Introduction to Financial Statements and Capital vs Revenue

Stakeholders And Their Information Requirements

Accounting is often referred to as the "language of business" because it provides essential information about the financial health and performance of an organisation. This information is crucial for various individuals and groups who have a vested interest in the business. These individuals or groups are known as Stakeholders. They use accounting information to make informed economic decisions.

Stakeholders can be broadly categorised into Internal Users and External Users. Each group has different information requirements.

1. Internal Users:

These are individuals or groups within the organisation who need financial information for planning, operating, and decision-making purposes.

Management: Needs detailed and timely information to make operational decisions, formulate strategies, set prices, control costs, evaluate performance of different departments or products, and plan for the future (e.g., budgeting). They need information on cost of production, sales trends, profitability of segments, cash flows, etc.
Employees: Need information about the profitability and stability of the company, especially regarding its ability to pay salaries and bonuses, provide retirement benefits (like Provident Fund or Gratuity), and ensure job security. Trade unions also use this information during wage negotiations.

2. External Users:

These are individuals or groups outside the organisation who use financial information for various purposes, including investment, lending, regulation, and research.

Investors (Current and Potential): Need information to evaluate the profitability, financial soundness, and growth prospects of the company before making decisions to buy, hold, or sell shares or other investments. They are interested in past performance, future earning potential, and the value of assets.
Creditors (Lenders and Suppliers): Need information to assess the company's ability to repay loans or pay for goods and services purchased on credit. Banks granting loans are interested in solvency and liquidity, while suppliers selling on credit are primarily interested in short-term liquidity.
Government and Regulatory Bodies: Need information for purposes of taxation (e.g., calculating Income Tax, GST), regulation (ensuring compliance with laws like the Companies Act), compiling national income statistics, and formulating economic policies.
Customers: May need information about the stability and profitability of a business, especially if they have long-term contracts or rely on the business for essential supplies or services.
Public: Interested in various aspects of the business, such as the number of jobs provided, the impact on the local economy, environmental practices, and contributions to society. They might use annual reports for general understanding.
Researchers: Use financial statements for academic research, analysis, and comparison across industries or time periods.

Financial statements, prepared following accounting principles and standards, are the primary means of communicating this vital information to external stakeholders, ensuring transparency and accountability.

Distinction Between Capital And Revenue

A fundamental distinction in accounting is between items of a capital nature and items of a revenue nature. Correctly classifying transactions as either capital or revenue is crucial for accurately determining the profit or loss for an accounting period and presenting a true and fair view of the financial position in the Balance Sheet.

Expenditure

Expenditure is the spending of money or incurring a liability for value received. Expenditures are classified based on the nature of the benefit received and the period over which that benefit is expected to extend.

1. Capital Expenditure:

Expenditure incurred for acquiring assets that are intended for long-term use in the business (Fixed Assets), or for making additions or improvements to existing fixed assets that increase their earning capacity or useful life. The benefit of Capital Expenditure is expected to extend over more than one accounting period. Capital Expenditures are shown on the Assets side of the Balance Sheet.

Examples of Capital Expenditure:

Purchase of Land, Building, Machinery, Furniture, Vehicles.
Cost of installation of new machinery.
Major additions or extensions to existing buildings or plant.
Expenditure incurred to acquire intangible assets like Patents or Goodwill.
Preliminary expenses incurred before the start of business (sometimes treated as capital expenditure or amortised).

Example 1. Capital Expenditure.

A business in Kolkata buys a new delivery van for ₹8,00,000 and spends ₹50,000 on modifications that increase its carrying capacity.

Answer:

Both the purchase cost of the van (₹8,00,000) and the modification cost (₹50,000) are Capital Expenditures because they result in the acquisition of a long-term asset and enhance its future earning capacity. The total Capital Expenditure on the van is ₹8,50,000, which will be shown as an asset in the Balance Sheet and depreciated over its useful life.

2. Revenue Expenditure:

Expenditure incurred for the day-to-day running of the business, maintaining assets, or acquiring goods and services the benefit of which is consumed within the current accounting period. Revenue Expenditures are treated as expenses and are debited to the Trading Account or Profit and Loss Account.

Examples of Revenue Expenditure:

Cost of goods purchased for resale.
Salaries and Wages paid.
Rent, Electricity, Telephone bills.
Repair and maintenance expenses (routine).
Advertising and selling expenses.
Depreciation on fixed assets.

Example 2. Revenue Expenditure.

For the delivery van purchased in Example 1, the business spends ₹10,000 on petrol and ₹2,000 on routine servicing during the month.

Answer:

The cost of petrol (₹10,000) and routine servicing (₹2,000) are Revenue Expenditures. Their benefit is consumed within the current period (month). These costs will be shown as expenses (Vehicle Running Expense, Repairs) in the Profit and Loss Account.

Receipts

Receipts are amounts received by the business. Receipts are classified based on their nature and whether they relate to normal business operations or other sources.

1. Capital Receipts:

Receipts that are not earned from the normal operating activities of the business. They are usually non-recurring in nature and result in an increase in Capital or reduction in Assets/Increase in Liabilities. Capital Receipts are generally shown in the Balance Sheet.

Examples of Capital Receipts:

Amount invested by the owner (Capital).
Amount received from the sale of fixed assets.
Amount received from taking loans.
Amount received from issue of shares or debentures.

