Financial Statements: The Income Statement and the Balance Sheet

The balance sheet

A statement of assets, liabilities and capital as at a date. It is not an account; it is a statement, which is why it has no debit and credit sides in the modern form.

Assets are usually split:

• Fixed assets: things kept and used, such as furniture, a computer, the library.
• Current assets: things that turn over, such as cash, the bank balance, and fees billed but not received, called debtors or receivables.

Liabilities likewise:

• Long-term liabilities: a loan repayable over years.
• Current liabilities: what is payable soon, including money held for clients.

Capital is the proprietor's stake: opening capital, plus profit, minus drawings.

Client money on an advocate's balance sheet. This is the point that makes the topic a law topic. Money held for clients appears twice: once as part of the bank balance, an asset, and once as a liability to the clients. It must never be shown as income or as capital. That is the accounting form of the proposition that runs through this whole module: client money is not the advocate's money, and it is why rules 25 to 30 require a separate client account.

The worked month, continued

Taking Advocate Nandini's April figures from chapter [The Books a Lawyer Keeps: Cash Book, Ledger, Journal and Trial Balance] without change.

Receipts and payments account for April

Notice what is wrong with it as a measure of performance. It includes the capital she put in, which is not income; the laptop and books, which are assets and not expenses; and the client money in and out, which is neither. On this statement she appears to have taken in Rs 2,95,000, which tells nobody anything about the practice.

Income and expenditure account for April

What has been excluded, and why.

• Capital introduced, Rs 2,00,000: it is not income; it goes to the balance sheet.
• Computer, Rs 60,000, and Library, Rs 18,000: capital expenditure, so they become assets. Only depreciation on them would be an expense, and in a first month it is commonly ignored or charged pro rata.
• Client A's Rs 20,000, the Rs 12,000 court fee and the Rs 8,000 refund: none of them is hers. They pass through the bank and through the client's ledger and touch neither income nor expenditure.

Net profit is Rs 46,000.

Balance sheet as at 30 April

Check it against the equation. Assets 2,46,000 equal Liabilities nil plus Capital 2,46,000. The balance sheet balances because the profit of Rs 46,000 from the income statement was added to capital.

And notice the client liability is nil, because Client A's matter was concluded and the unspent balance returned on 30 April. Had Nandini still held Rs 8,000 of his money on 30 April, the balance sheet would show Bank Rs 1,76,000 on the asset side and Client A Rs 8,000 as a liability, and it would still balance, with capital unchanged at Rs 2,46,000. Client money changes both sides and never touches profit.

Adjustments a practice usually makes

Four, and each is a standard examination point.

Depreciation. The laptop and books lose value with use. A portion of cost is charged as an expense each year and deducted from the asset. It converts capital expenditure into revenue expenditure over the asset's life.

Outstanding expenses. Rent for March paid in April is an expense of March on the accrual basis, and appears as a current liability at 31 March.

Prepaid expenses. Insurance paid in March for the year to February is partly an expense of the next year, and the unused part is a current asset.

Fees due but not received. On the accrual basis they are income and appear as debtors, a current asset. On the cash basis they are neither, which is the main practical difference between the two bases and the reason a busy practice can be profitable on paper and short of cash.

Reading the statements

An advocate should be able to ask three questions of his own accounts.

Am I profitable? Income and expenditure account.

Am I solvent, and is the money in the bank mine? Balance sheet, and specifically the comparison between the bank balance and the total of client liabilities. If clients are owed Rs 3,00,000 and the bank holds Rs 2,40,000, something is seriously wrong, and it is the arithmetic that reveals the misconduct.

Where is my money going? The expenses side of the income and expenditure account.

That second question is the reason this topic is in a law syllabus. In Harish Chandra Tiwari v. Baiju, AIR 2002 SC 548, an advocate withdrew Rs 8,118 of a poor client's compensation and neither told him nor paid it over; in Prahlad Saran Gupta v. Bar Council of India, AIR 1997 SC 1338, an advocate retained Rs 1,500 for a considerable period without justification. Both would show at once in a balance sheet where client liabilities exceed the money held for clients.

A worked example

At 31 March a practice shows: bank Rs 4,10,000; cash Rs 5,000; furniture Rs 90,000; library Rs 60,000; fees billed and unpaid Rs 1,20,000; client money held for six clients totalling Rs 3,50,000; an unpaid electricity bill of Rs 6,000; capital at the start of the year Rs 2,00,000; drawings Rs 3,00,000; and fees received during the year Rs 9,00,000 against expenses of Rs 4,00,000.

