Financial Statements | NABARD Grade A & Grade B Preparation - Bank Exams PDF Download

 Page 1


 
 
69 69 
Financial Statements Accounting: An 
Overview 
UNIT 3  FINANCIAL STATEMENTS 
Learning Objectives  
After reading this chapter, you will be able to: 
? Explain the meaning and objectives of financial statements of a business entity 
? Understand the basic concepts of a Profit & Loss account 
? Classify income and expense items 
? Understand the structure and components of a balance sheet 
? Classify the various assets, liabilities and capital accounts in a balance sheet  
? Understand the basic principles of assets valuation 
? Appreciate the concept of a balance sheet equation 
? Appreciate the linkage between profit and loss account and balance sheet 
Structure 
3.1  Introduction to Financial Statements 
3.2    Objectives of Financial Statements 
3.3 Income determination: Basic concepts  
3.4  Revenue and Expense 
3.5  Profit and Loss 
3.6    Income Statement  
3.7 Preparing a Trading and Profit and Loss Account 
3.8 Balance Sheet 
3.9 Balance Sheet contents and classification 
 3.9.1 Dual Aspect Concept 
 3.9.2 Current Assets 
 3.9.3 Fixed Assets 
 3.9.4 Intangible Assets 
 3.9.5 Long Term Liabilities 
 3.9.6 C ap ital o r O w n er ’ s E q u it y  
3.10 Relationship between Income Statement and Position Statement 
3.11 Summary 
3.12 Key Words 
3.13 Self-assessment Questions/Exercises 
3.14 Further Readings 
 
 
 
 
Page 2


 
 
69 69 
Financial Statements Accounting: An 
Overview 
UNIT 3  FINANCIAL STATEMENTS 
Learning Objectives  
After reading this chapter, you will be able to: 
? Explain the meaning and objectives of financial statements of a business entity 
? Understand the basic concepts of a Profit & Loss account 
? Classify income and expense items 
? Understand the structure and components of a balance sheet 
? Classify the various assets, liabilities and capital accounts in a balance sheet  
? Understand the basic principles of assets valuation 
? Appreciate the concept of a balance sheet equation 
? Appreciate the linkage between profit and loss account and balance sheet 
Structure 
3.1  Introduction to Financial Statements 
3.2    Objectives of Financial Statements 
3.3 Income determination: Basic concepts  
3.4  Revenue and Expense 
3.5  Profit and Loss 
3.6    Income Statement  
3.7 Preparing a Trading and Profit and Loss Account 
3.8 Balance Sheet 
3.9 Balance Sheet contents and classification 
 3.9.1 Dual Aspect Concept 
 3.9.2 Current Assets 
 3.9.3 Fixed Assets 
 3.9.4 Intangible Assets 
 3.9.5 Long Term Liabilities 
 3.9.6 C ap ital o r O w n er ’ s E q u it y  
3.10 Relationship between Income Statement and Position Statement 
3.11 Summary 
3.12 Key Words 
3.13 Self-assessment Questions/Exercises 
3.14 Further Readings 
 
 
 
 
 
