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Financial Statements - I

NCERT Class 11 · Accountancy Based on NCERT Class 11 Accountancy textbook · Free CBSE study kit

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Chapter Notes

Overview
This chapter explains the preparation of financial statements—Trading and Profit & Loss Account and Balance Sheet—for a sole proprietorship firm. It covers the distinction between capital and revenue items, the needs of various stakeholders, and the concepts of gross profit, net profit, and operating profit. The big idea is that financial statements provide a true and fair view of a business's financial performance and position, and correct classification of items is essential for accurate profit calculation.
Key Concepts (20)
Stakeholder
Any person associated with the business, whose stakes can be monetary or non-monetary, active or passive, direct or indirect.
e.g. Owner (monetary stake), Government (non-monetary stake).
Expenditure
Payment and/or incurrence of an outlay made for a purpose other than the settlement of an existing liability.
e.g. Payment of salaries, purchase of furniture.
Revenue Expenditure
Expenditure whose benefit extends up to one accounting period, incurred for day-to-day conduct of business.
e.g. Salaries paid, rent paid.
Capital Expenditure
Expenditure whose benefit extends more than one accounting period, incurred to acquire fixed assets or make additions/extensions.
e.g. Payment to acquire furniture for use in business.
Deferred Revenue Expenditure
Revenue expenditure that is likely to give benefit for more than one accounting period, written off over its expected period of benefit.
e.g. Heavy advertising expenditure.
Revenue Receipt
A receipt that does not incur an obligation to return the money and is not from sale of a fixed asset.
e.g. Sales made by the firm, interest on investment received.
Capital Receipt
A receipt that implies an obligation to return the money or is from sale of a fixed asset.
e.g. Additional capital brought in by owner, loan taken from bank, sale of old machinery.
Gross Profit
Excess of sales over purchases and direct expenses, representing the result from basic operational activities.
e.g. Sales ₹1,25,000 minus (Purchases ₹75,000 + Wages ₹8,000) = Gross Profit ₹42,000.
Net Profit
Excess of gross profit plus other incomes over indirect expenses.
e.g. Gross Profit ₹42,000 + Commission ₹5,000 minus (Salaries ₹25,000 + Rent ₹13,000 + Bad debts ₹4,500) = Net Profit ₹4,500.
Operating Profit (EBIT)
Profit earned through normal operations and activities of the business, calculated as Net Profit + Non-Operating Expenses – Non-Operating Incomes.
e.g. Net Profit ₹19,000 + Interest ₹500 – nil = Operating Profit ₹19,500.
Closing Stock
Unsold goods in hand at the end of the accounting period, valued at cost or market price whichever is lower.
e.g. Goods costing ₹15,000 unsold at year-end.
Cost of Goods Sold (COGS)
Opening Stock + Purchases + Direct Expenses – Closing Stock.
e.g. Opening Stock ₹3,00,000 + Purchases ₹15,00,000 + Freight ₹1,00,000 + Wages ₹1,00,000 – Closing Stock ₹4,00,000 = COGS ₹16,00,000.
Marshalling
Arrangement of assets and liabilities in a particular order, either in order of liquidity or permanence.
e.g. In order of permanence: Furniture first, then Debtors, Bank, Cash. In order of liquidity: Cash first, then Bank, Debtors, Furniture.
Grouping
Putting together items of similar nature under a common heading.
e.g. Cash, Bank, Debtors grouped under 'Current Assets'; Furniture under 'Non-Current Assets'.
Current Assets
Assets either in the form of cash or can be converted into cash within a year.
e.g. Cash in hand, bank, bills receivable, stock, sundry debtors, prepaid expenses.
Current Liabilities
Liabilities expected to be paid within a year, usually out of current assets.
e.g. Bank overdraft, bills payable, sundry creditors, short-term loans, outstanding expenses.
Fixed Assets
Assets held on a long-term basis, not acquired for resale.
e.g. Land, building, plant and machinery, furniture and fixtures.
Intangible Assets
Assets which cannot be seen or touched.
e.g. Goodwill, patents, trademarks.
Drawings
Amount withdrawn by the proprietor, reducing the capital account balance.
e.g. Proprietor withdraws ₹2,000 for personal use.
Opening Entry
Journal entry made at the beginning of the next year to bring forward the balances of assets, liabilities, and capital from the previous year.
e.g. Debit all assets, credit all liabilities and capital.
Formulas & Equations (4)
Gross Profit = Sales – (Purchases + Direct Expenses)
Reads as: Gross profit equals sales minus the sum of purchases and direct expenses.
Variables: Sales = total revenue from goods sold (₹); Purchases = cost of goods bought for resale (₹); Direct Expenses = expenses directly connected with manufacture/purchase (e.g., wages, carriage inwards) (₹)
Use when: Calculating gross profit from trading account when there is no opening or closing stock.
⚠ Students forget to deduct direct expenses like wages and carriage inwards from sales, or they include indirect expenses like salaries.
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
Reads as: Cost of goods sold equals opening stock plus purchases plus direct expenses minus closing stock.
Variables: Opening Stock = stock at beginning of year (₹); Purchases = net purchases after returns (₹); Direct Expenses = e.g., wages, freight inwards (₹); Closing Stock = stock at end of year (₹)
Use when: Calculating cost of goods sold when opening and closing stock exist.
⚠ Students omit opening stock or add closing stock instead of subtracting it.
Net Profit = Gross Profit + Other Incomes – Indirect Expenses
Reads as: Net profit equals gross profit plus other incomes minus indirect expenses.
Variables: Gross Profit = from trading account (₹); Other Incomes = e.g., commission received, interest received (₹); Indirect Expenses = e.g., salaries, rent, bad debts (₹)
Use when: Calculating net profit in the profit and loss account.
⚠ Students include direct expenses like wages in the profit and loss account instead of trading account.
Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Incomes
Reads as: Operating profit equals net profit plus non-operating expenses minus non-operating incomes.
Variables: Net Profit = from profit and loss account (₹); Non-Operating Expenses = e.g., interest on loan, loss on sale of asset (₹); Non-Operating Incomes = e.g., profit on sale of investment, dividend received (₹)
Use when: Calculating operating profit (EBIT) for analysis of core business performance.
⚠ Students forget to add back non-operating expenses or subtract non-operating incomes, or they include abnormal items like loss by fire incorrectly.
How It Works
Preparation of Trading and Profit & Loss Account
  1. Step 1: Transfer all revenue and expense accounts from the trial balance to the trading and profit & loss account using closing entries.
  2. Step 2: On the debit side of trading account, record opening stock, purchases (net of returns), and direct expenses (e.g., wages, carriage inwards).
  3. Step 3: On the credit side of trading account, record sales (net of returns) and closing stock (via closing stock entry).
  4. Step 4: Calculate gross profit (credit side total minus debit side total) and transfer it to the credit side of profit & loss account.
  5. Step 5: On the debit side of profit & loss account, record all indirect expenses (e.g., salaries, rent, bad debts, interest).
  6. Step 6: On the credit side of profit & loss account, record all other incomes (e.g., commission received, interest received).
  7. Step 7: Calculate net profit (credit side total minus debit side total) and transfer it to the capital account in the balance sheet.
💡 Closing stock does not normally appear in the trial balance; it is brought into books with the entry: Closing Stock A/c Dr. To Trading A/c.
Preparation of Balance Sheet
  1. Step 1: Identify all accounts from the trial balance that have NOT been transferred to the trading and profit & loss account (i.e., assets, liabilities, and capital).
  2. Step 2: List liabilities (including capital) on the left side and assets on the right side.
  3. Step 3: Add net profit (or subtract net loss) to the capital account.
  4. Step 4: Arrange assets and liabilities in a particular order (marshalling) — either in order of permanence or liquidity.
  5. Step 5: Group similar items under common headings (e.g., current assets, fixed assets, current liabilities, long-term liabilities).
  6. Step 6: Ensure the total of liabilities side equals the total of assets side.
💡 The balance sheet is a statement, not an account. It shows the financial position at a given date, not for a period.
Distinction between Capital and Revenue Items
  1. Step 1: Determine the nature of the expenditure or receipt.
  2. Step 2: If the benefit extends beyond one accounting period, classify as capital; if benefit is only for the current period, classify as revenue.
  3. Step 3: Capital items (expenditure and receipts) are shown in the balance sheet; revenue items are shown in the trading and profit & loss account.
  4. Step 4: For deferred revenue expenditure, treat like capital expenditure and write off over expected benefit period.
💡 Wrong classification leads to incorrect profit calculation. For example, treating repairs (revenue) as capital expenditure overstates profit and understates expenses.
Closing Entries
  1. Step 1: Close all direct expense accounts (e.g., purchases, wages) by debiting Trading A/c and crediting each expense account.
  2. Step 2: Close sales account by debiting Sales A/c and crediting Trading A/c.
  3. Step 3: Close indirect expense accounts (e.g., salaries, rent) by debiting Profit & Loss A/c and crediting each expense account.
  4. Step 4: Close income accounts (e.g., commission received) by debiting each income account and crediting Profit & Loss A/c.
  5. Step 5: Transfer net profit by debiting Profit & Loss A/c and crediting Capital A/c (or reverse for net loss).
