FINANCIAL STATEMENTS WITH ADJUSTMENTS

Alterations in accounts have to be made in respect of incomes which have been earned during the current year but not received, and also the incomes which have been received in advance. The alterations thus made in various items are called 'adjustments'. The purpose of making various adjustments is to ensure that the final accounts reveal the true profit or loss and the true financial position of the business.

Adjustments are of the following types-

• Closing Stock
• Outstanding Expenses
• Outstanding or Accrued Incomes
• Prepaid Expenses
• Incomes Received in Advance or Unearned Incomes
• Depreciation
• Interest on Capital
• Interest on drawings
• Bad Debts
• Provision for Bad Debts
• Provision for Discount on Debtors
• Provision for Discount on Creditors

Closing Stock

While preparing the final accounts it is first credited to the Trading Account and then shown as an asset in the Balance Sheet.

Trading Account

Outstanding Expenses

Outstanding expenses are those expenses which have become due in the current year but remain unpaid till the end of the year. They are also known as 'expenses accrued' or 'expenses due but not yet paid'.

The Adjustments in Final Accounts following journal entry is passed for adjustment of outstanding expenses.

Concerned Expenses Account Dr.

To Outstanding Expenses Account

(Being outstanding expenses brought into account) The effect of this entry will be:

1. the concerned expenses account will now show an increased amount, and
2. a new account called 'Outstanding Expense Account' will be opened in the books. Thus, the Trading and Profit and Loss Account will be debited with the increased amount of expense and the 'Outstanding Expense Account' will be shown as a liability in the Balance Sheet.

Trading Account

Balance Sheet

Outstanding Incomes

Outstanding incomes are those incomes which have been earned during the current year but have not been received till the end of the year. They are also called 'incomes accrued' or 'incomes earned but not yet received'.

The following journal entry will be passed for the adjustment of outstanding incomes. Outstanding Income Account Dr. To Concerned Income Account (Being outstanding income brought into account) The effect of this entry will be:

1. the concerned income account will now show an increased amount, and
2. a new account called 'Outstanding Income Account' will be opened in the books. Thus, the Profit and Loss Account will be credited with the increased amount of income and the outstanding income will be shown as an asset in the Balance Sheet.

Trading & Profit & loss Account

Balance Sheet

Prepaid Expenses

The benefit of some expenses will be available not only in the current year but also for the next year. That portion of an expense the benefit of which is yet to be received, is called prepaid expense. It is also called 'unexpired expense’.

The adjustment for a prepaid expense is made with the following journal entry. Prepaid Expense Account Dr. To Concerned Expense Account (Being the adjustment of prepaid expense) The effect of this entry will be:

1. the concerned expense account will now show a reduced balance, and
2. a new account called 'Prepaid Expense Account will be opened in the books.

Thus, the Profit and Loss Account will be debited with the reduced amount of expense and the Prepaid Expense Account will be shown as an asset in the Balance Sheet.

Trading & Profit & loss Account

Balance Sheet

Income received in advance

Certain income is received during the current year but the service in respect thereof has not yet been provided in full by the firm. The portion of income in respect of which the service is yet to be provided is known as 'income received in advance'. It is also called 'unearned income'.

The unearned portion of such income should be adjusted before preparing the final accounts. This is done by passing the following journal entry:

Concerned Income Account Dr. To Income Received in Advance Account (Being the adjustment of income received in advance) The effect of this entry will be:

1. the concerned income account will now show a reduced balance, and
2. a new account called 'Income Received in Advance Account' will be opened in the books. Thus, the Profit and Loss Account will be credited with the reduced income, and the Income Received in Advance Account will appear as a liability-in the Balance Sheet

Trading & Profit & loss Account

Balance Sheet

Depreciation

The term 'depreciation' means decrease in the value of a fixed asset resulting from normal wear and tear and the passage of time. The fixed assets such as machinery, building, etc., are used for the purpose of earning revenue. Therefore, the fall in their value should be considered as an expense or loss incurred in realising such revenue. It must be charged to the Profit and Loss Account. The fixed assets will also be shown in the Balance Sheet at reduced values otherwise the Balance Sheet will fail , to disclose the correct financial position.

1. the value of the concerned asset is reduced, and
2. a new account called 'Depreciation Account' is opened in the books. The depreciation @ charged to the Profit and Loss Account as a separate item of expense and shown in the Balance Sheet by way of deduction from the value of the concerned fixed asset.