 
70 70 
Financial Statements Accounting: An 
Overview 
3.1  INTRODUCTION TO FINANCIAL 
STATEMENTS 
The process of accounting aims at providing the financial information about 
the business entity to the users with the help of financial statements. Financial 
statements are the formal end reports that summarise the business operations 
and transactions conducted in a financial year. These statements are prepared 
as per the accounting principles to generate systematic and consistent results. 
They are useful indicators of the financial health of a business entity at a 
particular point of time. The various users of financial statements include 
owners and external parties such as investors, tax authorities, government, 
employees, etc. It is vital to present the financial statements in a proper form 
with suitable contents so that the shareholders and other users of financial 
statements can easily understand and use them in their economic decisions in 
a meaningful way. 
There are three main financial statements of a business entity: the Balance 
Sheet (position statement) as at the end of accounting period, the Statement 
of Profit & Loss (income statement) and the Cash Flow Statement. 
3.2  OBJECTIVES OF FINANCIAL 
STATEMENTS 
The financial statements are prepared with the purpose to determine the 
financial standing of a business entity by measuring three main variables: 
profitability, liquidity, and solvency. 
? Profitability is the ability of a business to make profit. After paying all 
the business expenses out of the sales revenue for a particular accounting 
period, is the entity still able to make a profit? 
? Liquidity is the ability of a business to pay current obligations without 
disrupting normal operations. It is the ability to pay regular bills without 
having to sell off assets needed to operate the business. In short, being 
liquid means having enough cash to pay the bills. 
? Solvency is the ability of a business to pay all its debts if the business 
were liquidated, or sold out. A solvent business must have more assets 
than it has debt. 
These variables are shown in the revenue generated by business (profit-and-
loss statement), the movement of cash in various business activities and 
balance cash available (cash-flow statement), and the net worth of the 
business (balance sheet). 
3.3 INCOME DETERMINATION: BASIC 
CONCEPTS 
To be able to understand the income statement of a business, the basic 
concepts of revenue recognition and income measurement must be clearly 
Page 3


 
 
69 69 
Financial Statements Accounting: An 
Overview 
UNIT 3  FINANCIAL STATEMENTS 
Learning Objectives  
After reading this chapter, you will be able to: 
? Explain the meaning and objectives of financial statements of a business entity 
? Understand the basic concepts of a Profit & Loss account 
? Classify income and expense items 
? Understand the structure and components of a balance sheet 
? Classify the various assets, liabilities and capital accounts in a balance sheet  
? Understand the basic principles of assets valuation 
? Appreciate the concept of a balance sheet equation 
? Appreciate the linkage between profit and loss account and balance sheet 
Structure 
3.1  Introduction to Financial Statements 
3.2    Objectives of Financial Statements 
3.3 Income determination: Basic concepts  
3.4  Revenue and Expense 
3.5  Profit and Loss 
3.6    Income Statement  
3.7 Preparing a Trading and Profit and Loss Account 
3.8 Balance Sheet 
3.9 Balance Sheet contents and classification 
 3.9.1 Dual Aspect Concept 
 3.9.2 Current Assets 
 3.9.3 Fixed Assets 
 3.9.4 Intangible Assets 
 3.9.5 Long Term Liabilities 
 3.9.6 C ap ital o r O w n er ’ s E q u it y  
3.10 Relationship between Income Statement and Position Statement 
3.11 Summary 
3.12 Key Words 
3.13 Self-assessment Questions/Exercises 
3.14 Further Readings 
 
 
 
 
 
 
70 70 
Financial Statements Accounting: An 
Overview 
3.1  INTRODUCTION TO FINANCIAL 
STATEMENTS 
The process of accounting aims at providing the financial information about 
the business entity to the users with the help of financial statements. Financial 
statements are the formal end reports that summarise the business operations 
and transactions conducted in a financial year. These statements are prepared 
as per the accounting principles to generate systematic and consistent results. 
They are useful indicators of the financial health of a business entity at a 
particular point of time. The various users of financial statements include 
owners and external parties such as investors, tax authorities, government, 
employees, etc. It is vital to present the financial statements in a proper form 
with suitable contents so that the shareholders and other users of financial 
statements can easily understand and use them in their economic decisions in 
a meaningful way. 
There are three main financial statements of a business entity: the Balance 
Sheet (position statement) as at the end of accounting period, the Statement 
of Profit & Loss (income statement) and the Cash Flow Statement. 
3.2  OBJECTIVES OF FINANCIAL 
STATEMENTS 
The financial statements are prepared with the purpose to determine the 
financial standing of a business entity by measuring three main variables: 
profitability, liquidity, and solvency. 
? Profitability is the ability of a business to make profit. After paying all 
the business expenses out of the sales revenue for a particular accounting 
period, is the entity still able to make a profit? 
? Liquidity is the ability of a business to pay current obligations without 
disrupting normal operations. It is the ability to pay regular bills without 
having to sell off assets needed to operate the business. In short, being 
liquid means having enough cash to pay the bills. 
? Solvency is the ability of a business to pay all its debts if the business 
were liquidated, or sold out. A solvent business must have more assets 
than it has debt. 
These variables are shown in the revenue generated by business (profit-and-
loss statement), the movement of cash in various business activities and 
balance cash available (cash-flow statement), and the net worth of the 
business (balance sheet). 
3.3 INCOME DETERMINATION: BASIC 
CONCEPTS 
To be able to understand the income statement of a business, the basic 
concepts of revenue recognition and income measurement must be clearly 
 
