Chapter Notes

Here are your study notes for the chapter on Financial Statements - II.

Need for Adjustments

When preparing financial statements like the Trading and Profit and Loss Account and the Balance Sheet, we can't simply use the figures directly from the trial balance. Business operations have complexities that need to be accounted for to get a true and fair picture of the company's financial health. This is where adjustments come in.

The main reason for these adjustments is the accrual basis of accounting. This principle states that:

• Revenues should be recorded when they are earned, not necessarily when cash is received.
• Expenses should be recorded when they are incurred (when the benefit is used), not necessarily when cash is paid.

Because of this, at the end of an accounting year, there might be:

• Expenses paid this year that actually belong to the next year.
• Incomes received this year that are for services to be provided next year.
• Expenses for this year that haven't been paid yet.
• Incomes earned this year that haven't been received yet.

Without adjusting for these items, the financial statements would not accurately show the profit or loss for the period or the true financial position of the business.

Common items that require adjustments include:

• Closing stock
• Outstanding expenses
• Prepaid expenses
• Accrued income
• Income received in advance
• Depreciation
• Bad debts
• Provision for doubtful debts
• Provision for discount on debtors
• Manager's commission
• Interest on capital

Closing Stock

Closing stock refers to the value of unsold goods lying in the store at the end of an accounting period. It is usually given as additional information outside the trial balance.

Accounting Treatment

The adjustment entry for closing stock is:

Closing Stock A/c Dr. To Trading A/c

This has two effects on the final accounts:

1. Trading Account: It is shown on the credit side to calculate the gross profit or gross loss for the year.
2. Balance Sheet: It is shown on the assets side as a current asset, as it represents a resource that will provide future economic benefit.

Alternative Treatment: Adjusted Purchases

Sometimes, opening and closing stock are adjusted through the Purchases account.

• Closing stock is credited to the Purchases account (Closing stock A/c Dr. To Purchases A/c).
• Opening stock is debited to the Purchases account (Purchases A/c Dr. To Opening stock A/c).

In this case, the final figure is called Adjusted Purchases, which is shown on the debit side of the Trading Account. The closing stock will then appear inside the trial balance and will only be shown on the asset side of the Balance Sheet, not on the credit side of the Trading Account.

Outstanding Expenses

Outstanding expenses are expenses that have been incurred during the current accounting year but have not been paid by the end of the year. Examples include unpaid salaries, wages, or rent.

To follow the accrual concept, these expenses must be charged against the revenue of the current year to find the correct profit.

Accounting Treatment

The adjustment entry is:

Concerned Expense A/c Dr. To Outstanding Expense A/c

This has two effects on the final accounts:

1. Trading and Profit & Loss Account: The amount of the outstanding expense is added to the respective expense on the debit side.
2. Balance Sheet: It is shown on the liabilities side as a current liability, as it is an amount the business owes.

Prepaid Expenses

Prepaid expenses (or unexpired expenses) are expenses that have been paid in advance, where the benefit will be received in the next accounting year.

The portion of the expense that relates to the next year is not an expense for the current year and should be carried forward.

Accounting Treatment

The adjustment entry is:

Prepaid Expense A/c Dr. To Concerned Expense A/c

This has two effects on the final accounts:

1. Trading and Profit & Loss Account: The prepaid amount is deducted from the total of that particular expense on the debit side.
2. Balance Sheet: It is shown on the assets side as a current asset, because the business is entitled to receive a future service or benefit.

Accrued Income

Accrued income is income that has been earned during the current accounting period but has not yet been received by the end of that period. Examples include commission earned but not received or interest on investments that is due but not yet collected.

Accounting Treatment

The adjustment entry is:

Accrued Income A/c Dr. To Concerned Income A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The accrued amount is added to the related income on the credit side.
2. Balance Sheet: It is shown on the assets side as a current asset, as it is an amount receivable by the business.

Income Received in Advance

Income received in advance (or unearned income) is income that has been received during the current year, but a portion of it relates to the next accounting period.