Trading & Profit & loss Account

Balance Sheet

• Land does not depreciate. So there is no depreciation on land

Interest on Capital

Sometimes, the proprietor may like to know the profits made by the business after taking into consideration interest on his capital. The purpose is to find out the real profits of the business after deducting the interest on capital which the proprietor could have earned even otherwise by investing the amount elsewhere. Hence, interest is allowed at a certain rate on the capital. Such interest is treated as an expense to the business. The following adjustment entry is passed to bring interest on capital into the books of account.

Interest on Capital Account Dr. To Capital Account (Being interest allowed on capital)

Interest on capital is treated in the final accounts as follows:

1. On the debit side Profit and Loss Account as a separate item of expenses.
2. On the liabilities side of the Balance Sheet as addition to capital. Interest on capital should be calculated on the opening balance of Capital Account i.e., the balance at the beginning of the year. If any additional capital is introduced during the year, interest on the additional capital should be calculated from the date on which it was brought into the business.

Trading & Profit & loss Account

Balance Sheet

Interest on Drawings

Drawings refer to the amounts withdrawn by the proprietor from the business for personal use. In case interest is allowed to the proprietor on his capital, it is usual practice to also charge interest on drawings. Interest on drawings is a gain to the business. The following adjustment entry is passed for interest on drawings:

Capital Account or Drawings Account Dr. To Interest on Drawings Account (Being interest charged on drawings)

Interest on Drawings will be treated in the final accounts as follows:

1. On the credit side of Profit and Loss Account as a separate item of income.
2. On the liabilities side of the Balance Sheet as deductions from capital. Interest on drawings should be calculated at a given rate from the date of withdrawal till the end of the year. In case the relevant information regarding the date of 1 withdrawals were not given, the interest should be charged for six months assuming that the amounts were drawn evenly throughout the year.

Trading & Profit & loss Account

Balance Sheet

Bad Debts

The amount of debt which cannot be recovered from the debtor is called 'Bad Debt'. It is a loss to the business and so must be charged to Profit and Loss Account.

The following journal entry is passed when a debt becomes bad. Bad Debts Account Dr. To Concerned Debtor's Account (Being bad debts)

The effect of this entry will be:

1. debtor's personal account stands closed, and
2. a new account called Bad Debts Account is opened in the books.

The total amount of bad debts incurred during the year appears as a separate item in the Trial Balance and the Sundry Debtors appear at reduced amount.

The Bad Debts Account, like any other account of expenses on losses, is transferred to the Profit and Loss Account by means of the following closing entry.

Profit and Loss Account Dr. to Bad Debts Account

(Being bad debts transferred to Profit and Loss Account)

Bad Debts Given Outside the Trial Balance

Sometimes, the bad debts to be written off may be stated outside the Trial Balance as an adjustment item. It means that such bad debts have not been written off. For convenience, we may call them 'further bad debts'. It is necessary to record such bad debts at the time of preparing the Final Accounts.

This is done by passing the following adjustment entry. Bad Debts Account Dr. to Sundry Debtors (Being bad debts written off)

Such additional bad debts are treated in the final accounts as follows:

1. On the debit side of Profit and Loss Account as addition to Bad Debts already written off.
2. On the assets side of the Balance Sheet as deduction from Sundry Debtors

Trading & Profit & loss Account

Balance Sheet

Provision for Bad Debts

As per Conservatism Concept all possible losses must be provided for. Hence, it is a common practice to make a suitable provision for doubtful debts at the time of preparing the final accounts. Otherwise, the Profit and Loss Account will not reveal the correct amount of profit or loss and the Balance Sheet will not show true position of Adjustments in Find Accounts Sundry Debtors. The provision for doubtful debts is usually calculated as a certain percentage of the total amount due from Sundry Debtors after writing off all known bad debts.

Provision for doubtful debts is also called 'Provision for Bad Debts' or 'Provision for Bad and Doubtful Debts'. Such provision is made by debiting the amount of doubtful debts to the Profit and Loss Account thus, the journal entry for creating such provision will be as follows.

Profit and Loss Account Dr. to Provision for Bad Debts Account (Being the provision for doubtful debts)

Trading & Profit & loss Account

Balance Sheet