 
71 71 
Financial Statements Accounting: An 
Overview 
understood. But before that, one must be able to distinguish between capital 
and revenue items. The revenue items form part of the income statement 
whereas the capital items are shown in the balance sheet. These basic 
concepts have been discussed as follows: 
3.3.1 EXPENDITURE 
Expenditure represents any payment or outlay made for the purposes of 
business. The expenditures are incurred with a view to provide benefits to the 
business. Such benefit may extend up to one accounting year or more than 
one year. If the benefit of expenditure extends up to one accounting period, it 
is termed as revenue expenditure. Revenue expenditure is the outflow of 
funds to meet the running expenses of a business and it will benefit the 
business during the current period only. It is incurred to carry on the normal 
course of business or for the repairs and maintenance of the capital assets. In 
other words, revenue expenditure is incurred to maintain the earning capacity 
of business. For example, salaries, rent, routine repairs of machinery, interest 
paid on loan, etc. are all revenue expenditures as they will only benefit the 
current accounting period. Also, revenue expenditures are of a recurring 
nature. Revenue expenditures form part of the Income Statement and are also 
referred to as expenses recognised during an accounting period.  
If, however, the benefit of certain expenditure extends for more than one 
accounting period, it is termed as capital expenditure. For example, 
payment to acquire machinery for use in the business. Machinery acquired in 
the current accounting period will give benefits for many accounting periods 
to come. Hence, it will be treated as a capital expenditure that affects the 
balance sheet by an increase in the fixed assets. In simple words, capital 
expenditure is incurred to increase the earning capacity of a business and is of 
a non-recurring nature. Common examples of capital expenditure can be 
payment to acquire fixed assets and/or to make additions/extensions in the 
fixed assets to increase their useful life. 
3.3.2  Receipts 
A similar distinction of capital and revenue nature is made in case of receipts 
of the business. A receipt of money is treated as a capital receipt when the 
contribution is made by the owners towards the capital of the business 
(example: equity share capital) or, a contribution towards the capital is made 
by an outsider to the business (example: debentures, long term loan) or when 
a fixed asset is sold. Capital receipts do not usually have any effect on the 
profits earned or losses incurred during an accounting year as they are not 
shown in the Income Statement (P&L A/c). Capital receipts have an impact 
on the balance sheet. 
Next, a receipt is considered as a revenue receipt when it is received from 
sale of goods or services, fee received for rendering technical services, or any 
interest/dividend earned on investments made by business, or any receipt 
from business activities done in the normal course during an accounting 
period. Revenue receipts are shown in the Income statement. They are set off 
Page 4


 
 
