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Structure:
7.1 Final Accounts – Introduction
7.2 Adjustments before preparing final accounts
7.2.1 Outstanding expenses
7.2.2 Prepaid expenses
7.2.3 Accured Income
7.2.4 Income received in advance
7.2.5 Depreciation
7.2.6 Bad Debts
7.2.7 Provision for doubtful debts
7.2.8 Reserve for Discount on Debtors
7.2.9 Reserve for discount on creditors
7.2.10 Closing Stock
7.3 Trading Account
7.4 Preparation of Trading Account
7.5 Profit and Loss Account
7.6 Preparation of Profit and Loss Account
7.7 Balance Sheet – Meaning
7.8 Preparation of Balance Sheet
Learning Objectives:
After studying this unit, you should be able to understand the following:
1. To understand the process of preparing the final accounts of a business
organization from Trial balance.
The basis for preparing final accounts is the Trial Balance. For Trial
Balance, the ledger balances are the root. For ledger accounts, the journal
entries or entries in the subsidiary books (Books of original entry) are the
roots. Hence the final accounts reflect the original business transactions,
which are systematically and scientifically recorded, classified, and
analyzed. Final accounts provide bundle of information for decision making
activities.
Objectives:
1. To know the meaning and purpose of final accounts
2. To identify the items of Trading Account
3. To identify the items of Profit and Loss Account
4. To identify the items of assets and liabilities of a Balance Sheet and
modes of preparing it.
5. To know the adjustments such as Reserve for bad debts, Reserve for
discounts on Debtors, Reserve for discount on Creditors, bad debts out
side the trial balance.
6. To understand the adjustments like depreciation on assets, closing
stock, stock lost in fire, goods given as samples, goods used for
personal purpose etc.,
7. To know the adjustments of prepaid expenses, outstanding expenses,
pre-received incomes, outstand incomes etc.
8. To prepare Balance Sheet without any adjustments from trial balance.
9. To prepare Balance Sheet with adjustments.
for the current period whether actually received in cash or not. Every asset
is subject to wear and tear and the value of the asset gets reduced even if
the loss on account of this is not recorded by means of a journal entry.
Some stock of goods at the end of the period is left over and it has to be
valued and be taken to accounts for fair computation of profit. Such internal
adjustments have to be made and recorded before preparing Trading
Account, Profit and Loss Account and Balance Sheet. The adjustments to
be incorporated are briefly described in the following paragraphs.
Example
Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts
are finalized on 31-12-2005. Therefore rent received for January, February
and March of 2006 is said to have been received in advance Rs.12000. The
entry is
7.2.5 Depreciation
Depreciation is reduction in the value of an asset due to constant use of the
same, which is called wear and tear. Fixed assets like, buildings, plant,
machinery, furniture etc., are subject to depreciation. Whenever, an asset is
depreciated, its value goes down and therefore it is a loss to the
organization. Depreciation account is debited and the concerned asset
account is credited. The item of depreciation may appear in the trial
balance, which means that already the concerned asset is reduced by the
amount of depreciation. If depreciation is given as an additional adjustment,
Page No.: 141
Financial and Management Accounting Unit 7
then the depreciation amount should be charged against profit and loss
account on one hand and the concerned asset account is reduced on the
other hand in the balance sheet.
Example
Building is of the book value of Rs.400000. It is depreciated at 10% on fixed
installment method. Show the journal entry and how does it appear in the
balance sheet?
Solution
The entry for depreciation is
Depreciation being a loss is transferred to profit and loss account and in the
balance sheet, the value of Building is shown as Rs.400000 – 40000 =
360000.
Note: For the second year the depreciation will be Rs.40000 if the asset is
depreciated under fixed installment method. If it is depreciated under
reducing balance method, the depreciation for the second year is Rs.36000
(10% of 360000).
If bad debts are identified well before preparing trial balance, then bad debts
appear in the trial balance and they should be taken to the debit side of
profit and loss account. Since debtors account is already reduced by the
amount of bad debts, it does not require any further adjustment in the
balance sheet.
If bad debts are shown outside the trial balance, which means that they are
identified after the preparation of Trial Balance, then two adjustments should
be incorporated. One – bad debts should be charged against profits in P & L
A/C and the second – the debtor’s account should be reduced by the
amount of bad debts in the balance sheet on the asset side.
Example
The sundry debtors for the year 2005 are Rs.50000. The bad debts
amounted to Rs.4000 as on 31-12-2005 already shown in the trail balance.
