UNIT 2
FINAL ACCOUNTS
Accounting aims in ascertaining and presenting the results of the business for an accounting period. For ascertaining the periodical business results, the nature of transactions should be analyzed whether they are of capital or revenue nature. The Revenue Expense relates to the operations of the business of an accounting period or to the revenue earned during the period or the items of expenditure, benefits of which do not extend beyond that period. Capital Expenditure, on the other hand, generates enduring benefits and helps in revenue generation over more than one accounting period. Revenue Expenses must be associated with a physical activity of the entity. Therefore, whereas production and sales generate revenue in the earning process, use of goods and services in support of those functions causes expenses to occur. Expenses are recognised in the Profit & Loss Account through matching principal which tells us when and how much of the expenses to be charged against revenue. A part of the expenditure can be capitalised only when these can be traced directly to definable streams of future benefits.
The distinction of transaction into revenue and capital is done for the purpose of placing them in Profit and Loss account or in the Balance Sheet. For example: revenue expenditures are shown in the profit and loss account as their benefits are for one accounting period i.e. in which they are incurred while capital expenditures are placed on the asset side of the balance sheet as they will generate benefits for more than one accounting period and will be transferred to profit and loss account of the year on the basis of utilisation of that benefit in particular accounting year. Hence, both capital and revenue expenditures are ultimately transferred to profit and loss account.
Revenue expenditures are transferred to profit and loss account in the year of spending while capital expenditures are transferred to profit and loss account of the year in which their benefits are utilised. Therefore we can conclude that it is the time factor, which is the main determinant for transferring the expenditure to profit and loss account. Also expenses are recognized in profit and loss account through matching concept which tells us when and how much of the expenses to be charged against revenue. However, distinction between capital and revenue creates a considerable difficulty. In many cases borderline between the two is very thin.
The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business: For a trader dealing in furniture, purchase of furniture is revenue expenditure but for any other trade, the purchase of furniture should be treated as capital expenditure and shown in the balance sheet as asset. Therefore, the nature of business is a very important criterion in separating expenditure between capital and revenue.
(b) Recurring nature of expenditure: If the frequency of an expense is quite often in an accounting year then it is said to be an expenditure of revenue nature while non-recurring expenditure is infrequent in nature and do not occur often in an accounting year. Monthly salary or rent is the example of revenue expenditure as they are incurred every month while purchase of assets is not the transaction done regularly therefore, classified as capital expenditure unless materiality criteria defines it as revenue expenditure.
(c) Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal maintenance of the asset. Such expenses are revenue in nature. On the other hand, expenditure incurred for major repair of the asset so as to increase its productive capacity is capital in nature. However, determination of the cost of maintenance and ordinary repairs which should be expensed, as opposed to a cost which ought to be capitalised, is not always simple.
(d) Effect on revenue generating capacity of business: The expenses which help to generate income/ revenue in the current period are revenue in nature and should be matched against the revenue earned in the current period. On the other hand, if expenditure helps to generate revenue over more than one accounting period, it is generally called capital expenditure.
When expenditure on improvements and repair of a fixed asset is done, it has to be charged to Profit and Loss Account if the expected future benefits from fixed assets do not change, and it will be included in book value of fixed asset, where the expected future benefits from assets increase.
(e) Materiality of the amount involved: Relative proportion of the amount involved is another important consideration in distinction between revenue and capital.
As we have already discussed, capital expenditure contributes to the revenue earning capacity of a business over more than one accounting period whereas revenue expense is incurred to generate revenue for a particular accounting period. The revenue expenses either occur in direct relation with the revenue or in relation with accounting periods, for example cost of goods sold, salaries, rent, etc. Cost of goods sold is directly related to sales revenue whereas rent is related to the particular accounting period. Capital expenditure may represent acquisition of any tangible or intangible fixed assets for enduring future benefits. Therefore, the benefits arising out of capital expenditure last for more than one accounting period whereas those arising out of revenue expenses expire in the same accounting period.
ILLUSTRATION 1
State with reasons whether the following statements are ‘True’ or ‘False’.
(1) Overhaul expenses of second-hand machinery purchased are Revenue Expenditure.
(2) Money spent to reduce working expenses is Revenue Expenditure.
(3) Legal fees to acquire property are Capital Expenditure.
(4) Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the plaintiff’s land is Capital Expenditure.
(5) Amount spent for replacement of worn out part of machine is Capital Expenditure.
(6) Expense incurred on the repairs and white washing for the first time on purchase of an old building are Revenue Expenses.
(7) Expenses in connection with obtaining a license for running the cinema are Capital Expenditure.
(8) Amount spent for the construction of temporary huts, which were necessary for construction of the Cinema House and were demolished when the cinema house was ready, is Capital Expenditure.
SOLUTION:
(1) False: Overhaul expenses are incurred to put second-hand machinery in working condition to derive endurable long-term advantage. So it should be capitalised.
(2) False: It may be reasonably presumed that money spent for reducing revenue expenditure would have generated long-term benefits to the entity. It becomes part of intangible fixed assets if it is in the form of technical know-how and tangible fixed assets if it is in the form of additional replacement of any of the existing tangible fixed assets. So this is capital expenditure.
(3) True: Legal fee paid to acquire any property is part of the cost of that property. It is incurred to possess the ownership right of the property and hence a capital expenditure.