💡 Closing entries are recorded in the journal proper and then posted to ledger accounts to bring their balances to zero.
Exam Traps — Don't Make These Mistakes
⚠ Treating wages as indirect expense
✗ Students often put wages in the profit and loss account as an indirect expense.
→ Wages are a direct expense related to production/manufacturing and must be debited to the trading account, not the profit and loss account.
✓ Show wages on the debit side of the trading account as a direct expense.
⚠ Including closing stock in trial balance as credit
✗ Students sometimes show closing stock on the credit side of the trial balance or omit it entirely.
→ Closing stock does not normally appear in the trial balance; it is brought into books with a journal entry and shown on the credit side of the trading account and as an asset in the balance sheet.
✓ Record closing stock via: Closing Stock A/c Dr. To Trading A/c. Show it on credit side of trading account and as an asset in balance sheet.
⚠ Confusing carriage inwards and carriage outwards
✗ Students often treat carriage outwards as a direct expense in the trading account.
→ Carriage inwards (freight on purchases) is a direct expense debited to trading account; carriage outwards (freight on sales) is an indirect expense debited to profit and loss account.
✓ Debit carriage inwards to trading account; debit carriage outwards to profit and loss account.
⚠ Forgetting to deduct returns from purchases and sales
✗ Students show gross purchases and gross sales in the trading account without deducting returns.
→ Returns inwards (sales returns) must be deducted from sales, and returns outwards (purchases returns) must be deducted from purchases to get net figures.
✓ Show Sales less Returns Inwards and Purchases less Returns Outwards in the trading account.
⚠ Mistaking operating profit for net profit
✗ Students often state that operating profit equals net profit.
→ Operating profit excludes non-operating items (e.g., interest, abnormal gains/losses). Net profit includes all items.
✓ Operating Profit = Net Profit + Non-Operating Expenses – Non-Operating Incomes.
Compare & Contrast
Benefit period
Capital Expenditure
Revenue Expenditure
Capital expenditure benefits more than one accounting period; revenue expenditure benefits only the current accounting period.
Scope of calculation
Gross Profit
Net Profit
Gross profit is calculated from trading account as sales minus cost of goods sold (direct expenses only); net profit is calculated after adding other incomes and deducting all indirect expenses from gross profit.
Exam Focus
Marks pattern: 2 MCQs (1 mark each), 1 Short Answer (3 marks), 1 Long Answer (5-6 marks) — typically a full question on preparing financial statements from trial balance.
Most asked: Preparation of Trading and Profit & Loss Account · Preparation of Balance Sheet · Distinction between Capital and Revenue Expenditure · Calculation of Gross Profit, Net Profit, and Operating Profit · Closing Entries · Marshalling and Grouping of Assets and Liabilities
Don't skip: Prepare Trading and Profit & Loss Account and Balance Sheet from a given trial balance with adjustments (e.g., closing stock, outstanding expenses).; Distinguish between capital and revenue expenditure with examples.; Calculate operating profit from given data.
One-Line Revision (read aloud before the exam)
  1. Stakeholders are users of accounting information with diverse needs, classified as internal (owners, managers) and external (government, bank, prospective owners).
  2. Expenditure is any outlay made; revenue expenditure benefits one year, capital expenditure benefits more than one year.
  3. Capital expenditure increases earning capacity; revenue expenditure maintains earning capacity.
  4. Deferred revenue expenditure is revenue expenditure whose benefit extends beyond one year (e.g., heavy advertising).
  5. Capital receipts create an obligation to return money (e.g., loan, capital); revenue receipts do not (e.g., sales, interest).
  6. Wrong classification of capital and revenue items leads to incorrect profit and misstated financial statements.
  7. Trading account shows gross profit = Sales – (Purchases + Direct Expenses).
  8. Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock.
  9. Net Profit = Gross Profit + Other Incomes – Indirect Expenses.
  10. Operating Profit (EBIT) = Net Profit + Non-Operating Expenses – Non-Operating Incomes.
  11. Closing stock is not in trial balance; it is recorded via: Closing Stock A/c Dr. To Trading A/c.
  12. Balance sheet is a statement of assets and liabilities at a given date, not an account.
  13. Marshalling arranges assets/liabilities in order of liquidity or permanence; grouping puts similar items under common headings.
  14. Current assets convert to cash within a year; fixed assets are held long-term for business use.
  15. Drawings reduce capital and are shown as deduction from capital in balance sheet.
  16. Closing entries transfer all revenue and expense balances to Trading and Profit & Loss Account.