Write off further bad debts Rs5000. Show how the above internal
adjustments appear in the final accounts.
Solution
There are bad debts shown in the trial balance Rs4000 and not shown in
the trial balance Rs.5000. To incorporate those bad debts not yet shown
in the trial balance, the adjusting entry is
Bad debts account Dr 5000
To Debtor’s account 5000
In the profit and loss account of 2005, the total bad debts appearing on
the debit side are Rs. 9000(4000 + 5000)
In the balance sheet, on the asset side, the amount of debtors is
Rs45000(50000 -5000).
Since the provision for bad debts is a charge against current year profit, the
adjusting entry is to debit P & L A/C and credit Provision for Bad Debts
Account.
Provision for bad and doubtful debts is a running account and every year the
amount keeps on changing because from the provision made in the current
year, bad debts occurring in the following year have to be adjusted and
additional amount of provision to be made is calculated. Every year, the
amount transferred to P & L A/C is B + N – O, where B stands for bad debts;
N stands for new provision and O stands for old reserve. For example, the
old reserve stands at Rs.15000 and bad debts to be adjusted is Rs4000 and
new reserve to be maintained is Rs18000. The amount to be charged
against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The formula
can also be shown as
Illustration:
On 1st January 2006, the RBD account stood at Rs.9000 in the books of a
merchant. The bad debts written off during the year ended 31st December,
2006 amounted to Rs.4800 and Sundry Debtors stood at Rs.480000. It was
desired to maintain the reserve for bad debts at 5% on Debtors. During the
year 2007 bad debts written off amounted to Rs.12000 and sundry debtors
on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was
required. Show the journal entries for recording the above transactions and
write up the bad debts reserve account.
Solution
Journal Entries
Debit Credit
Date Particulars LF
Rs. Rs.
2006 Bad debts account Dr 4800
st
Dec, 31 To Sundry Debtors Account 4800
(Being the bad debts written off)
st
Dec, 31 Bad Debts Reserve account Dr 4800
To Bad Debts account 4800
(Being bad debts set off against
Dec 31
st RBD)
19800
Profit and Loss Account Dr 19800
To Bad Debts Reserve account
(Being additional RBD made to
bring the reserve to 5% of 480000)
12000
2007 Bad debts account Dr
12000
Dec, 31
st To Sundry Debtors account
(Being bad debts written off )
NOTE:
On January 1st 2006, the RBD account stands at Rs9000 and during the
year the actual bad debts are Rs4800 and so there is unused balance of
Rs.4200 (9000 -4800). It is desirable to have reserve of 5% of 480000 –
Rs24000. Therefore additional reserve required to be provided in P & L A/C
is Rs19800 (24000 – 4200).
Similarly during 2007 the actual bad debts are Rs.12000 and the available
reserve is used for writing it off. Still there is a balance left over is Rs.12000
(24000 – 12000). The additional reserve to be maintained is 5% of 380000,
that comes to Rs19000. So the additional amount to be provided in P & L
A/C in 2007 is Rs.7000 (19000 – 12000).
Dr Cr
J Amount J Amount
Date Particulars Date Particulars
F Rs. F Rs.
2006 2006
st st
Dec, 31 To bad debts 4800 Jan, 1 By Balance b/d 9000
To balance c/d 24000 Dec 31st By P&L A/C 19800
Total 28800 Total 28800
2007 2007 By balance b/d 24000
st
Dec,31st To bad debts 12000 Jan 1
To balance c/d 19000 Dec 31st By P&L A/C 7000
Total 31000 Total 31000
Just as in the case of provision for bad and doubtful debts, the bad debts
are first written off against provision for bad debts and later the required
amount of provision is provided in the P&L A/c, similar procedure takes
place in the case of provision for discount on debtors. The following guide
lines may be kept in mind while dealing with the reserve for discount on
debtors
1. If a reserve for discount on debtors is not existing and cash discount is
allowed, then transfer the discount to P&L account.
2. Any fresh reserve for discount on debtors is to be made, debit the P&L
A ccount with the amount of reserve.
Illustration
The following items are found in the trial balance of Praksh on 31st
December 2000.
Sundry Debtors Rs. 160000
Bad Debts written off 9000
Discount allowed to Debtors 1800
Reserve for Bad and doubtful Debts 31-12-1999 16500
Reserve for discount on Debtors 31-12-1999 3200
You are required to provide for the bad and doubtful debts at 5% and for
discount on debtors at 2%. Give necessary journal entries and show bad
debts account, bad debts reserve account, discount account and provision
for discount on debtors account.