Since this income has not yet been earned, it is treated as a liability.

Accounting Treatment

The adjustment entry is:

Concerned Income A/c Dr. To Income Received in Advance A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The amount received in advance is deducted from the respective income on the credit side.
2. Balance Sheet: It is shown on the liabilities side as a current liability, because the business has an obligation to provide a service or good in the future.

Depreciation

Depreciation is the decline in the value of fixed assets due to wear and tear, usage, or the passage of time. It is considered a business expense and must be charged to the Profit and Loss Account to determine the true profit.

Accounting Treatment

The adjustment entry is:

Depreciation A/c Dr. To Concerned Asset A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The depreciation amount is shown as an expense on the debit side.
2. Balance Sheet: The amount of depreciation is deducted from the cost of the specific asset on the assets side to show its written-down value.

Bad Debts

Bad debts are amounts owed to the business by its debtors that are now considered irrecoverable. It is a loss for the business.

Sometimes, after the trial balance is prepared, additional information reveals that some debtors have become insolvent. These are called further bad debts.

Accounting Treatment

The adjustment entry for further bad debts is:

Bad Debts A/c Dr. To Debtors A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The amount of further bad debts is added to any existing bad debts shown in the trial balance on the debit side.
2. Balance Sheet: The amount of further bad debts is deducted from the Sundry Debtors on the assets side.

Provision for Bad and Doubtful Debts

Even after writing off known bad debts, a business may still expect that some of its remaining debtors might not pay in the future. It is not possible to know the exact amount, so a reasonable estimate is made. This estimate is called a provision for bad and doubtful debts.

Creating this provision ensures that potential losses are accounted for in the year the sales were made, following the principle of prudence.

Accounting Treatment

The adjustment entry to create or increase a provision is:

Profit and Loss A/c Dr. To Provision for Doubtful Debts A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The amount of the new provision created is shown on the debit side. If there is an existing provision (old provision) in the trial balance, the amount debited is adjusted as follows:
   • (Bad Debts + Further Bad Debts + New Provision) - Old Provision
2. Balance Sheet: The new provision is deducted from Sundry Debtors on the assets side (after deducting further bad debts).

Provision for Discount on Debtors

Businesses often offer a discount to debtors for prompt payment. To account for this potential future expense, a provision for discount on debtors is created.

This provision is calculated on good debtors, which is the amount of debtors remaining after deducting further bad debts and the provision for doubtful debts.

Accounting Treatment

The adjustment entry is:

Profit and Loss A/c Dr. To Provision for Discount on Debtors A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The amount of the provision is shown as an expense on the debit side.
2. Balance Sheet: The provision is deducted from Sundry Debtors on the assets side.

Manager's Commission

A manager is sometimes entitled to a commission based on the net profit of the business. This commission can be calculated in two ways:

1. On profit before charging such commission:
   • Formula: Net Profit before Commission × (Rate / 100)
2. On profit after charging such commission:
   • Formula: Net Profit before Commission × (Rate / (100 + Rate))

Unless specified otherwise, assume the commission is calculated on profit before charging.

Accounting Treatment

The commission is an expense for the business.

1. Profit & Loss Account: The commission amount is shown on the debit side.
2. Balance Sheet: Since the commission is calculated at the end of the year, it is usually unpaid. It is shown as Manager's Commission Outstanding on the liabilities side.

Interest on Capital

A proprietor may want to see how much profit the business has made after accounting for interest on the capital they invested. Interest on capital is treated as an expense for the business.

It is calculated on the opening capital for the full year. If additional capital was introduced during the year, interest is calculated on that amount from the date it was introduced.

Accounting Treatment

The adjustment entry is:

Interest on Capital A/c Dr. To Capital A/c

This has two effects on the final accounts:

1. Profit & Loss Account: The amount of interest is shown as an expense on the debit side.
2. Balance Sheet: The interest is added to the Capital account on the liabilities side.