MCQs — 10 Questions with Answers

Q1. Which of the following is an internal user of accounting information?

  • A. Bank lending to the business
  • B. Current owner of the business ✓
  • C. Government taxation authority
  • D. Prospective investor considering investment

Answer: B — Internal users work inside the business organisation; current owners and managers are internal users, while banks, government, and prospective investors are external users.

Q2. Which of the following is revenue expenditure?

  • A. Purchase of machinery for factory use
  • B. Construction of factory building
  • C. Payment of salary to factory workers ✓
  • D. Installation of new equipment in the plant

Answer: C — Salary payment is a day-to-day operating expense with benefit limited to one accounting period, making it revenue expenditure; purchases and construction create fixed assets (capital).

Q3. The main advantage of distinguishing between capital and revenue items is that:

  • A. It helps reduce the total expenses of business
  • B. It ensures correct classification in Trading/P&L Account and Balance Sheet ✓
  • C. It helps business pay less tax to government
  • D. It helps business increase its sales revenue

Answer: B — Capital items belong in Balance Sheet as assets while revenue items belong in P&L Account as expenses; proper classification determines accurate profit and financial position.

Q4. A business paid ₹50,000 to repair an old machine and ₹1,00,000 to install a newly purchased machine. How should these be classified?

  • A. Both are capital expenditure
  • B. Both are revenue expenditure
  • C. Repair is revenue; installation is capital ✓
  • D. Repair is capital; installation is revenue

Answer: C — Repairs on existing assets are recurring revenue expenditure maintaining earning capacity, while installation of new equipment is capital expenditure as it enhances asset value.

Q5. According to CBSE Class 11 Accountancy, which information requirement is most important for a bank lending money to a business?

  • A. Maximising profit to increase employee salaries
  • B. Adequacy of profits for interest repayment and asset liquidity position ✓
  • C. Extent of fixed assets owned by business
  • D. Number of years the business has been operating

Answer: B — Banks are concerned with profit adequacy as assurance of principal and interest repayment, plus liquidity (cash/near-cash assets) to ensure actual payment capability.

Q6. Which statement is CORRECT regarding capital expenditure?

  • A. It is recurring in nature like revenue expenditure
  • B. It is shown in the Trading and Profit & Loss Account
  • C. It increases the earning capacity of the business ✓
  • D. It is incurred for day-to-day business operations

Answer: C — Capital expenditure increases earning capacity by acquiring fixed assets; it is non-recurring, shown in Balance Sheet as assets, and not for daily operations.

