Basics of Accounting and Financial Statements: Balance Sheet, Profit and Loss and Cash Flow for RBI Grade B Finance

Last updated: 2026-11-13 · MockMentor

"Basics of Accounting and Financial Statements: Balance Sheet, Profit and Loss, Cash Flow Statements" is a line of the General Topics unit in the RBI Grade B Phase 2 Finance syllabus. Accounting and ratio numericals have become the largest Finance topic in recent papers: three questions in 2025 and six in 2026. They ask students to classify items, compute profit or cash flow, calculate depreciation or read a balance sheet. This chapter builds the basics step by step, with worked examples. Ratios are covered in the next chapter on ratio analysis.

In one line: accounting records business transactions using double entry and summarises them in three main statements: the balance sheet (what a firm owns and owes on a date), the profit and loss statement (its income and expenses over a period) and the cash flow statement (how cash came in and went out).

Basic concepts

Accounting: the process of identifying, recording, classifying, summarising and interpreting financial transactions, and communicating the results to users.
Assets: resources owned or controlled by a business that will bring future benefits, such as cash, inventory, machinery and receivables.
Liabilities: obligations of the business to outsiders, such as loans, creditors and outstanding expenses.
Equity (capital): the owners' claim on the business, equal to assets minus liabilities.
Revenue: income from the main activities of the business, such as sales.
Expense: costs incurred to earn revenue, such as wages, rent and raw materials.

Why in News?

Accounting and ratio analysis were the largest Finance topic in the 2026 RBI Grade B Phase 2 objective paper, with six questions, up from three in 2025.
RBI's expected credit loss framework, effective April 2027, brings bank provisioning closer to Indian Accounting Standard (Ind AS) 109 on financial instruments.
Accounting lapses in the derivatives book of a large private bank in 2025 showed how accounting and internal controls affect a bank's reported net worth.
The National Financial Reporting Authority (NFRA) has stepped up its review of audit quality for listed companies and large banks and NBFCs.

Users of accounting information

Users	What they want to know
Owners and shareholders	Profit, return on their investment and dividends
Managers	Information for planning and control
Lenders and banks	Ability to repay loans and interest
Creditors and suppliers	Ability to pay on time
Investors	Growth, risks and value of shares
Government and tax authorities	Taxable income and compliance
Employees	Stability and ability to pay wages and bonus
Regulators	Compliance with rules, such as capital for banks

Accounting concepts and conventions

Concept	Meaning
Business entity	The business is separate from its owners; the owner's personal transactions are not recorded
Money measurement	Only transactions that can be measured in money are recorded
Going concern	The business will continue for the foreseeable future, so assets are valued at cost, not sale value
Accounting period	Results are reported for fixed periods, such as a year
Cost concept	Assets are recorded at the price paid for them
Dual aspect	Every transaction has two equal effects, which is the basis of double entry
Realisation	Revenue is recognised when it is earned, usually when goods are delivered, not when cash is received
Accrual	Income and expenses are recorded when they occur, not when cash moves
Matching	Expenses are matched with the revenue of the same period
Consistency	The same methods are used from year to year
Prudence (conservatism)	Anticipate no profit, but provide for all possible losses
Materiality	Items that would affect decisions must be disclosed; trivial items need not be shown separately
Full disclosure	All material information must be disclosed

The accounting equation

Assets = Liabilities + Capital

Example: a person starts a business with ₹5 lakh of own money and a bank loan of ₹3 lakh, and buys machinery for ₹6 lakh.

Assets: machinery ₹6 lakh + cash ₹2 lakh = ₹8 lakh
Liabilities: bank loan ₹3 lakh
Capital: ₹5 lakh

₹8 lakh = ₹3 lakh + ₹5 lakh.

Double entry system

Every transaction affects at least two accounts, with equal debit and credit entries.

Types of accounts and the golden rules

Type of account	Debit	Credit	Example
Personal (persons, firms, banks)	The receiver	The giver	Supplier, customer, bank
Real (assets)	What comes in	What goes out	Cash, machinery, building
Nominal (expenses, incomes, losses, gains)	All expenses and losses	All incomes and gains	Rent, salary, commission received

Modern approach

Account	Increase	Decrease
Assets	Debit	Credit
Expenses	Debit	Credit
Liabilities	Credit	Debit
Capital	Credit	Debit
Revenue	Credit	Debit

Example: goods bought on credit from Ravi for ₹20,000. Purchases account (expense) is debited ₹20,000, and Ravi's account (liability) is credited ₹20,000.

The accounting cycle

Journal: each transaction is recorded in date order in the book of original entry, showing the accounts debited and credited.
Ledger: entries are posted to individual accounts, such as cash, sales and each customer.
Trial balance: a list of all ledger balances. The total of debit balances should equal the total of credit balances. A trial balance that agrees does not prove that there are no errors; errors of omission, principle and compensating errors do not affect its agreement.
Adjustments: for items such as outstanding expenses, prepaid expenses, accrued income, depreciation and provisions.
Final accounts: the profit and loss statement and the balance sheet.

Subsidiary books, such as the cash book, purchases book and sales book, are used for frequent transactions.

The profit and loss statement

The profit and loss (P&L) statement, also called the income statement, shows revenue, expenses and profit for a period.

Item	₹ lakh
Revenue from operations (net sales)	1,000
Less: Cost of goods sold	600
Gross profit	400
Less: Operating expenses (salaries, rent, selling and administrative)	180
Earnings before interest, tax, depreciation and amortisation (EBITDA)	220
Less: Depreciation and amortisation	40
Earnings before interest and tax (EBIT)	180
Less: Interest (finance cost)	30
Profit before tax (PBT)	150
Less: Tax	38
Profit after tax (PAT)	112

Cost of goods sold

Cost of goods sold = Opening inventory + Purchases + Direct expenses − Closing inventory

Example: opening inventory ₹50 lakh, purchases ₹620 lakh, direct expenses ₹30 lakh and closing inventory ₹100 lakh give a cost of goods sold of 50 + 620 + 30 − 100 = ₹600 lakh.

Capital and revenue items

Capital expenditure	Revenue expenditure
Gives benefit over several years	Benefit used up within the year
Buying machinery, buildings, vehicles	Wages, rent, repairs, electricity
Shown in the balance sheet as an asset	Charged to the P&L statement

Deferred revenue expenditure, such as heavy advertising for a new product, is a revenue expense whose benefit lasts several years; under Ind AS, most such items are expensed immediately.

The balance sheet

The balance sheet shows the financial position of a business on a particular date. Companies in India follow the format in Schedule III of the Companies Act, 2013.

Equity and liabilities	Assets
Shareholders' funds: share capital, reserves and surplus	Non-current assets: property, plant and equipment, intangible assets, capital work in progress, long-term investments, long-term loans and advances
Non-current liabilities: long-term borrowings, deferred tax liabilities, long-term provisions	Current assets: inventories, trade receivables, cash and cash equivalents, short-term investments, short-term loans and advances
Current liabilities: short-term borrowings, trade payables, other current liabilities, short-term provisions

Current assets are expected to be converted into cash within a year or the operating cycle; current liabilities are due within a year.

Example

Equity and liabilities	₹ lakh	Assets	₹ lakh
Share capital	300	Property, plant and equipment	500
Reserves and surplus	200	Investments	100
Long-term borrowings	250	Inventory	150
Trade payables	120	Trade receivables	130
Other current liabilities	80	Cash and bank	70
Total	950	Total	950

Here, net worth = 300 + 200 = ₹500 lakh; current assets = 150 + 130 + 70 = ₹350 lakh; current liabilities = 120 + 80 = ₹200 lakh; working capital = 350 − 200 = ₹150 lakh.

Bank balance sheets

Banks follow the Third Schedule of the Banking Regulation Act, 1949. Their liabilities are mainly capital, reserves, deposits and borrowings; their assets are cash and balances with RBI, balances with other banks, investments (mostly government securities), advances (loans) and fixed assets. Deposits are a bank's liabilities and loans its assets, the opposite of what a customer sees.

The cash flow statement

The cash flow statement shows how cash came in and went out over a period, under Ind AS 7 (or Accounting Standard 3 for some firms). Profit is not the same as cash, because of accruals and non-cash items such as depreciation.

Activity	Examples of inflows	Examples of outflows
Operating	Cash from customers	Payments to suppliers and employees, taxes
Investing	Sale of fixed assets and investments, interest and dividends received (for non-financial firms)	Purchase of fixed assets and investments
Financing	Issue of shares, borrowing	Repayment of loans, dividends and interest paid (for non-financial firms)

Direct and indirect methods

Direct method: lists gross cash receipts and payments.
Indirect method: starts with net profit and adjusts for non-cash items and changes in working capital. Most companies use this method.