69 69 
Financial Statements Accounting: An 
Overview 
UNIT 3  FINANCIAL STATEMENTS 
Learning Objectives  
After reading this chapter, you will be able to: 
? Explain the meaning and objectives of financial statements of a business entity 
? Understand the basic concepts of a Profit & Loss account 
? Classify income and expense items 
? Understand the structure and components of a balance sheet 
? Classify the various assets, liabilities and capital accounts in a balance sheet  
? Understand the basic principles of assets valuation 
? Appreciate the concept of a balance sheet equation 
? Appreciate the linkage between profit and loss account and balance sheet 
Structure 
3.1  Introduction to Financial Statements 
3.2    Objectives of Financial Statements 
3.3 Income determination: Basic concepts  
3.4  Revenue and Expense 
3.5  Profit and Loss 
3.6    Income Statement  
3.7 Preparing a Trading and Profit and Loss Account 
3.8 Balance Sheet 
3.9 Balance Sheet contents and classification 
 3.9.1 Dual Aspect Concept 
 3.9.2 Current Assets 
 3.9.3 Fixed Assets 
 3.9.4 Intangible Assets 
 3.9.5 Long Term Liabilities 
 3.9.6 C ap ital o r O w n er ’ s E q u it y  
3.10 Relationship between Income Statement and Position Statement 
3.11 Summary 
3.12 Key Words 
3.13 Self-assessment Questions/Exercises 
3.14 Further Readings 
 
 
 
 
 
 
70 70 
Financial Statements Accounting: An 
Overview 
3.1  INTRODUCTION TO FINANCIAL 
STATEMENTS 
The process of accounting aims at providing the financial information about 
the business entity to the users with the help of financial statements. Financial 
statements are the formal end reports that summarise the business operations 
and transactions conducted in a financial year. These statements are prepared 
as per the accounting principles to generate systematic and consistent results. 
They are useful indicators of the financial health of a business entity at a 
particular point of time. The various users of financial statements include 
owners and external parties such as investors, tax authorities, government, 
employees, etc. It is vital to present the financial statements in a proper form 
with suitable contents so that the shareholders and other users of financial 
statements can easily understand and use them in their economic decisions in 
a meaningful way. 
There are three main financial statements of a business entity: the Balance 
Sheet (position statement) as at the end of accounting period, the Statement 
of Profit & Loss (income statement) and the Cash Flow Statement. 
3.2  OBJECTIVES OF FINANCIAL 
STATEMENTS 
The financial statements are prepared with the purpose to determine the 
financial standing of a business entity by measuring three main variables: 
profitability, liquidity, and solvency. 
? Profitability is the ability of a business to make profit. After paying all 
the business expenses out of the sales revenue for a particular accounting 
period, is the entity still able to make a profit? 
? Liquidity is the ability of a business to pay current obligations without 
disrupting normal operations. It is the ability to pay regular bills without 
having to sell off assets needed to operate the business. In short, being 
liquid means having enough cash to pay the bills. 
? Solvency is the ability of a business to pay all its debts if the business 
were liquidated, or sold out. A solvent business must have more assets 
than it has debt. 
These variables are shown in the revenue generated by business (profit-and-
loss statement), the movement of cash in various business activities and 
balance cash available (cash-flow statement), and the net worth of the 
business (balance sheet). 
3.3 INCOME DETERMINATION: BASIC 
CONCEPTS 
To be able to understand the income statement of a business, the basic 
concepts of revenue recognition and income measurement must be clearly 
 
