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Chapter: 11th Accountancy : Final Accounts of Sole Proprietors-II

Adjustment entries and accounting treatment of adjustments

Adjustment entries are the journal entries made at the end of the accounting period to account for items which are omitted in trial balance and to make adjustments for outstanding and prepaid expenses and revenues accrued and received in advance.

Adjustment entries and accounting treatment of adjustments

 

1. Meaning of adjustment entries

Adjustment entries are the journal entries made at the end of the accounting period to account for items which are omitted in trial balance and to make adjustments for outstanding and prepaid expenses and revenues accrued and received in advance.

 

2. Purpose of adjustment entries

The main purpose of adjustment entries are to match current year revenue with the expenses incurred to earn these revenues. Other purposes are:

 

i.               To exhibit true and fair view of profitability

 

ii.               To exhibit true and fair view of financial status.

 

3. Need for adjustment entries

The need arises to pass adjusting entries for the following reasons:

i.               To record omissions in trial balance such as closing stock, interest on capital, interest on drawings, etc.

 

ii.               To bring into account outstanding and prepaid expenses.

 

iii.               To bring into account income accrued and received in advance.

 

iv.               To create reserves and provisions.

 

4. Adjustments and adjustment entries

The following are the common adjustments and adjustment entries which are made while preparing the final accounts.

i.               Closing stock

 

ii.               Outstanding expenses

 

iii.               Prepaid expenses

 

iv.               Accrued income

 

v.               Income received in advance

 

vi.               Interest on capital

 

vii.               Interest on drawings

 

viii.               Interest on loan

 

ix.               Interest on investment

 

x.               Depreciation

 

xi.               Bad debts

 

xii.               Provision for bad and doubtful debts

 

xiii.               Provision for discount on debtors

 

xiv.               Income tax paid

 

xv.               Manager’s commission


(i) Closing stock

The unsold goods in the business at the end of the accounting period are termed as closing stock. As per AS-2 (Revised), the stock is valued at cost price or net realisable value, whichever is lower.


Presentation in final accounts



Tutorial note

Closing stock is the opening stock for the next accounting period. At the beginning of the next accounting period this entry is reversed to bring into account the opening stock.

Example

The value of closing stock shown as adjustment on 31st March, 2016 is Rs.  10,000. The adjusting entry is:

Adjusting entry


In final accounts, it is presented as follows:



Tutorial note

If closing stock is already adjusted, adjusted purchases account and closing stock will appear in trial balance. Adjusted purchases account will be shown on the debit side of the trading account and closing stock will be shown on the assets side of the balance sheet.

(ii) Outstanding expenses

Expenses which have been incurred in the accounting period but not paid till the end of the accounting period are called outstanding expenses. In other words, if certain benefits or services are received during the year but payment is not made for the services received and utilised, these are termed as outstanding expenses. Outstanding expense account is a representative personal account and expense account is a nominal account.



Presentation in final accounts


Tutorial note

·           If outstanding expenses account appears in the trial balance with credit balance, it means that journal entry has been made already for outstanding expenses. Hence, the outstanding expenses account will be shown only in the liabilities side of balance sheet. No adjustment is therefore necessary in expenses account as already expenses would have been adjusted.

·           At the beginning of the next accounting period the above entry is reversed to bring into account outstanding expenses at the beginning so that it is reduced from amount of expense of next year.

Example

For the year 2017, rent is payable @ Rs.  2,000 p.m. and during the year Rs.  20,000 is paid on account of rent.

Total rent for the year 2017 is Rs.  24,000 i.e., 2,000 p.m. x 12 months. The difference between total rent payable and actual rent paid Rs.  4,000 ( i.e. Rs.  24,000 - Rs.  20,000) is outstanding rent. The adjusting entry is:




(iii) Prepaid Expenses

Prepaid expenses refer to any expense or portion of expense paid in the current accounting year but the benefit or services of which will be received in the next accounting period. They are also called as unexpired expenses. Though these expenses are paid in the accounting period, they are not incurred during the accounting period. Prepaid expense account is a representative personal account. Expense account is a nominal account.

Presentation in final accounts



Tutorial note

·           If prepaid expense already appears in trial balance it means that it is already adjusted and journal entry has already been made. Hence, prepaid expense is shown only in balance sheet.