Q7. A business paid ₹5,000 as annual insurance premium and ₹50,000 to repair the factory roof. Both items should appear in which financial statement?

  • A. Both in Balance Sheet
  • B. Both in Trading and Profit & Loss Account ✓
  • C. Insurance in P&L Account, repair in Balance Sheet
  • D. Insurance in Balance Sheet, repair in P&L Account

Answer: B — Both insurance premium (revenue expenditure—maintains coverage for one year) and roof repair (maintenance of existing asset—revenue expenditure) are shown in Trading/P&L Account.

Q8. The accounting process follows this sequence: (1) Trial Balance, (2) Recording in Journal, (3) Posting to Ledger, (4) Trading and P&L Account. Which is the correct order?

  • A. 2 → 3 → 1 → 4 ✓
  • B. 1 → 2 → 3 → 4
  • C. 3 → 2 → 1 → 4
  • D. 2 → 1 → 3 → 4

Answer: A — Correct sequence: (2) Record in Journal → (3) Post to Ledger → (1) Prepare Trial Balance → (4) Prepare financial statements (Trading/P&L and Balance Sheet).

Q9. Both: 'Revenue expenditure maintains earning capacity' AND 'Capital expenditure provides benefits for only one accounting period'. Which is correct?

  • A. Both statements are correct
  • B. Only first statement is correct ✓
  • C. Only second statement is correct
  • D. Both statements are incorrect

Answer: B — First statement is correct—revenue expenditure maintains earning capacity; second is wrong—capital expenditure provides benefits across multiple periods, while revenue expenditure is limited to one period.

Q10. A manufacturing business recorded: Machinery purchase ₹2,00,000, salary payment ₹50,000, rent paid ₹30,000, and tools worth ₹5,000. Total capital expenditure is:

  • A. ₹2,00,000
  • B. ₹2,05,000 ✓
  • C. ₹2,35,000
  • D. ₹2,85,000

Answer: B — Capital expenditure includes machinery (₹2,00,000) and tools (₹5,000) = ₹2,05,000; salary and rent are revenue expenditure (day-to-day operations, one-period benefit).

Flashcards

What is a stakeholder in accounting?

Any person associated with the business who has an active or passive monetary or non-monetary stake in it.

Define revenue expenditure with one example.

Expenditure whose benefit is limited to one accounting period, incurred for day-to-day business operations like payment of salaries or rent.

Define capital expenditure with one example.

Expenditure whose benefit extends beyond one accounting period, incurred to acquire fixed assets like purchasing furniture or machinery.

Name two internal users of accounting information.

Current owners and managers are internal users because they work inside the business organisation.

What information does a bank primarily want from financial statements?

Bank wants information about adequacy of profits to ensure repayment of principal and interest, plus liquidity of assets.

How does capital expenditure differ from revenue expenditure in nature?

Capital expenditure is non-recurring and increases earning capacity, while revenue expenditure is recurring and maintains earning capacity.

What is the main objective of financial accounting?

To communicate meaningful financial information to various stakeholders so they can make informed business decisions.

Which accounts form the basis for preparing financial statements?

Trial Balance accounts are the foundation for preparing Trading and Profit & Loss Account and Balance Sheet.

Why is the distinction between capital and revenue items important?

Capital items go to the Balance Sheet while revenue items go to Trading and Profit & Loss Account, affecting profit and asset values.

Name one external user and their main accounting information need.

Prospective owner needs information about past profits and financial position to assess future investment potential and returns.

Important Board Questions

Define capital expenditure and revenue expenditure with one example each. State one point of distinction between them. [2 marks]

Capital expenditure = benefit extends beyond one period (e.g., machinery purchase); Revenue expenditure = benefit limited to one period (e.g., salary). Key distinction: capital increases earning capacity, revenue maintains it.