 
71 71 
Financial Statements Accounting: An 
Overview 
understood. But before that, one must be able to distinguish between capital 
and revenue items. The revenue items form part of the income statement 
whereas the capital items are shown in the balance sheet. These basic 
concepts have been discussed as follows: 
3.3.1 EXPENDITURE 
Expenditure represents any payment or outlay made for the purposes of 
business. The expenditures are incurred with a view to provide benefits to the 
business. Such benefit may extend up to one accounting year or more than 
one year. If the benefit of expenditure extends up to one accounting period, it 
is termed as revenue expenditure. Revenue expenditure is the outflow of 
funds to meet the running expenses of a business and it will benefit the 
business during the current period only. It is incurred to carry on the normal 
course of business or for the repairs and maintenance of the capital assets. In 
other words, revenue expenditure is incurred to maintain the earning capacity 
of business. For example, salaries, rent, routine repairs of machinery, interest 
paid on loan, etc. are all revenue expenditures as they will only benefit the 
current accounting period. Also, revenue expenditures are of a recurring 
nature. Revenue expenditures form part of the Income Statement and are also 
referred to as expenses recognised during an accounting period.  
If, however, the benefit of certain expenditure extends for more than one 
accounting period, it is termed as capital expenditure. For example, 
payment to acquire machinery for use in the business. Machinery acquired in 
the current accounting period will give benefits for many accounting periods 
to come. Hence, it will be treated as a capital expenditure that affects the 
balance sheet by an increase in the fixed assets. In simple words, capital 
expenditure is incurred to increase the earning capacity of a business and is of 
a non-recurring nature. Common examples of capital expenditure can be 
payment to acquire fixed assets and/or to make additions/extensions in the 
fixed assets to increase their useful life. 
3.3.2  Receipts 
A similar distinction of capital and revenue nature is made in case of receipts 
of the business. A receipt of money is treated as a capital receipt when the 
contribution is made by the owners towards the capital of the business 
(example: equity share capital) or, a contribution towards the capital is made 
by an outsider to the business (example: debentures, long term loan) or when 
a fixed asset is sold. Capital receipts do not usually have any effect on the 
profits earned or losses incurred during an accounting year as they are not 
shown in the Income Statement (P&L A/c). Capital receipts have an impact 
on the balance sheet. 
Next, a receipt is considered as a revenue receipt when it is received from 
sale of goods or services, fee received for rendering technical services, or any 
interest/dividend earned on investments made by business, or any receipt 
from business activities done in the normal course during an accounting 
period. Revenue receipts are shown in the Income statement. They are set off 
 
 
72 72 
Financial Statements Accounting: An 
Overview 
against the expenses in order to ascertain the profit or loss for the accounting 
period. 
3.3.3  Revenue Recognition 
Now that we have learnt about revenue receipts and expenditure, the next 
question that arises is, when should the revenue and expense be recognised in 
the books of accounts? Should we record the revenue when the transaction is 
made or when the cash is received or paid? The answer lies in the 
fundamental accounting concept of accrual basis and the revenue 
realisation principle.  
The accrual basis of accounting states that revenues should be recorded 
when they are earned or accrued, and not when they are received in cash. 
Similarly, expenses should be recorded when they are incurred, and not when 
they are paid in cash. For example, assume RT Ltd. made a sale of goods on 
12-06-2019 to a customer on credit. The cash was received on 25-08-2019. 
Hence, under accrual accounting, the revenue from sale will be recorded on 
12-06-2019 and not on 25-08-2019.Later, when the cash is received; no 
revenue is recorded because it has already been recorded on the day of sale. 
In simple terms, accrual basis requires income and expense to be recorded in 
the accounting period to which they relate and not on a cash basis. Taking 
another example, if any advance salary is paid to the employee, it will be 
debited as an expense in the Profit and loss account in the accounting period 
to which it belongs and not in the period in which it is paid. However, 
advance salary paid will be shown as a current asset in the Balance sheet of 
the accounting year in which it is paid. 
Realisation principle, on the other hand, is the point of recognising the 
revenue. It states that the revenue should be recognized only to the extent to 
which it is certainly realizable. Therefore, just receiving an order of goods or 
se rvic e s f rom the c ustom e r won’ t make it eligible to be recognized as 
revenue. The reasonable certainty of realizing the revenue will come only 
when the goods or services ordered are actually supplied to the customer and 
an invoice is created for the same. This concept ensures that income unearned 
or unrealized will not be considered as revenue. Further, realisation principle 
also enables the recognition of costs, incurred in making available such goods 
or services, as expense. Thus, the realisation principle facilitates the process 
of income measurement by recognising revenues and also the expenses 
incurred with respect to such revenues. This also implies, if costs are incurred 
in producing the goods, such costs are not considered as expenses unless 
sales are made. 
3.3.4  Measurement of Income 
Income is nothing but the excess of amount the business entity has earned 
from its operations over what they have invested into it over its lifetime. 
However, as per the going concern concept the business is expected to run 
its operations for an indefinite period of time. Therefore, it is impractical to 
wait till the winding up of business to measure the net income earned by it 
over its lifetime. There comes the concept of accounting period. 
Page 5