·           At the beginning of the next accounting period, the above entry is reversed to bring into account prepaid expenses at the beginning so that it is added to amount of expense of next year.

Example

Insurance premium of Rs.  6,000 for one year is paid on 1st January, 2016 and the accounting year closes on 31st March, 2016.

In this example, insurance premium has been paid in advance or prepaid for nine months, i.e.from 1st April to 31st December amounting to Rs.  4,500 (i.e., Rs.   6000 × 9/12). The adjusting entry is:




(iv) Accrued income

Accrued income is income or portion of income which has been earned during the current accounting year but not received till the end of that accounting year. It generally happens in case of amount to be received on account of commission, interest, dividend, etc.


Presentation in final accounts



Tutorial note

·           If accrued income account appears in the trial balance with debit balance, it means that journal entry has been made already for accrued income. Hence, the accrued income account will be shown only in the assets side of balance sheet. No adjustment is necessary in income account as already it would have been adjusted.

·           At the beginning of the next accounting period, the above entry is reversed to bring into account accrued income at the beginning, so that it is reduced from amount of income in the next year.

Example

A business has a fixed deposit of Rs.  1,00,000 with a bank for 12 months in the accounting period ending 31st March, 2018 @ 9% interest p.a. Interest received during the year was Rs.  6,750.

In this example, income earned is Rs.  9,000 (i.e., 1,00,000 × 9%). Income received is Rs.  6,750.Hence, the income earned but not received, is the accrued interest ie., Rs.  2,250 (9,000 - 6,750).

The adjusting entry is:



In final accounts, it is presented as follows:



v. Income received in advance

Income received in advance refers to income or portion of income received in an accounting year which is not earned in the accounting period. It is also known as unearned income or unexpired income. Though the amount is received in the current accounting year, the benefit is yet to be offered to the concerned person in the next accounting year.


Presentation in final accounts

Tutorial note

·           If income received in advance account appears in the trial balance with credit balance, it means that journal entry has been made already for income received in advance. Hence, the income received in advance account will be shown only in the liabilities side of balance sheet. No adjustment is necessary in income account as already it would have been adjusted.

·           At the beginning of the next accounting period, the above entry is reversed to bring into account income received in advance at the beginning, so that it is added to the amount of income in the next year.

Example

The trial balance as on 31st March, 2017 shows commission received as Rs.  7,500.

Adjustment: One-third of the commission received is in respect of work to be done in the next accounting year.

 

Commission received includes one-third of the commission for the next accounting period.Rs.  7,500 × 1/3, that is Rs.  2,500 is received in advance. The adjusting entry is:


In final accounts, it is presented as follows:



(vi) Interest on capital

According to separate entity concept business and proprietor are two separate entities. Capital contributed by proprietor is a liability to the business. Hence, interest may be provided on capital contributed by proprietor. It is treated as a business expense. The purpose is to know the true profit of the business.

Presentation in final accounts


Tutorial note

Interest on capital is calculated on the opening balance of capital if there is no change in the capital account during the accounting year. If there is any additional capital introduced or capital withdrawn, then interest on capital is to be calculated proportionately on the balance outstanding.

Example

The trial balance prepared on 31st December, 2016 shows Capital of Rs.  5,00,000.

 

Adjustment: Provide interest on capital @ 4% p.a.

Interest on capital = Rs.  5,00,000 × 4/100 = Rs.  20,000. The adjusting entry is:


In final accounts, it is presented as follows:


(vii) Interest on drawings

Drawings represent the amount or goods withdrawn by the proprietor from the business for his personal use. As business is separate from owner, interest charged on drawings, if any, is to be treated as business income.


Presentation in final accounts



Example

The trial balance on 31st March, 2016 shows capital as Rs.  1,50,000 and drawings as Rs.  10,000.

 

Adjustment: Charge interest on drawings at 4%.

 

Interest on drawings = Rs.  10,000 × 4/100 = Rs.  400. The adjusting entry is:

In final accounts, it is presented as follows:



(viii) Interest on loan

Business entities may have loans borrowed from banks and other financial institutions, private money lenders, etc. If any interest is payable on loan and not yet provided at the time of preparation of trial balance, it is necessary to provide for outstanding interest on loan. It is an outstanding expense.