Solution
Debit Credit
Date Particulars LF
Rs. Rs.
2000 RBD account Dr 9000
st
Dec, 31 To Bad Debts account 9000
(Being bad debts written off against
existing RBD)
Dec 31st P & L Account Dr 500
500
To RBD account
(Being addition to RBD to make the
new RBD equal to 5% of 160000)
st
Dec 31 Reserve for discount on debtors
account Dr
1800
To Discount on Drs A/c 1800
(Being discount on debtors written
off against Reserve for discount on
Debtors)
NOTE:
1. The amount debited to P&L Account towards RBD is computed as
follows
Old RBD = Rs. 16500
Less Bad debts = 9000
Balance = 7500
New RBD @5% on160000 = 8000
RBD to be provided = 500 (8000-7500)
In the balance sheet, the Sundry debtors are reduced by bad debts shown
out side the trial balance, the new RBD, discount on debtors shown out side
the trial balance and the new Reserve for discount on debtors.
When provision for discount on creditors is made in P&L Account, the entry
will be
Reserve for discount on creditors account Dr
To Profit and loss account
2. Sales account Dr
Closing stock account Dr
To Trading account
(Being sales and closing stock transferred to trading account)
3. Trading account Dr
To Profit and Loss Account
(Being gross profit carried forward to P&L A/C)
Illustration
From the following balances extracted from Trial balance, prepare Trading
Account. The closing stock at the end of the period is Rs. 56000
Amount in
Particulars
Rs.
Stock on 1-1-2004 70700
Returns inwards 2000
Returns outwards 3000
Purchases 102000
Debtors 56000
Creditors 45000
Carriage inwards 5000
Carriage outwards 4000
Import duty on materials received from 6000
abroad 7000
Clearing charges 12000
Rent of business shop 10000
Royalty paid to extract materials 2000
Fire insurance on stock 8000
Wages paid to workers 10000
Office salaries 1000
Cash discount 4000
Gas, electricity and water 250000
Sales
Particulars Rs Particulars Rs
303000 303000
In this connection, it is important to note that Trading and Profit and Loss
Account are regarded as revenue accounts. Any capital receipts or capital
The transferring entries are drawn to prepare Profit and loss account. They
are
4. Capital account Dr
To Profit and Loss Account To Transfer Net loss to Capital
Particulars Rs Particulars Rs
To Trading Account (GL) By Trading account (GP)
To Salaries + Out standing – By Interest earned + Accrued
Prepaid salaries as per interest as per adjustments
adjustments By Commission earned
To Rent of the premises By discount earned
To Travelling expenses By Rent received
To Rates and Taxes By Bad debts recovered
To Printing and stationery By Interest on drawings
2. P & L account is revenue account showing the revenue net profit or loss
for the accounting period(state True / False ).
3. Painting for a new building, Installation expenses paid to install a plant,
amount spent for advertising for promotion of sale of a product are
revenue expenses (state True / False ).
4. Net profit / loss is carried to owners equity / capital (state True / False )
Illustration
The following Trial Balance is extracted from the books of a merchant on
31-12-2004.
Rs
Particulars
Furniture and fittings 640
Motor Vehicles 6250
Buildings 7500
Capital Account 12500
Bad Debts 125
Provision for Bad debts 200
Sundry Debtors 3800
Sundry Creditors 2500
Stock on 1-1-2004 3460
Purchases 5475
Sales 15450
Bank Over Draft 2850
Sales Returns 200
Purchase Returns 125
Advertising 450
Interest on Bank Over Draft 118
Commission 375
Cash 650
Taxes and Insurance 1250
General Expenses 782
Salaries 3300
2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and
Motor Vehicles @ 20%.
7. Write off a further sum of Rs.100 as bad debts and provision for bad and
doubtful debts to be made equal to 10% on sundry debtors.
Particulars Rs Particulars Rs
Note:
Sundry Debtors are Rs.3800 and there have been bad debts outside TB
Rs100. The good debtors are Rs.3700. The new RBD is 10% of 3700,
i.e.Rs370. The old RBD unspent is Rs100 (200 -100). Therefore RBD to be
charged against profit is Rs270
containing capital and liabilities and on the right side, containing assets and
properties. Often the statement is prepared vertically, mentioning sources of
funds first and later application of funds. Sources of funds indicate capital
and liabilities and application of funds indicate assets.