 
 
69 69 
Financial Statements Accounting: An 
Overview 
UNIT 3  FINANCIAL STATEMENTS 
Learning Objectives  
After reading this chapter, you will be able to: 
? Explain the meaning and objectives of financial statements of a business entity 
? Understand the basic concepts of a Profit & Loss account 
? Classify income and expense items 
? Understand the structure and components of a balance sheet 
? Classify the various assets, liabilities and capital accounts in a balance sheet  
? Understand the basic principles of assets valuation 
? Appreciate the concept of a balance sheet equation 
? Appreciate the linkage between profit and loss account and balance sheet 
Structure 
3.1  Introduction to Financial Statements 
3.2    Objectives of Financial Statements 
3.3 Income determination: Basic concepts  
3.4  Revenue and Expense 
3.5  Profit and Loss 
3.6    Income Statement  
3.7 Preparing a Trading and Profit and Loss Account 
3.8 Balance Sheet 
3.9 Balance Sheet contents and classification 
 3.9.1 Dual Aspect Concept 
 3.9.2 Current Assets 
 3.9.3 Fixed Assets 
 3.9.4 Intangible Assets 
 3.9.5 Long Term Liabilities 
 3.9.6 C ap ital o r O w n er ’ s E q u it y  
3.10 Relationship between Income Statement and Position Statement 
3.11 Summary 
3.12 Key Words 
3.13 Self-assessment Questions/Exercises 
3.14 Further Readings 
 
 
 
 
 
 
70 70 
Financial Statements Accounting: An 
Overview 
3.1  INTRODUCTION TO FINANCIAL 
STATEMENTS 
The process of accounting aims at providing the financial information about 
the business entity to the users with the help of financial statements. Financial 
statements are the formal end reports that summarise the business operations 
and transactions conducted in a financial year. These statements are prepared 
as per the accounting principles to generate systematic and consistent results. 
They are useful indicators of the financial health of a business entity at a 
particular point of time. The various users of financial statements include 
owners and external parties such as investors, tax authorities, government, 
employees, etc. It is vital to present the financial statements in a proper form 
with suitable contents so that the shareholders and other users of financial 
statements can easily understand and use them in their economic decisions in 
a meaningful way. 
There are three main financial statements of a business entity: the Balance 
Sheet (position statement) as at the end of accounting period, the Statement 
of Profit & Loss (income statement) and the Cash Flow Statement. 
3.2  OBJECTIVES OF FINANCIAL 
STATEMENTS 
The financial statements are prepared with the purpose to determine the 
financial standing of a business entity by measuring three main variables: 
profitability, liquidity, and solvency. 
? Profitability is the ability of a business to make profit. After paying all 
the business expenses out of the sales revenue for a particular accounting 
period, is the entity still able to make a profit? 
? Liquidity is the ability of a business to pay current obligations without 
disrupting normal operations. It is the ability to pay regular bills without 
having to sell off assets needed to operate the business. In short, being 
liquid means having enough cash to pay the bills. 
? Solvency is the ability of a business to pay all its debts if the business 
were liquidated, or sold out. A solvent business must have more assets 
than it has debt. 
These variables are shown in the revenue generated by business (profit-and-
loss statement), the movement of cash in various business activities and 
balance cash available (cash-flow statement), and the net worth of the 
business (balance sheet). 
3.3 INCOME DETERMINATION: BASIC 
CONCEPTS 
To be able to understand the income statement of a business, the basic 
concepts of revenue recognition and income measurement must be clearly 
 
