right
side of P&L A/c) and another expenses (left side).
Profit and Loss Account of Royal Industries for June, Current Year
Expenses Amount (Rs) Revenues Amount (Rs)
Cost of goods sold (equivalent to cost of goods 6,00,000 Sales revenue 7,60,000
purchased and sold)
Gross Profit 1,60,000
7,60,000 7,60,000
Salaries 30,000 Gross profit 1,60,000
Rent of the shop 10,000
Electricity 2,000
Stationary 2,000
Refreshments 3,000
Telephone, postage and courier charges 1,000
Miscellaneous expenses 2,000
Net profit 1,10,000
1,60,000 1,60,000

From the foregoing, it is apparent that P&L A/c provides a candid and condensed
summary of all revenues and expenses of a firm (for a specified period) at one place. The
perusal of this account provides a crystal bird’s eye-view to the owners’ and others, the
way net profit of Rs 1,10,000 has been earned; it may be recalled that such clear-cut
picture was not plausible in balance sheet. In fact, B/S is not intended to provide the
same.
Thus, income statement constitutes another significant financial statement of a
business firm. It is an important supplement to B/S. In fact, there exists an inter-locking
relationship between the two. P&L A/c provides summary figure of all items related to
revenues and expenses of a firm in terms of net profit (Revenues > Expenses) or net loss
(Expenses > Revenues) to B/S. Evidently, but for net profit/ net loss amount, two sides of
B/S will not balance. In operational terms, net profit (loss) is a link-pin between P&L A/c
and B/S.
Again, the tallying of two sides of B/S perplexes the beginner. He wonders how
such a thing happens with innumerable transactions of revenues and expenses. Separate
entity concept of accounting provides explanation. As per the concept, revenues (since
payable to owners) will augment owners’ equity/capital and expenses (since receivable
from owners) will cause decrease in it. As a result, surplus (profit) or deficiency (loss) (as
per the situation) is transferred to capital account. Let us explain this in the context of
Royal Industries.
Capital (Ist June) Rs 30,00,000
Add Sales Revenues (during June) 7,60,000
Less Expenses (during June) (6,50,000)
Capital (effective)/Owners equity (June-end) (including profit of Rs 1,10,000) 31,10,000