A business is preparing financial statements. It has identified the following items: (1) Purchase of office furniture ₹30,000, (2) Repair of existing building ₹10,000, (3) Salary of employees ₹20,000, (4) Installation of new machinery ₹50,000, (5) Insurance premium ₹5,000. Classify each item as capital or revenue expenditure and explain why office repair is classified differently from machinery installation. [5 marks]

Classify: (1) Capital—new asset; (2) Revenue—maintains existing asset; (3) Revenue—daily operations; (4) Capital—new asset with multi-year benefit; (5) Revenue—annual protection cost. Explain: repair maintains earning capacity (revenue), while machinery installation increases it (capital).

Explain the concept of stakeholders and their diverse information requirements in financial accounting. Why is it important for a business to provide relevant information to both internal and external stakeholders? Provide one example each of an internal user and external user with their specific information needs. [6 marks]

Define stakeholders as anyone associated with business (monetary/non-monetary stake). Internal users: owners, managers (need profit + position for decision-making). External users: banks, government, investors (need specific info for lending, tax, investment decisions). Explain importance: different stakeholders make different business-related decisions; accurate info ensures informed choices. Example: Owner needs profit level for wealth growth; Bank needs liquidity details for loan safety.

Assertion-Reason Questions for Financial Statements - I

Q1. Assertion (A):

Capital expenditure increases the earning capacity of a business, while revenue expenditure maintains the existing earning capacity.

Reason (R):

Capital expenditure is incurred to acquire fixed assets, whereas revenue expenditure is incurred for day-to-day operations.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both assertion and reason are true, and the reason correctly explains the assertion. Acquiring fixed assets (capital) increases capacity; regular operations (revenue) maintain capacity. The cause-effect relationship is correctly established.

Q2. Assertion (A):

Bank is primarily interested in the liquidity position of a business rather than overall profitability.

Reason (R):

Banks need assurance that the business can repay loans and interest promptly, which depends on available liquid assets.

Answer: B — Both A and R are true, but R is NOT the correct explanation of A — Both statements are true, but the reason is not the complete correct explanation. While liquidity is important, banks are also interested in profitability as an indicator of repayment capacity. The assertion is too absolute—banks need both liquidity and profitability information.

Q3. Assertion (A):

All expenditures that benefit the business for more than one accounting period should be classified as capital expenditure.

Reason (R):

Revenue expenditure is strictly limited to benefits within a single accounting period.

Answer: D — A is false but R is true — The assertion is false. Expenditure extending beyond one period doesn't automatically qualify as capital—it must also involve fixed assets. For example, rent prepaid for 2 years is revenue expenditure. The reason is partially true but doesn't make the assertion correct.

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Case-Based Questions (CBQ) for Financial Statements - I

Case Study:

On 1st April 2025, Vikram started 'Vikram Traders' with a capital of ₹2,00,000. He deposited ₹1,50,000 into the bank account and kept ₹50,000 as cash in hand. During the year, he purchased goods worth ₹80,000 on credit from Ravi, paid rent ₹12,000 by cheque, and withdrew ₹5,000 cash for personal use. On 31st March 2026, the total assets were ₹2,50,000 and total liabilities were ₹30,000.

Q1. What is the amount of Vikram's capital as on 31st March 2026, based on the accounting equation?

  • A. ₹2,00,000
  • B. ₹2,20,000 ✓
  • C. ₹2,50,000
  • D. ₹2,80,000

Answer: B

Q2. The journal entry for 'withdrew ₹5,000 cash for personal use' will debit which account?

  • A. Cash Account
  • B. Drawings Account ✓
  • C. Capital Account
  • D. Personal Expenses Account

Answer: B

Q3. Which of the following is a liability for Vikram Traders on 31st March 2026?

  • A. Cash in hand ₹50,000
  • B. Bank balance ₹1,50,000
  • C. Capital ₹2,00,000
  • D. Goods purchased on credit from Ravi ₹80,000 ✓

Answer: D

Q4. If Vikram's net profit for the year is ₹55,000, what will be the closing capital after considering drawings?

  • A. ₹2,50,000 ✓
  • B. ₹2,55,000
  • C. ₹2,45,000
  • D. ₹2,60,000

Answer: A

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