Presentation in final accounts



Tutorial note

·           If the trial balance contains loan account specifying the percentage of interest and date of borrowing and interest paid appears in the trial balance, it is to be checked whether interest for the whole year is paid. If it is not paid, outstanding interest must be adjusted.

·           Similar to any other expenses outstanding, this entry also will be reversed at the beginning of the next accounting period.

Example

Extracts from the trial balance as on 31st December, 2017 is given below:

Adjustment: Interest on loan is unpaid for three months.

Interest unpaid = Rs. 5,00,000 × 12/100 × 3/12 = Rs. 15,000. The adjusting entry is:



In final accounts, it is presented as follows:


(ix) Interest on investment

Business entities may have investments in outside securities carrying specified rate of interest. If interest is due but not yet received, adjustment is to be made for the same in the accounting records before preparation of final accounts. Interest receivable on any investments in the form of shares, deposits, etc. made outside the business is called accrued interest. It is an accrued income.

Presentation in final accounts


Example

Extracts from the trial balance as on 31st December, 2017 is given below:


Adjustment: Provide for accrued interest on investment ` 3,000. The adjusting entry is:

In final accounts, it is presented as follows:


(x) Depreciation

The decrease in book value of fixed assets due to usage or passage of time is called depreciation. It is a loss to the business. Therefore, it must be written off from the value of asset. Generally, a certain percentage on the value of the asset is calculated as the amount of depreciation.


Presentation in final accounts



Tutorial note

When depreciation already appears in trial balance, it means journal entry is already made and asset account has been already reduced to the extent of depreciation. Hence, depreciation will be shown only in profit and loss account.

 

Example

The trial balance prepared on 31st March, 2016 shows the value of buildings as Rs.  50,000.

 

Adjustment: Depreciate buildings @ 10% p.a.

 

Amount of depreciation = Rs. 50,000 x 10/100 = Rs. 5,000. The adjusting entry is:


In final accounts, it is presented as follows:



(xi) Bad debts

When it is definitely known that amount due from a customer (debtor) to whom goods were sold on credit, cannot be realised at all, it is treated as bad debts. In other words, debts which cannot be recovered or irrecoverable debts are called bad debts. It is a loss for the business and should be charged against profit.


Presentation in final accounts


Tutorial note

·           When bad debts already appears in the trial balance it means journal entry is already made, i.e., debtors is already reduced. Hence, bad debt is taken only to debit side of profit and loss account.

·           If there is bad debt in trial balance as well as in adjustments, total bad debt is debited in profit and loss account. Additional bad debt only is deducted from debtors in the balance sheet.

Example

The trial balance as on 31st December, 2016 shows sundry debtors as Rs.  1,02,000.

 

Adjustment: Write off Rs.  2,000 as bad debts. The adjusting entry is:



In final accounts, it is presented as follows:



(xii) Provision for bad and doubtful debts

Provision for bad and doubtful debts refers to amount set aside as a charge against profit to meet any loss arising due to bad debt in future. At the end of the accounting period, there may be certain debts which are doubtful, i.e., the amount to be received from debtors may or may not be received. The reason may be incapacity to pay the amount or deceit.

In general, based on past experience, the amount of doubtful debts is calculated on the basis of some percentage on debtors at the end of the accounting period after deducting further bad debts (if any). Since the amount of loss is impossible to ascertain until it is proved bad, doubtful debts are charged against profit and loss account in the form of provision. A provision for doubtful debts is created and is charged to profit and loss account. When bad debts occur, it is transferred to provision for doubtful debts account and not to profit and loss account.

This is according to the convention of conservatism. Moreover, according to matching principle, all costs related to earning revenue in a period must be charged in the relevant period itself. Hence, it is appropriate that provision is created in the current year against debtors of current year.


Presentation in final accounts



Example

The trial balance prepared on 31st December, 2016 shows sundry debtors as Rs.  1,50,000.

 

Adjustment: Provide 5% for bad and doubtful debts on sundry debtors.

Provision for bad and doubtful debts = Rs.  1,50,000 x 5/100 = Rs.  7,500. The adjusting entry is:


In final accounts, it is presented as follows:




Tutorial note

When provision already exists and appears in trial balance, the accounting treatment is as below:

·           If the provision required at the end plus the bad debts written off, is higher than the existing provision, the difference amount will be created as provision in the current year and will appear on the debit side of profit and loss account.