 
71 71 
Financial Statements Accounting: An 
Overview 
understood. But before that, one must be able to distinguish between capital 
and revenue items. The revenue items form part of the income statement 
whereas the capital items are shown in the balance sheet. These basic 
concepts have been discussed as follows: 
3.3.1 EXPENDITURE 
Expenditure represents any payment or outlay made for the purposes of 
business. The expenditures are incurred with a view to provide benefits to the 
business. Such benefit may extend up to one accounting year or more than 
one year. If the benefit of expenditure extends up to one accounting period, it 
is termed as revenue expenditure. Revenue expenditure is the outflow of 
funds to meet the running expenses of a business and it will benefit the 
business during the current period only. It is incurred to carry on the normal 
course of business or for the repairs and maintenance of the capital assets. In 
other words, revenue expenditure is incurred to maintain the earning capacity 
of business. For example, salaries, rent, routine repairs of machinery, interest 
paid on loan, etc. are all revenue expenditures as they will only benefit the 
current accounting period. Also, revenue expenditures are of a recurring 
nature. Revenue expenditures form part of the Income Statement and are also 
referred to as expenses recognised during an accounting period.  
If, however, the benefit of certain expenditure extends for more than one 
accounting period, it is termed as capital expenditure. For example, 
payment to acquire machinery for use in the business. Machinery acquired in 
the current accounting period will give benefits for many accounting periods 
to come. Hence, it will be treated as a capital expenditure that affects the 
balance sheet by an increase in the fixed assets. In simple words, capital 
expenditure is incurred to increase the earning capacity of a business and is of 
a non-recurring nature. Common examples of capital expenditure can be 
payment to acquire fixed assets and/or to make additions/extensions in the 
fixed assets to increase their useful life. 
3.3.2  Receipts 
A similar distinction of capital and revenue nature is made in case of receipts 
of the business. A receipt of money is treated as a capital receipt when the 
contribution is made by the owners towards the capital of the business 
(example: equity share capital) or, a contribution towards the capital is made 
by an outsider to the business (example: debentures, long term loan) or when 
a fixed asset is sold. Capital receipts do not usually have any effect on the 
profits earned or losses incurred during an accounting year as they are not 
shown in the Income Statement (P&L A/c). Capital receipts have an impact 
on the balance sheet. 
Next, a receipt is considered as a revenue receipt when it is received from 
sale of goods or services, fee received for rendering technical services, or any 
interest/dividend earned on investments made by business, or any receipt 
from business activities done in the normal course during an accounting 
period. Revenue receipts are shown in the Income statement. They are set off 
 