Example 3. Capital Receipts.

A company in Mumbai sells an old machine for ₹50,000 and takes a bank loan of ₹5,00,000.

Answer:

The ₹50,000 from the sale of the machine (an asset) and the ₹5,00,000 from the bank loan (a liability) are Capital Receipts. They are not from regular sales of goods/services. These amounts will be recorded as Cash/Bank inflow and affect the Balance Sheet (decrease in Asset and increase in Liability, respectively). Any profit on sale of the machine (calculated by comparing sale price with book value) is a Capital Profit, which goes to Capital Reserve.

2. Revenue Receipts:

Receipts earned from the normal operating activities of the business. These are recurring in nature. Revenue Receipts are treated as income and are credited to the Trading Account or Profit and Loss Account.

Examples of Revenue Receipts:

Amount received from sales of goods or services (Sales Revenue).
Rent Received.
Interest Received.
Commission Received.
Dividend Received (on investments).

Example 4. Revenue Receipts.

A retail shop in Delhi receives ₹1,50,000 from customers for goods sold during the day and ₹5,000 as commission for selling lottery tickets.

Answer:

Both the ₹1,50,000 from sales and ₹5,000 from commission are Revenue Receipts. They are part of the regular income of the business from its operating activities. These amounts will be credited to the Sales Account and Commission Received Account respectively, which are shown in the Trading and Profit & Loss Account.

Revenue from sales of goods is the primary source of Revenue Receipts for a trading or manufacturing business.

Importance Of Distinction Between Capital And Revenue

The correct classification of expenditures and receipts as capital or revenue is of paramount importance in accounting for the following reasons:

1. Accurate Profit/Loss Calculation:

Revenue Expenditures and Revenue Receipts are used to calculate the net profit or loss for an accounting period (in the Trading and Profit and Loss Account). Misclassifying a Capital Expenditure as Revenue Expenditure would overstate expenses and understate profit, and vice versa. Misclassifying a Capital Receipt as Revenue Receipt would overstate income and profit, and vice versa.

Example 5.

Cost of installing a new machine (Capital Expenditure ₹20,000) is wrongly debited to Wages Account (Revenue Expenditure).

Answer:

If correctly classified:

Machine Cost (Asset) increases by ₹20,000.
Net Profit is NOT directly affected in the year of purchase (only by depreciation).

If wrongly classified:

Wages Expense increases by ₹20,000.
Net Profit is reduced by ₹20,000 in the current year.
Machine (Asset) is understated by ₹20,000 in the Balance Sheet.

This error leads to understated profit in the current year and overstated profit in future years (as depreciation is not charged on the omitted amount), and an incorrect Balance Sheet.

2. True And Fair Financial Position:

Capital Expenditures and Capital Receipts appear in the Balance Sheet. Misclassifying them (e.g., treating Capital Expenditure as Revenue Expenditure) leads to an incorrect valuation of assets or liabilities and an incorrect depiction of the capital structure, thus failing to present a true and fair view of the financial position.

3. Compliance With Accounting Standards And Law:

Accounting standards and company laws (like the Companies Act, 2013) mandate the correct distinction between capital and revenue items for proper financial reporting. Incorrect classification is a violation of these regulations.

4. Decision Making:

Stakeholders (management, investors, creditors) rely on accurate profit figures and the Balance Sheet to make informed decisions. Incorrect classification distorts these statements, leading to faulty decision-making.

Therefore, the distinction between capital and revenue items is one of the most critical judgments in accounting and requires careful consideration based on the nature of the transaction and the accounting principles.

Financial Statements

Financial Statements, also known as Final Accounts, are the end product of the accounting cycle. They are prepared at the end of an accounting period (usually a financial year) to summarise the financial performance and financial position of a business. They provide the key financial information used by various stakeholders for decision-making.

In the context of a sole proprietorship or partnership business, the main financial statements prepared are:

1. Trading Account:

Prepared to determine the Gross Profit or Gross Loss during the accounting period. It primarily deals with revenues from sales of goods and the direct costs associated with those goods (Cost of Goods Sold).

Gross Profit = Net Sales - Cost of Goods Sold

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses - Closing Stock

Direct expenses include expenses directly related to the purchase of goods or bringing them to a salable condition (e.g., wages for production labour, carriage inwards, freight, factory lighting).

2. Profit and Loss Account (P&L Account):

Prepared to determine the Net Profit or Net Loss for the accounting period. It starts with the Gross Profit (or Loss) from the Trading Account and then includes all other indirect revenues (incomes) and indirect expenses (operating expenses).

Net Profit = Gross Profit + Other Incomes - Indirect Expenses

Indirect expenses are expenses incurred in the general running and administration of the business, and selling and distribution of goods (e.g., salaries, rent, depreciation, advertising, bad debts, interest paid).

3. Balance Sheet:

Prepared to show the financial position of the business on a specific date (the last day of the accounting period). It lists the assets, liabilities, and owner's capital of the business. It is based on the fundamental Accounting Equation: Assets = Liabilities + Capital.

The Net Profit (or Loss) from the Profit and Loss Account is added to (or deducted from) the Capital in the Balance Sheet.

These three statements are interconnected and provide a comprehensive picture of the business's financial activities over a period and its financial standing at the end of that period. For companies, the format of these statements is prescribed by the Companies Act, 2013, and they are often presented with additional schedules and notes.