Profit for the year, on the cash basis: fees Rs 9,00,000 less expenses Rs 4,00,000, that is Rs 5,00,000. On the accrual basis add the Rs 1,20,000 billed and unpaid and the Rs 6,000 outstanding electricity becomes an expense, giving Rs 6,14,000.

Capital at the year end, on the cash basis: Rs 2,00,000 opening, plus Rs 5,00,000 profit, less Rs 3,00,000 drawings, that is Rs 4,00,000.

The balance sheet, cash basis, ignoring the unbilled fees and the outstanding bill for simplicity:

The statement does not balance without that shortfall, and that is the point of the example. Assets other than the shortfall total Rs 5,65,000 against liabilities and capital of Rs 7,50,000.

What it means. Clients are owed Rs 3,50,000, but the practice holds only Rs 4,15,000 in bank and cash in total, out of which Rs 4,00,000 is supposed to be the proprietor's own capital. The client money has been spent, and the drawings of Rs 3,00,000 are where it went.

The legal consequence. That is misconduct, whether or not any individual client has complained and whether or not the advocate meant to replace it. Rules 25 to 32 require the client's money to be accounted for; on Prahlad Saran Gupta even retaining a client's money without justification is conduct not befitting an advocate; and on Harish Chandra Tiwari misappropriation of a client's money is among the gravest professional misconducts. Chapter [When an Accounting Failure Becomes Misconduct] takes this up.

What beginners get wrong

The income statement covers a period, the balance sheet a date.

Capital introduced is not income.

Buying an asset is not an expense, though depreciation is.

Client money is neither income nor expense. It appears on both sides of the balance sheet and never in the profit.

Drawings are not an expense. They reduce capital.

The balance sheet balances because profit is added to capital.

Quick revision

• Income statement: a period; income less expenses gives profit or loss. Balance sheet: a date; Assets = Liabilities + Capital. The profit is added to capital, which is why the balance sheet balances.
• Receipts and payments account: a summary of the cash book, cash basis, including capital and revenue items alike; a poor measure of performance.
• Income and expenditure account: revenue items of the period only; result is a surplus or deficit, or net profit.
• Cash basis records on receipt and payment; accrual basis on earning and incurring, producing debtors and outstanding expenses.
• Assets: fixed (furniture, computer, library) and current (cash, bank, debtors). Liabilities: long-term and current, the latter including money held for clients.
• Client money appears twice: in the bank balance as an asset and as a liability to clients. Never as income or capital.
• Adjustments: depreciation, outstanding expenses, prepaid expenses, fees due but not received.
• The test that matters legally: compare the money held with the total owed to clients. A shortfall is the arithmetic of misconduct.

Test yourself

1. What is the difference between an income statement and a balance sheet? The income statement covers a period and shows income and expenses to produce the profit or loss. The balance sheet is as at a date and shows assets, liabilities and capital. The profit from the income statement is added to capital in the balance sheet, which is why the balance sheet balances.

2. Distinguish a receipts and payments account from an income and expenditure account. A receipts and payments account is a summary of the cash book on the cash basis, and includes capital as well as revenue items and amounts belonging to other periods. An income and expenditure account includes only revenue items belonging to the period, and on the accrual basis includes income earned and expenses incurred whether or not money has moved.

3. How does client money appear in an advocate's balance sheet? Twice. It forms part of the bank or cash balance on the assets side, and it appears as a liability to the clients concerned. It is never income and never capital, because it is not the advocate's money.

4. Are drawings an expense? No. Drawings are amounts taken by the proprietor for himself and are deducted from capital in the balance sheet. They do not appear in the income statement.

5. A practice holds Rs 4,15,000 in bank and cash, owes clients Rs 3,50,000, and shows capital of Rs 4,00,000. What does that tell you? That client money has been used. The money held is less than the sum of the client liabilities and the proprietor's own capital, so there is a shortfall. That is the arithmetic of misappropriation, and it is misconduct whether or not any client has complained and whether or not the advocate intended to replace it.

6. Why is a laptop not an expense of the year in which it is bought? Because it is capital expenditure: the value is retained in a different form, so it becomes a fixed asset in the balance sheet. Only depreciation, which charges part of its cost in each year of its useful life, is an expense in the income statement.