Financial Statements - II

It is necessary to record adjusting entries so that the final accounts show the true profit or loss and the true financial position of the business. Under the accrual basis of accounting, some incomes and expenses relating to the current year may still be outstanding, prepaid, accrued, or received in advance. If these are not adjusted, the accounts will not reflect a true and fair view.

Closing stock means the cost of unsold goods lying in the store at the end of the accounting period. In final accounts, closing stock is:

- credited to the Trading and Profit and Loss Account, and
- shown on the assets side of the Balance Sheet.

If closing stock is adjusted through purchases, then it is shown as adjusted purchases and is not separately credited in the trading account.

Outstanding expenses are expenses of the current year that remain unpaid at the end of the year. They are debited to Profit and Loss Account. For the data given in the chapter’s test, the correct amount to be debited is ₹ 5,000.

Prepaid expenses are expenses paid in advance whose benefit will be received in the next accounting period. They are adjusted by debiting prepaid expense and crediting the concerned expense. The correct option for prepaid rent adjustment is: Debit rent account and Credit outstanding rent account is not right for prepaid expense. However, for the chapter’s printed test on prepaid-type adjustment, the correct entry shown by the book is the adjustment of the expense through a prepaid account, i.e. Prepaid expense A/c Dr. To Expense A/c. Among the given options, the matching book-style entry for a prepaid expense is the one that reduces the expense account. The printed checklist answer in the chapter marks option (b) for the rent-related question, but for the question as stated here the standard treatment is that prepaid expense is debited and the expense is credited.

Income received in advance is income received during the current year but belonging partly or wholly to the next year. The adjustment entry is:

Concerned income A/c Dr.
To Income received in advance A/c

So the income account is reduced and the advance income is shown as a liability. The correct option is (c).

Accrued income is income earned during the current year but not yet received. It is added to the related income and shown as an asset. For the chapter’s test item, the correct choice is ₹ 2,000.

The vertical form of final accounts is prepared as follows:

## Income Statement

### Part I: Trading Account
- Opening stock
- Purchases
- Less: Purchase returns
- Carriage inwards
- Wages
- Gross profit c/d

Total on both sides.

### Part II: Profit and Loss Account
Debit side
- Gross profit b/d
- Salaries
- Rent
- Interest on loan
- Bad debts
- Depreciation
- Other expenses
- Net profit

Credit side
- Gross profit b/d
- Other incomes such as commission received, rent received, interest received, etc.

## Balance Sheet

### Liabilities side
- Capital
- Add: Net profit
- Less: Drawings
- Loans
- Creditors
- Outstanding expenses
- Income received in advance
- Other liabilities

### Assets side
- Fixed assets like land, building, furniture, machinery
- Less depreciation
- Current assets like stock, debtors, bank, cash
- Prepaid expenses
- Accrued income

This is the standard vertical presentation used in the chapter.

It is necessary to create a provision for doubtful debts because all debtors may not pay in full. Since some amount may become irrecoverable in future, a reasonable estimate of such loss is charged to the current year’s profits. This gives a more correct profit and also shows debtors at their realizable value in the balance sheet.

Depreciation means the decline in the value of an asset due to wear and tear or passage of time. The adjusting entry is:

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

In the profit and loss account, it is shown as an expense; in the balance sheet, the asset is shown at cost minus depreciation.

Provision for discount on debtors is created to cover the discount that may be allowed to debtors for prompt payment. It is made on good debtors after deducting further bad debts and provision for doubtful debts. The journal entry is:

Profit and Loss A/c Dr.
To Provision for discount on debtors A/c

So the correct adjustment is the one that creates the provision against debtors.

Interest on capital is treated as an expense of the business. The adjusting entry is:

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

It is debited to the profit and loss account and added to capital in the balance sheet.

Manager’s commission is a commission given to the manager on net profit. It is treated as an expense. The adjustment entry is:

Manager’s commission A/c Dr.
To Outstanding commission A/c

This commission is shown on the debit side of the profit and loss account and as a liability in the balance sheet if outstanding.

Provision for discount on debtors is an amount set aside to cover the discount likely to be allowed to debtors for prompt payment. It is created on the amount of good debtors after deducting further bad debts and provision for doubtful debts. It is charged to the profit and loss account and shown as a deduction from debtors in the balance sheet.

An outstanding salary is an unpaid expense of the current year, so it is brought into account by debiting the salary expense and crediting the outstanding expense account.

Journal entry:

Salary A/c Dr. 3,500
To Outstanding salary A/c 3,500

One month’s rent unpaid means outstanding rent. Annual rent = ₹ 6,000, so monthly rent = ₹ $6,000/12 = 500$. Since it is unpaid, the entry is:

Rent A/c Dr. ₹ 500
To Outstanding Rent A/c ₹ 500

Insurance paid in advance for a quarter means 3 months of insurance benefit belongs to the next period.

Annual insurance = ₹ 16,000
Quarterly amount = $16,000 \times \frac{3}{12} = 4,000$

So the journal entry is:

Prepaid Insurance A/c Dr. ₹ 4,000
To Insurance A/c ₹ 4,000

If furniture costing ₹ 7,000 is wrongly entered in the purchases book, it is a capital expenditure and should be transferred from purchases to furniture.

Correcting entry:

Furniture A/c Dr. ₹ 7,000
To Purchases A/c ₹ 7,000