·           If the provision required at the end plus bad debts written off, is lesser than the existing provision, the excess is written back and will appear on the credit side of profit and loss account.

The journal entries are:

(a) For bad debts written off

 Bad debts A/c Dr. xxx

 To Debtors A/c xxx

(b) For transferring bad debts 

 Provision for doubtful debts A/c Dr. xxx

 To Bad debts A/c xxx

(c) For creating provision to the extent of difference 

 Profit and Loss A/c Dr. xxx

 To Provision for doubtful debts A/c xxx

(d) For writing back provision to the extent of difference 

 Provision for doubtful debts A/c Dr. xxx

 To Profit and Loss A/c xxx


(xiii) Provision for discount on debtors

Cash discount is allowed by the suppliers to customers for prompt payment of amount due either on or before the due date. A provision created on sundry debtors for allowing such discount is called provision for discount on debtors. This provision is a charge against profit and hence profit and loss account is debited.

Provision for discount on debtors is made on the basis of past experience at an estimated rate on sundry debtors. Discount should be calculated on sundry debtors after deducting bad debts and provision for bad debts.



Presentation in final accounts



Tutorial note

i.               Provision for discount on debtors is calculated on the balance of debtors after deducting bad debts and provision for doubtful debts. This is because provision for discount is to be expected only on good book debts. When the amount realisable itself is doubtful, provision for discount is not to be made. Similar to bad debts and provision for doubtful debts, here also discount allowed to debtors must be transferred to provision for discount on debtors account if a provision exists.

ii.               When provision already exists and appears in trial balance, the accounting treatment is as below:

·           If the provision required at the end plus the discount allowed, is higher than the existing provision, the difference amount will be created as provision in the current year and will appear on the debit side of profit and loss account.

 

·           If the provision required at the end plus discount allowed, is lesser than the existing provision, the excess is written back and will appear on the credit side of profit and loss account.

 

The presentation in the balance sheet is as below:

Debtors xxx

 Less Bad debts (in adjustments) xxx

 Less Provision for doubtful debts (end) (adjustment) xxx/xxx

 Less Provision for discount on debtors (end) (adjustment) xxx/xxx

Balance to be shown in balance sheet xxx



Example

The trial balance for the year ended 31st March, 2016 shows sundry debtors as Rs.  50,000.

 

Adjustment: Create a provision for discount on debtors @ 1%.

 

Provision for discount on debtors = Rs.  50,000 x 1/100 = Rs.  500. The adjusting entry is:


In final accounts, it is presented as follows:


(xiv) Income tax paid

As per the Indian Income Tax Act, 1961, business income of the sole proprietor is not assessed and taxed separately. It is the sole proprietor who is assessed to tax for his total income including the business income. Hence, income tax paid by the business is not a business expenditure and is treated as drawings.


Presentation in final accounts




Example


Trial balance of Sibi as on 31st December, 2017 shows the capital as Rs.  1,05,000 and cash at bank as Rs.  80,000.

 

Adjustment: Income tax paid Rs.  15,000. The adjusting entry is:



In final accounts, it is presented as follows:



(xv) Manager’s commission

Sometimes the manager is given commission as a percentage on profit of the business. It may be given at a certain percentage on the net profit before charging such commission or after charging such commission. Calculation procedure is explained below:x




The purpose of giving such commission may be to motivate the managers to work with their full potential, to reward the managers for their efficiency and to retain the efficient managers by rewarding them sufficiently. Such commission can be calculated only at the end of the accounting period after calculating net profit. Hence, it remains outstanding at the end of the accounting period.



Presentation in final accounts



Example

On 31st March, 2017, Net profit before charging commission is Rs.  11,000.

 

The manager is entitled to receive 10% as commission on the profit before charging such a commission.

 

Commission = 11,000 x 10/100 = Rs.  1,100. The adjusting entry is:


In final accounts, it is presented as follows:





Example

On 31st March, 2017, Net profit before charging commission is Rs.  11,000.

 

Adjustment: Provide manager’s commission at 10% on the profit after charging such Manager’s commission.







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11th Accountancy : Final Accounts of Sole Proprietors-II : Adjustment entries and accounting treatment of adjustments |


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