Ascertainment of Profit and Loss by Statement of Affairs Method and Double Entry System Method

For any business firm, it is important to ascertain its financial statements at the end of every financial year to know the profit/loss incurred by the business. It is necessary to prepare financial statements because they are the major representative of the financial health of any business. It is created to determine if the business activities are in harmony with the financial goals of the business. It is important to see if all the financial operations are efficient and are actually capable of earning good profits for the business firm. 

Financial statements reports for mainly two important aspects:

1. The total profits or the losses pulled in for that particular year, and
2. Total of assets and liabilities available to be transferred to the balance sheet on the closing date of the financial year.

But sometimes there are cases where financial records have not been maintained properly. Accounting records when are not precisely sustained according to the rules of the double entry system, which results in a term called incomplete records. Incomplete records are the result of an unsystematic single-entry system. But despite the incomplete records, ascertaining profits and losses for any business still remains important. Because in incomplete records, limited records are created like Debtors Account, Creditors Account, Cash Account, etc so it provides limited financial information regarding the business. So, the problem here is how using limited financial information in incomplete records, profit or loss for that particular financial year can be ascertained or how financial position for the same accounting year can be measured. There are two following methods to ascertain profit/loss in incomplete records:

1. Preparing Statement of Affairs at the beginning and at the end of the financial year, also called Capital Conversion method or Net Worth method.

2. Preparing Trading Account, Profit & Loss Account and Balance Sheet as per the rules of double entry system,  also called Conversion method.

1. Statement of Affairs Method:

Using this method, profits are calculated by performing a comparative analysis of the capital at the beginning and at the end of the accounting year. If the capital at the end of the financial year comes out to be higher than the capital available at the beginning of the financial year then the difference is termed as profits, incorporating all the relevant adjustments. Alternatively, if the capital at the end of the financial year comes out to be lower than the capital available at the beginning of the financial year then the difference is considered a loss. 

Statement of Affairs is a statement that shows the record of all the assets on one side and liabilities on the other just like a balance sheet. By comparing the values of assets and liabilities on both sides, capital employed can be found. And by comparing opening and closing balances of capital, profits or losses can be ascertained. 

Capital = Assets – Liabilities

To calculate the capital at the beginning of the year, ‘Opening Statement of Affairs’ is prepared and likewise for the capital at the end of year, “Closing Statement of Affairs” is prepared. Statement of Affairs seems to be much as same as Balance Sheet, but unlike balance sheet, statement of affairs is not dependent solely on the ledger balances rather the assets and liabilities are recorded here using vouchers, bank balances, and physical count of fixed assets or expenses and other relevant records available. So, the difference between both of the capitals depicts the increase or the decrease in the capital which is yet to be adjusted with any of the drawings made by the owner or any additional capital introduced afresh during this given financial year and then after incorporating all the adjustments, business entities land up to the correct profit or loss. So, the formula for Profit or Loss becomes as follows:

Profit/Loss = Closing Capital + Drawings – Additional Capital – Opening Capital

If the adjusted value is positive then it will be the profit for that accounting year and if this value comes out to be negative then it will be treated as a loss.

2. Double Entry System Method:

The very first account to be created is Trading account. It helps to measure the gross profit or the gross loss for that particular financial year which becomes the opening balance for the Profit and Loss account. For Profit and Loss account, it is desired to have complete information on all the expenses and incomes of the concerned year. Then for the balance sheet, complete details and documentation regarding all the assets and liabilities are required. To have an access to the complete information, it is necessary to first complete the incomplete records using the rules of the double-entry system. 

Following are the most common records which are usually not available in incomplete records but are required to be known to create Trading and Profit and Loss account:

• Opening capital 
• Credit Purchases
• Credit Sales
• Bills receivable received
• Bills payable accepted
• Payments to debtors
• Payments to creditors
• Any bank or cash-related transactions

Statement of affairs can be made to find out the opening capital at the beginning of the year. But finding the values for the missing items stated above using double-entry system, ascertaining profit or loss becomes easier and relatively more accurate.

Illustration:

Miss Shilpa owns a clothing store. She started her business on 1st April 2021 with a capital of ₹1,00,000. She did not record her transactions according to the double entry system. During the year she withdrew ₹30,000 for her personal use. Also, introduced an additional capital of ₹20,000. As on 31st March 2022, the incomplete records of Miss Shilpa provided the following data:

Calculate the profit or loss for the business of Miss Shilpa as on 31st March 2022 using Statement of Affairs.

Solution: