Financial Statements – II

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Test Your Understanding
Tick the correct answer.
1. Rahul’s trial balance provide you the following information :
Debtors
₹ 80,000
Bad debts
₹ 2,000
Provision for doubtful debts
₹ 4,000
It is desired to maintain a provision for bad debts of ₹ 1,000. State the amount to be debited/credited in profit and loss account :
  1. ₹ 5,000 (Debit)
  2. ₹ 3,000 (Debit)
  3. ₹ 1,000 (Credit)
  4. None of these
2. If the rent of one month is still to be paid the adjustment entry will be :
  1. Debit outstanding rent account and Credit rent account
  2. Debit profit and loss account and Credit rent account
  3. Debit rent account and Credit profit and loss account
  4. Debit rent account and Credit outstanding rent account.
3. If the rent received in advance ₹ 2,000. The adjustment entry will be :
  1. Debit profit and loss account and Credit rent account
  2. Debit rent account Credit rent received in advance account
  3. Debit rent received in advance account and Credit rent account
  4. None of these.
4. If the opening capital is Rs. 50,000 as on April 01, 2014 and additional capital introduced Rs. 10,000 on January 01, 2015. Interest charge on capital 10% p.a. The amount of interest on capital shown in profit and loss account as on March 31, 2015 will be :
  1. ₹ 5,250
  2. ₹ 6,000
  3. ₹ 4,000
  4. ₹ 3,000
5. If the insurance premium paid Rs. 1,000 and pre-paid insurance Rs. 300. The amount of insurance premium shown in profit and loss account will be :
  1. ₹ 1,300
  2. ₹ 1,000
  3. ₹ 300
  4. ₹ 700

Short Answers
1. Why is it necessary to record the adjusting entries in the preparation of final accounts?
It is necessary to record the adjusting entries in the preparation of final accounts due to the following reasons
  1. Assures that the final accounts reflect the true profit or loss and true financial position of the business.
  2. It ensures that the final accounts are in true compliance with the accrual basis of accounting.
  3. Carry forward the provisions or adjustments from the past.
  4. It ensures that all the financial transactions that truly belong to the current financial year are considered. Any transactions that are related to the past or future years are unaccounted. At the same time it ensure that any transactions that are occurred in the past year or due in the coming years but belong to the current year are taken into account.
  5. Ensures that future provisions for various purposes are taken into consideration.

2. What is meant by closing stock? Show its treatment in final accounts?
Definition: Closing stock refers to the cost of the unsold goods left out in the inventory at the end of the accounting period. Before entering into the accounts, the realized value of the closing stock is assessed. This realized value is then compared with the cost price of the stock and the minimum of the two is considered for entering into the accounts.
Treatment in the final accounts: The closing stock is adjusted by
  1. By crediting it to the trading and profit and loss account.
  2. By considering it on the asset side of the balance sheet.
The following will be the adjustment entry.
Closing Stock A/c
Dr.
To Trading A/c
Sometimes the closing stock is adjusted through the purchases account. The corresponding entry in this case would be
Closing Stock A/c
Dr.
To Purchases A/c
When such adjustment is done, the closing stock will not be entered on the credit side of the trading and profit and loss account. This entry reduces the purchases account and is called as adjusted purchases. However, it will still be shown on the assset side of the balance sheet (though it is not shown separately in the trading and profit and loss account).

3. State the meaning of:
  1. Outstanding expenses
  2. Prepaid expenses
  3. Income received in advance
  4. Accrued income
Outstanding Expenses: Outstanding expenses are those expenses that remain unpaid at the end of an accounting period. In otherwords certain services or benefits are received by the firm but the firm has not yet paid or partially paid (partially not paid) for these services or benefits. As these expenses are incurred in the current accounting periord while earning the revenue, it makes sense to charge these expenses against the revenue earned in the current accounting period itself to arrive at the true profit or loss. Outstanding expenses necessitate the opening of a new outstanding expenses account for each type of expense for which the expenses are due to be paid. These outstaning expenses are added to the corresponding expenses head in the trading and profit and losse account. Also, as outstanding expenses are the liabilities of the company they are shown on the liabilities side of the balance sheet. Examples include outstanding salaries, outstanding wages, outstanding rent etc.
Prepaid expenses: Prepaid expenses are those expenses for which the amount is paid in advance but the services or benefits are not yet received or partially received by the firm and the rest of the services or benefits are due to be realized in the coming accounting periods. Prepaid expenses necessitate the opening of a new prepaid expenses account for each type of expese for which the expenses are paid in advance. These expenses are deducted from the total expenses under a particular expenses head while preparing the trading and profit and loss account. Also, as these expenses are paid in advance, they will be reflected on the assets side of the balance sheet. Examples include prepaid rent, prepaid salaries etc.
Income received in advance: The income received by the firm in the current accounting period but does not belong to the current accounting period is called as Income Received in advance or Unearned income. As this income does not belong to the current accounting period, it will not be considered in the trading and profit and loss account. Also, the firm is liable to provide the services or benefits and hence this income will be shown on the liabilities side of the balance sheet.
Accrued Income: The income that is earned in the current accounting period but not yet received by the end of the accounting period is known as the accrued income. The services or benefits equal the accrued income are provided by the firm but the amount is not yet received from the buyers/debtors. The accrued income is due to be received in the next/upcoming accounting periods. The accrued income will be added to a specific income head on the credit side of the trading and profit and loss account. And it’ll be shown on the assets side of the balance sheet.

4. Give the Proforma (not performa) of income statement and balance in vertical form.
The following is the income statement format in vertical form.
Income statement of the company …………… for the year ended dd.mm.yyyy
Particulars
Amount
Amount
Sales
Less: Sales returns (Return inwards)

Total Sales Revenue
 
Cost of goods
Purchases
Less: Purchase returns (Return outwards)
Carriage on purchases
Wages
Add: Outstanding wages
Less: Prepaid wages
Fuel and power
Factory rent
Installation or erection of machines
Octroi
Less: Closing stock

Gross Profit/Gross Loss (whichever is applicable)
Operating Expenses/Losses
Selling Expenses/Losses
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total Selling expenses
General & Administrative expenses/losses
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total General & Administrative Expenses
Total Operating Expenses/Losses
Operating Profit/Loss
Non-operating revenues/gains
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total non-operating revenues/gains
Non-operating expenses/losses
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Less: Total non-operating expenses/losses
Net profit/loss
The following is the balance format in vertical form.
Balance sheet as on dd.mm.yyyy
Particulars
Amount
Amount
Current Assets
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Prepaid expenses

Total current assets
Current Liabilities
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total current Liabilities
Non-Current Assets
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total non-current assets
Non-Current Liabilities
……………………
……………………
……………………
……………………
……………………
……………………
……………………
……………………

Total non-current Liabilities
Capital
Add: Net profit
Less: Drawings/losses

Total capital
Total liabilities/assets (each of these should balance)

5. Why is it necessary to create a provision for doubtful debts at the time of preparation of final accounts?
While it is expected that the debtors should pay all the amount owed by them to the business, in reality it is not possible to recover all the debts from the debtors. Some of the debtors might default the amount either fully or partially. However, as it is uncertain that how much of the debt will actually turn out to be a bad debt, the business has to make a reasonable estimate of the amount that is likely to be a loss due to bad debt and provide the same. This estimated provision is called as provision for bad debts and it is entered into the financial statements by debiting the profit and loss account. The following is the corresponding journal entry.
Profit and Liss A/c
Dr
To Provision for doubtful debts A/c

This provision for doubtful debts is also shown as the deduction from the debtors on the asset side of the balanc sheet to as to present a true and fair view of the financial position of the business.
6. What adjusting entries would you record for the following :

(a) Depreciation
(b) Discount on debtors
(c) Interest on capital
(d) Manager’s commission

The adjustment entries for each of these is provided below.
Ajustment entries for the depreciation
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Depreciation
Balance Sheet
Liabilities
Amount
Assets
Amount
Assets
Less: Depreciation
Ajustment entries for the discount on debtors
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Discount on debtors
Balance Sheet
Liabilities
Amount
Assets
Amount
Debtors
Less: Discount on debtors
Ajustment entries for the interest on capital
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Interest on capital
Balance Sheet
Liabilities
Amount
Assets
Amount
Capital
Add: Interest on capital
Ajustment entries for the interest on capital
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Interest on capital
Balance Sheet
Liabilities
Amount
Assets
Amount
Capital
Add: Interest on capital
Ajustment entries for the Manager’s commission
Manager’s commission is applied on the profit either before charging such commission or after charging such commission. Let’s consider each of these scenarios. Note that it is only the way it is calculated that is going to be different. Once the calculation is done, tt is considered the same way in both the Trading and Profit and Loss account and the balance sheet in either of the cases.
When commission is applied on the profit before charging the commission.
Manager’s commission = Net Profit ×
Rate of Commission
100
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Manager’s commission
Balance Sheet
Liabilities
Amount
Assets
Amount
Manager’s commission outstanding
When commission is applied on the profit after charging the commission.
Manager’s commission = Net Profit ×
Rate of Commission
(100 + Rate of Commission)
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Manager’s commission
Balance Sheet
Liabilities
Amount
Assets
Amount
Manager’s commission outstanding

7. What is meant by provision for discount on debtors?
To encourage the debtors to make the payments online, the businesses allows discount on debtors. The amount of discount on debtors that is likely to be provided to the debtors is estimated and accounted for through a provision on discount on debtors. This discount is provided only for the good debtors. Good debtors can be obtained after the bad debts and provision for doubtful debts from the total debtors. The corresponding journal entry is as follows:
Profit and Loss A/c
Dr.
To Provision for Discount on Debtors A/c
Provision for discount on (good)debtors is an expense for the business in collecting the debts from the debtors. So, this will reduce the profit of the business.
It is shown on the expenses side in the profit and loss account on deducted from the debtors on the assets side in the balance sheet.
8. Give the journal entries for the following adjustments :

(a) Outstanding salary ₹ 3,500.
(b) Rent unpaid for one month at ₹ 6,000 per annum.
(c) Insurance prepaid for a quarter at ₹ 16,000 per annum.
(d) Purchase of furniture costing ₹ 7,000 entered in the purchases book.

Working notes
Rent unpaid for one month
=
6,000
12
= 500
Insurance prepaid for quarter
=
16,000
4
= 4,000
S.No.
Particulars
L.F.
Debit
Credit
a
Salaries A/c
Dr.
3,500
To Outstanding Salaries A/c
3,500
(Being Salaries worth of ₹ 3,500 outstanding to be paid)
b
Rent A/c
Dr.
500
To Outstanding Rent A/c
500
(Being one month rent of ₹ 500 outstanding to be paid)
c
Prepaid Insurance A/c
Dr.
4,000
To Insurance A/c
4,000
(Being advance insurance paid ₹ 4,000 for one quarter)
d
Furniture A/c
Dr.
7,000
To Purchases A/c
7,000
(Being correction entry for wrong debit of furniture worth of ₹ 7,000 into the purchases account)

Long Answers
1. What are adjusting entries? Why are they necessary for preparing final accounts?
The following are the entries which usually need adjustment.
 1. Closing stock
 2. Outstanding expenses
 3. Prepaid or Unexpired expenses
 4. Accured Income
 5. Income received in advance
 6. Depreciation
 7. Bad debts
 8. Provision for doubtful debts
 9. Provision for discount on debtors
10. Manager’s commission
11. Interest on capital
As per the accrual concept of accounting, the profit or loss for an accounting year is not based just on the revenues realized in cash and the expenses paid in cash during that accounting year. Part of the receipts and expenses that occured in a year might belong to the previous and/or next account year. There might be some incomes and expenses that belong to the current year but were not yet brought into the books of account. These items need to be adjusted so that the true and fair view of the state of affairs of the business are reflected.
So we need to make adjustments for the prepaid or outstanding expenses as well as accrued and advance receipts of income. In addition to this certain items like depreciation are not recorded on a daily basis and hence these need to be adjusted at the end of the accounting period. So, these adjustments need to be taken into consideration so taht the true profit and loss and true financial position of the business is reflected.

