Chapter 10 Financial Statements - 2

It is extremely important to record the adjusting entries in the preparation of final accounts.

1. This is done in order to assess the true net profit or net loss of the business organization.
2. It helps us record those adjustments which were left or omitted and were not recorded in the accounts.
3. It assists us to separate all the financial transactions into a year-wise category. The financial statements include only those entries which belong to the current year. It rules out the previous and forth coming years’ entries which are the basis for accrual basis of accounting.
4. Further, it provides us the room for making various provisions which are made at the end of the year, after assessing the entries year’s performance.

Closing stock implies the value of unsold goods at the end of an accounting period. The valuation of closing stock is done on the basis of its cost price or the realisable value, whichever of the two is lesser. If closing stock is given in the adjustment, then there will be two postings.

(a) Outstanding expenses are recorded in books of finance at the end of an accounting period to show the true numbers of a business. The outstanding expense is a personal account and is treated as a liability for the business. It is also shown on the liability side of a balance sheet.

(b) Prepaid expenses represent goods or services paid for upfront where the company expects to use the benefit within 12 months. It is a future expense that a company has paid for in advance. A prepaid expense is only recognized in the income statement when the company consumes the product or service.

(c) Income that is received in advance is a liability because the company that received the money has not yet earned it and it has an obligation (a liability) to deliver the related goods or services in the future.

(d) Accrued income is earnings from investments that have not yet been received by the investing entity, and to which the investing entity is entitled. This concept is used under the accrual basis of accounting, where income can be earned even when the related cash has not yet been received. Under the accrual basis, the investing entity should accrue its best estimate of the income in the accounting period in which it earns the income. It may not be necessary to generate this accrual if the amount is immaterial, since the resulting accrual would have no demonstrable impact on the financial statements.

Vertical Analysis refers to the analysis of the Income Statement where all the line items which are present in the company's income statement are listed as a percentage of the sales within such statement and thus helps in analyzing the company’s performance by highlighting whether it is showing an upward or downward trend.

The provision for doubtful debt accounts is created to reduce the accounts receivable balance to its net realizable value without having to credit it. Since it is a contra asset account it has a credit balance as compared to the debit balance of accounts receivable.

(a) It is treated as a business expense and is debited to a profit and loss account. In the balance sheet, the asset will be shown at cost minus the amount of depreciation.

(b) It is treated as a business expense and is debited to a profit and loss account. It will be shown as a deduction from the debtors account to portray correctly the expected reliable value of debtors.

(c) It is shown as an expense on the debit side of the profit and loss account and added to capital in the balance sheet.

(d) It is shown as an expense on the debit side of the profit and loss account and on the liability side in the balance sheet.

This is a discount which is being allowed by an enterprise to its debtors to encourage prompt payments. Discounts likely to be allowed to customers in an accounting year can be estimated and provided for by creating a provision for discount on debtors. Here, it is to be remembered that provision for discount is made on good debtors which are arrived at by deducting further bad debts and the provision for doubtful debts.

(a) 

(Salaries of ₹ 3,500 is remaining outstanding)

(b) 

(Rent unpaid for one month at ₹ 500 = 6,000/12)

(c) 

(Insurance paid in advance for 3 month i.e. ₹ 400)

(d) 

(Furniture was wrongly debited purchased a rectified now ratified)

Entries which are given outside the trial balance are called adjustment entries, to record those entries a proper treatment is required according to the double entry system. Here it is to be remembered that all adjustments given outside the Trial Balance are posted at two places. Adjustment is generally done for those items which are omitted or entered with the wrong amount and/or recorded under wrong heads.

The following are reasons for recording or incorporating these adjustment entries in preparation of the final account.

(i) Through these adjustment entries we come to know the actual figure of profit or loss.
(ii) Because of these adjusting entries we can assess the true financial position of an organisation based on accrual basis of accounting.
(iii) These adjustment entries enable us to record the omitted entries and help in rectifying all those errors.
(iv) These adjusting entries help in providing depreciation and making different provisions, such as Bad Debts and Depreciation.

Provision for doubtful debts is a kind of arrangement about the expected bad debts from the debtors. Generally it is provided after deducting the amount of bad debts from the debtors. In other words provision is made only on good debtors those who have already proven bad, there is no need to make any provision on that. As provision for doubtful debts is made after preparing the trial balance, to record it we need a kind of adjustment entry in this regard we prepare debtors account and provision for doubtful debts account. For recording bad debts, the following journal entry is passed:

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

(Being provision for doubtful debts is created out of current year profits)

Computation of the Amount of Provision for Doubtful Debts As it is given at the end of a trial balance as an adjustment, little other related adjustment may be there for instance bad debts and discount on debtors. In this case provision for doubtful debt will be created after deducting the figure for bad debts out of the debtor figure.

Treatment of prepaid expenses, depreciation and closing stock at the time of preparing the final account :

(a) When Given Inside the Trial Balance

Prepaid Expenses When prepaid expenses are given in the trial balance itself it will be treated as current assets only and will be posted in the Assets Side of the balance sheet. No further adjustment will be required in this case

Depreciation When depreciation is given in the trial balance it will be treated as an expenditure and will be shown in the debit side of the Profit and Loss Account. No further adjustment will be required in this case.

Closing Stock When closing stock is given in the trial balance it will purely be treated as assets and will be shown only in the Assets Side of the Balance sheet. No further adjustment will be required in this case.

(b) When Given Outside the Trial Balance

Prepaid Expenses When prepaid expenses are given outside the trial balance it will be treated as an Adjustment and will be posted at two places first of all it will be deducted from the concerned expenses in the debit side of Profit and Loss Account and after that it will be treated as current assets and will be posted in the Assets side of the Balance Sheet.

Depreciation When depreciation is given outside the trial balance it will be treated as an adjustment and will be posted at two places to comply with the rules of double entry book keeping system. First of all the amount of depreciation will be shown in the debit side of Profit and Loss account as an expenditure and the amount of depreciation will be deducted from the concerned assets in the assets side of Balance Sheet.

Closing Stock When closing stock is given outside the trial balance It will purely be treated as an adjustment and will be posted at two places first of all the amount of closing stock will be shown at the credit side of Trading Account and after that it will be shown as an assets in the Assets side of the Balance Sheet.

(c) Rs. 1,000 (Credit)

(d) Debit rent account and Credit outstanding rent account.

(b) Debit rent account Credit rent received in advance account.

(a) Rs. 5,250

(d) Rs. 700