 
72 72 
Financial Statements Accounting: An 
Overview 
against the expenses in order to ascertain the profit or loss for the accounting 
period. 
3.3.3  Revenue Recognition 
Now that we have learnt about revenue receipts and expenditure, the next 
question that arises is, when should the revenue and expense be recognised in 
the books of accounts? Should we record the revenue when the transaction is 
made or when the cash is received or paid? The answer lies in the 
fundamental accounting concept of accrual basis and the revenue 
realisation principle.  
The accrual basis of accounting states that revenues should be recorded 
when they are earned or accrued, and not when they are received in cash. 
Similarly, expenses should be recorded when they are incurred, and not when 
they are paid in cash. For example, assume RT Ltd. made a sale of goods on 
12-06-2019 to a customer on credit. The cash was received on 25-08-2019. 
Hence, under accrual accounting, the revenue from sale will be recorded on 
12-06-2019 and not on 25-08-2019.Later, when the cash is received; no 
revenue is recorded because it has already been recorded on the day of sale. 
In simple terms, accrual basis requires income and expense to be recorded in 
the accounting period to which they relate and not on a cash basis. Taking 
another example, if any advance salary is paid to the employee, it will be 
debited as an expense in the Profit and loss account in the accounting period 
to which it belongs and not in the period in which it is paid. However, 
advance salary paid will be shown as a current asset in the Balance sheet of 
the accounting year in which it is paid. 
Realisation principle, on the other hand, is the point of recognising the 
revenue. It states that the revenue should be recognized only to the extent to 
which it is certainly realizable. Therefore, just receiving an order of goods or 
se rvic e s f rom the c ustom e r won’ t make it eligible to be recognized as 
revenue. The reasonable certainty of realizing the revenue will come only 
when the goods or services ordered are actually supplied to the customer and 
an invoice is created for the same. This concept ensures that income unearned 
or unrealized will not be considered as revenue. Further, realisation principle 
also enables the recognition of costs, incurred in making available such goods 
or services, as expense. Thus, the realisation principle facilitates the process 
of income measurement by recognising revenues and also the expenses 
incurred with respect to such revenues. This also implies, if costs are incurred 
in producing the goods, such costs are not considered as expenses unless 
sales are made. 
3.3.4  Measurement of Income 
Income is nothing but the excess of amount the business entity has earned 
from its operations over what they have invested into it over its lifetime. 
However, as per the going concern concept the business is expected to run 
its operations for an indefinite period of time. Therefore, it is impractical to 
wait till the winding up of business to measure the net income earned by it 
over its lifetime. There comes the concept of accounting period. 
 
 
73 73 
Financial Statements Accounting: An 
Overview 
Accountants choose some convenient segment of time, such as a calendar 
year or quarter of a year, to collect, summarise and report all information on 
material changes in the owners' equity (retained earnings) during that period. 
This period is usually one year, which could be a calendar year i.e. 1
st
 
January to 31
st
 December or it could be a fiscal year, like in India it is 1
st
 
April to 31
st 
March. The business organizations have the freedom to choose 
their own accounting year. However, generally, as a convention, most 
business firms tend to have a uniform accounting period for easier 
comparison of results. 
The accountants measure the income of an accounting period by recognizing 
the revenue and expense of that particular accounting period based on 
accounting principles of realisation and accrual. Therefore, accounting period 
facilitates a practical system of valuation and measurement. Accounting 
periods are bounded by balance sheets at the beginning and at the end of the 
period. Operations during the period are summarised by income statements. 
3.3.5  Matching Concept 
The determination of profit earned or loss incurred by a business during a 
particular accounting period requires deduction of the expenses from the 
revenue relating to that period. The matching concept emphasises exactly on 
this aspect. It is an accounting principle that states that expenses incurred in 
an accounting period should be matched with the revenues of that period. It 
implies that both the revenues and the expenses incurred to earn these 
revenues must be recognised in the same accounting period. Matching 
concept ensures that the profit or loss of an accounting period is not over or 
under-stated. 
As previously discussed, revenue is recognised when a sale is made or 
service is rendered, not when cash is received. Similarly, an expense is 
recognised when an asset or service has been used to generate revenue, and 
not when the cash is paid. It is worth noting that, only when a cost is 
recognised or accrues during an accounting period, it becomes an expense. 
Therefore, cost is not a synonym for expense. Only those costs that have 
expired during an accounting period are treated as expenses. For example, 
e a c h y e a r’ s de pr e c iation is a n e x p ire d c ost of a n a sset whic h is tre a ted a s a n expense during the accounting period in which the asset is used. Similarly in 
a trading account, sales revenue is matched with its cost of goods sold to 
ascertain the gross profit. This implies, we should only consider the cost of 
goods that have been sold during that year, and not the cost of all the goods 
purchased or produced during that period. For this purpose, the cost of unsold 
goods should be deducted from the cost of the goods produced or purchased. 
The balance amount is called as closing inventory or closing stock and 
shown in the trading account. 
Other examples of expenses include salaries, rent, insurance, interest on loan 
etc. These are recognised in the accounting period to which they belong 
irrespective of the actual payment.