2. What is meant by provision for doubtful debts? How are the relevant accounts prepared and what journal entries are recorded in final accounts? How is the amount for provision for doubtful debts calculated?
While it is expected that the debtors should pay all the amount owed by them to the business, in reality it is not possible to recover all the debts from the debtors. Some of the debtors might default the amount either fully or partially. However, as it is uncertain that how much of the debt will actually turn out to be a bad debt, the business has to make a reasonable estimate of the amount that is likely to be a loss due to bad debt and provide the same. This estimated provision is called as provision for bad debts and it is entered into the financial statements by debiting the profit and loss account. The following is the corresponding journal entry.
Profit and Liss A/c
Dr
To Provision for doubtful debts A/c
This provision for doubtful debts is also shown as the deduction from the debtors on the asset side of the balanc sheet to as to present a true and fair view of the financial position of the business.
This provision for doubtful debts created at the end of the accounting period is carried forward to the next accounting period. During the next accounting period, this provision for the doubtful debts will be used to compensate the losses due to bad debts. Similarly, the business will carry forward the provision for doubtful debts from the previous year to the current year at the beginning of the current accounting period. This is called as opening provision or old provision. When the opening provision is already existing, the losses due to bad debts during current year are adjusted against it. The provision that is considered at the end of the accounting period for doubtful debts is called as new provision. The balance of old provision given in the trial balance should be taken into account while calculating it.
Ajustment entries for the provision for doubtful debts
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Provision for doubtful debts
Bad debts
Further bad debts
New provision
Less: Old Provision
Balance Sheet
Liabilities
Amount
Assets
Amount
Sundry debtors
Less: Further bad debts
Less: Provision for doubtful debts

3. Show the treatment of prepaid expenses, depreciation, closing stock at the time of preparation of final accounts when:

(a) When given inside the trial balance?
(b) When given outside the trial balance?

Prepaid expenses: When prepaid expenses occur in the trial balance it means that they’re already accounted for and hence need not be considered in the profit and loss statement. They should only be considered in the balance sheet. However, when they are given outside the trial balance (as part of the adjustments need to be made), they should be reflected in the trading and profit and loss account as well as the balance sheet.
When given inside the trial balance
Balance Sheet
Liabilities
Amount
Assets
Amount
Prepaid Expenses
When given outside the trial balance
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Concerned expenses
Less: Prepaid expenses
Balance Sheet
Liabilities
Amount
Assets
Amount
Prepaid expenses
Depreciation: When depreciation occur in the trial balance it should be shown in the profit and loss account as it is an incurred expense. However, its presence in the trial balance means that it has already been deducted from the concerned asset and hence need not be deducted/shown in the assets side. However, when the depreciation is given outside the trial balance (in the adjustment entries), it need to be accounted for both in the profit and loss account as well as in the balance sheet..
When given inside the trial balance
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Depreciation
When given outside the trial balance
Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Depreciation
Balance Sheet
Liabilities
Amount
Assets
Amount
Concerned Asset
Less: Depreciation
Closing stock: When closing stock occur in the trial balance it means that they’re already accounted for through adjustment in the purchases Ac/c and hence need not be considered in the trading (and profit and loss) statement as an asset. It should only be considered in the balance sheet. However, when it is considered outside the trial balance (as part of the adjustments need to be made), it should be reflected in the trading and profit and loss account as well as the balance sheet.
When given inside the trial balance
Balance Sheet
Liabilities
Amount
Assets
Amount
Closing stock
When given outside the trial balance
Trading Profit and Loss Account
Dr.
Cr.
Expenses/Losses
Amount
Revenues/Gains
Amount
Closing Stock
Balance Sheet
Liabilities
Amount
Assets
Amount
Closing Stock