Total Total
3. Make a mark of items with respect to which adjustments are given out
side the TB
4. All adjustments should find place in two places, one either in Trading
account or in Profit and Loss Account and another invariably Balance
Sheet. For example, closing Stock given outside TB is first shown on the
credit side of Trading Account and it is shown as an asset in the Balance
Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and
later shown as a deduction from Sundry Debtors in the Balance Sheet.
Similarly depreciation is charged against profits first and later deducted
from the book value of concerned asset in the balance sheet.
Illustration 1
From the Trial Balance given in para 6, prepare Balance Sheet of the
merchant as on 31-12-2004.
Solution
Balance Sheet as on 31-12-2004
Capital and Liabilities Rs Assets Rs
Sundry Creditors 2500 Cash 650
Bank Over Draft 2850 Building 7500
Add interest due 85 2935 Less Depreciation 375 7125
Commission received in Furniture and Fixtures 640
advance 125 Less Depreciation 64 576
Outstanding Taxes 120 Motor Vehicle 6250
Outstanding Salaries 300 Less Depreciation 1250 5000
Capital 12500 Sundry Debtors 3800
Add Net Profit 1551 14051 Less bad debts as per
Adjustments 100
Balance 3700
Less Reserve for Bad
Debts(New) 370 3330
Closing Stock 3250
Pre-Paid Insurance 100
NOTE: Every adjustment given outside Trial Balance finds place in two
accounts –Trading account / Profit and Loss Account and invariably in
Balance Sheet.
Terminal Questions
1. In taking out a Trial Balance, a Book keeper finds that debit total
exceeds the credit total by Rs.611. The amount is placed to the credit of
a newly opened Suspense Account. Subsequently the following
mistakes were discovered. You are required to pass the necessary
entries for rectifying the mistakes, and show how Suspense account.
(a) Sales day book was over cast by Rs.1000
(b) A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna
(c) General expenses Rs.180 were posted as 801
(d) Cash received from Bhatt was debited to his account RS.450
(e) While carrying forward the total from one page of the Purchases
book to the next, the amount of Rs.1235 was entered as Rs.1325.
2. Rectify the following errors:
(i) Furniture purchases for Rs.2500 was debited to Purchases
account
(ii) A sum of Rs.500 paid to Lalitha was debited to Shantha
(iii) A bill receivable for Rs.1000 received from Kumar has been
omitted to be entered.
(iv) Goods worth Rs2040 taken away by the proprietor were debited to
Bharath
(v) An engine purchased for Rs.12500 had been posted to Purchases
account
3. An accountant could not tally the Trial Balance. The difference was
temporarily transferred to Suspense account for preparing the final
accounts. The following errors were later discovered.
(a) The sales book was under cast by Rs.500
(b) Entertainment expenses Rs.950 though entered in the cash book
were omitted to be posted in the ledger.
(c) Discount column of the receipt side of cash book was wrongly
added as Rs114 instead of Rs.144.
(d) Commission of Rs.250 paid, was posted twice, once to discount
account and once to Commission account.
(e) A sale of Rs.169 to Rama Murthy though correctly entered in sales
book, was posted wrongly to his account as Rs.196.
(f) A purchase from Neeraj of Rs.290 though correctly entered in
purchases book was wrongly debited to his personal account.
You are required to
1. Pass the necessary rectifying entries
2. Prepare Suspense account
3. State the effect of each of the rectification on the profit.
Adjustments
1. Depreciate land and buildings at 5% and Motor Vehicles at 15%
2. Interest on loan is at 5% taken on 1st January,2003
3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due.
4. There has been a fire on 1st January, 2003 destroying goods worth
Rs.200
5. The bad debts provision is to be brought up to 5% on Sundry debtors
6. The stock in hand on 31-12-2003 was valued at Rs16000
7. Goods costing Rs.1000 were taken away by the proprietor for his
personal use, but no entry has been made in the books of accounts
8. Prepaid insurance amounted to Rs.500
9. Provide for Manager’s commission at 5% on net profit after charging
such commission.
Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off
of bad debts, but after allowing discounts. On December 31st, 2000, the
amount of debtors was Rs.57000 after writing off the bad debts but
before allowing discounts. Total creditors on these two dates were
Rs.60000 and Rs.75000 respectively.