Example (indirect method)

Item	₹ lakh
Net profit before tax	150
Add: Depreciation	40
Add: Interest expense (shown under financing)	30
Operating profit before working capital changes	220
Less: Increase in trade receivables	(20)
Less: Increase in inventory	(15)
Add: Increase in trade payables	10
Cash generated from operations	195
Less: Tax paid	(35)
Net cash from operating activities	160
Net cash used in investing activities (purchase of machinery)	(90)
Net cash used in financing activities (loan repaid 40, interest 30, dividend 20)	(90)
Net decrease in cash	(20)

An increase in current assets (other than cash) uses cash; an increase in current liabilities provides cash.

Depreciation

Depreciation is the reduction in the value of a fixed asset because of use, wear and tear, passage of time or obsolescence. It spreads the cost of an asset over its useful life, following the matching concept. It is a non-cash expense.

Methods

Method	Formula	Feature
Straight Line Method (SLM)	(Cost − Residual value) ÷ Useful life	Same amount every year
Written Down Value (WDV)	Rate × Book value at the start of the year	Higher depreciation in early years; never reaches zero
Units of production	Based on actual use	Suits machines whose wear depends on use

Example: a machine costs ₹10 lakh, with a residual value of ₹1 lakh and a useful life of 5 years.

SLM: (10 − 1) ÷ 5 = ₹1.8 lakh every year.
WDV at 20%: Year 1 = 20% of 10 = ₹2 lakh; Year 2 = 20% of 8 = ₹1.6 lakh; Year 3 = 20% of 6.4 = ₹1.28 lakh.

Land is not depreciated, as it does not wear out. Amortisation is the same concept for intangible assets such as patents and software, and depletion for natural resources such as mines.

Inventory valuation

Inventory is valued at cost or net realisable value, whichever is lower (the prudence concept).

Method	Meaning
First In, First Out (FIFO)	The oldest stock is assumed to be sold first; closing stock is valued at recent prices
Weighted Average Cost	Each unit valued at the average cost of all units available
Last In, First Out (LIFO)	The newest stock is assumed to be sold first; not permitted under Ind AS and IFRS

In times of rising prices, FIFO shows higher profit and higher closing inventory than weighted average.

Provisions and reserves

Term	Meaning
Provision	An amount set aside for a known liability or loss whose amount is uncertain, such as a provision for bad debts or for taxes; a charge against profit
Reserve	An appropriation of profit kept in the business, such as general reserve; not a charge against profit
Contingent liability	A possible obligation depending on a future event, such as a pending lawsuit or a guarantee; disclosed in notes, not shown as a liability

Accounting standards in India

Framework	Applies to
Accounting Standards (AS) issued by ICAI and notified by the government	Smaller unlisted companies
Indian Accounting Standards (Ind AS), converged with International Financial Reporting Standards (IFRS)	Listed companies and companies with net worth of ₹250 crore or more, in phases from 2016-17; NBFCs from 2018-19
Banks and insurers	Ind AS implementation for banks was deferred; RBI is aligning provisioning through the ECL framework

The National Advisory Committee on Accounting Standards was replaced by the National Financial Reporting Authority (NFRA), which advises on accounting and auditing standards and oversees auditors of large companies.

Common errors and limitations

Financial statements are based on historical cost and may not show current values.
They ignore non-monetary factors such as the quality of management.
Accounting choices (such as depreciation methods) affect profit.
Window dressing can make figures look better at the year end.
Inflation distorts comparisons over time.

Possible exam and interview questions

Explain the structure of a company's balance sheet and profit and loss statement. How do they relate to the cash flow statement? (620 words)
Why can a profitable company run short of cash? Explain with the help of the cash flow statement. (420 words)
A machine costing ₹5 lakh with no residual value is depreciated at 20% a year under the WDV method. Calculate its book value at the end of three years.
Distinguish between provisions, reserves and contingent liabilities.
Interview: Why do banks' balance sheets show deposits as liabilities and loans as assets?

Prepare with MockMentor

RBI Grade A/B 2027 Super-Elite Course (₹7,500) – Complete Phase 1 and Phase 2 preparation with the Descriptive Writing Programme. 365 days validity.