(4) False: Legal expenses incurred to defend a suit claiming that the firm’s factory site belongs to the plaintiff are maintenance expenditure of the asset. By this expense, neither any endurable benefit can be obtained in future in addition to that what is presently available nor will the capacity of the asset be increased. Maintenance expenditure in relation to an asset is revenue expenditure.
(5) False: Amount spent for replacement of any worn out part of a machine is revenue expense since it is part of its maintenance cost.
(6) False: Repairing and white washing expenses for the first time of an old building are incurred to put the building in usable condition. These are the part of the cost of building. Accordingly, these are capital expenditure.
(7) True: The Cinema Hall could not be started without license. Expenditure incurred to obtain the license is pre-operative expense which is capitalised. Such expenses are amortised over a period of time.
(8) True: Cost of temporary huts constructed which were necessary for the construction of the cinema house is part of the construction cost of the cinema house. Therefore such costs are to be capitalised.
ILLUSTRATION 2
State with reasons whether the following are Capital or Revenue Expenditure:
(1) Expenses incurred in connection with obtaining a license for starting the factory for Rs. 10,000.
(2) Rs. 1,000 paid for removal of Inventory to a new site.
(3) Rings and Pistons of an engine were changed at a cost of Rs. 5,000 to get fuel efficiency.
(4) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) Rs. 8,000 for installing telephone in the office.
(5) A factory shed was constructed at a cost of Rs. 1,00,000. A sum of Rs. 5,000 had been incurred in the construction of temporary huts for storing building material.
SOLUTION:
(1) Money paid Rs. 10,000 for obtaining license to start a factory is a capital expenditure. This is an item of expenditure incurred to acquire the right to carry on business.
(2) Rs. 1,000 paid for removal of Inventory to a new site is revenue expenditure. This is neither bringing enduring benefit nor enhancing the value of the asset.
(3) Rs. 5,000 spent in changing Rings and Pistons of an engine to get fuel efficiency is capital expenditure. This is an expenditure on improvement of a fixed asset. It results in increasing profit-earning capacity of the business by cost reduction.
(4) Money deposited with MTNL for installation of telephone in office is not expenditure. This is treated as an asset and the same is adjusted over a period of time against actual telephone bills.
(5) Cost of construction of building including cost of temporary huts is capital expenditure. Building is fixed asset which will generate enduring benefit to the business over more than one accounting period. Construction of temporary huts is incidental to the main construction. Such cost is also capitalised with the cost of building.
Just as a clear distinction between Capital and Revenue expenditure is necessary, in the same manner capital receipts must be distinguished from revenue receipts.
Receipts which are obtained in course of normal business activities are revenue receipts (e.g. Receipts from sale of goods or services, interest income etc.). On the other hand, receipts which are not revenue in nature are capital receipts (e.g. Receipts from sale of fixed assets or investments, secured or unsecured loans, owners’ contributions etc.). Revenue and capital receipts are recognised on accrual basis as soon as the right of receipt is established. Revenue receipts should not be equated with the actual cash receipts. Revenue receipts are credited to the Profit and Loss Account.
On the other hand, Capital receipts are not directly credited to Profit and Loss Account. For example, when a fixed asset is sold for Rs. 92,000 (cost Rs. 90,000), the capital receipts Rs. 92,000 are not credited to Profit and Loss Account. Profit/Loss on sale of fixed assets is calculated and credited to Profit and Loss Account as follows:
Sale Proceeds Rs. 92,000
Less: Cost Rs. 90,000
Profit Rs. 2,000
ILLUSTRATION 3
Good Pictures Ltd., constructs a cinema house and incurs the following expenditure during the first year ending 31st March, 2016.
1. Second-hand furniture worth Rs. 9,000 was purchased; repainting of the furniture costs Rs. 1,000. The furniture was installed by own workmen, wages for this being Rs. 200.
2. Expenses in connection with obtaining a license for running the cinema worth Rs. 20,000. During the course of the year the cinema company was fined Rs. 1,000, for contravening rules. Renewal fee Rs. 2,000 for next year also paid.
3. Fire insurance, Rs. 1,000 was paid on 1st October, 2015 for one year.
4. Temporary huts were constructed costing Rs. 1,200. They were necessary for the construction of the cinema. They were demolished when the cinema was ready.
Point out how you would classify the above items.
SOLUTION:
1. The total cost of the furniture should be treated as Rs. 10,200 i.e., all the amounts mentioned should be capitalised since without such expenditure the furniture would not be available for use. If Rs. 1,000 and Rs. 200 have been respectively debited to the Repairs Account and the Wages Account, these accounts will be credited to the Furniture Account.
2. License for running the cinema house is necessary, hence its cost should be capitalised. But the fine of Rs. 1,000 is revenue expenditure. The renewal fee for the next year is also revenue expenditure but pertains to the next year; hence, it is a prepaid expense.
3. Half of the insurance premium pertains to the year beginning on 1st April, 2016. Hence such amount should be treated as prepaid expense. The remaining amount is revenue expense for the current year.
4. Since the temporary huts were necessary for the construction, their cost should be added to the cost of the cinema hall and thus capitalised.
ILLUSTRATION 4
State with reasons, how you would classify the following items of expenditure:
1. Overhauling expenses of Rs. 25,000 for the engine of a motor car to get better fuel efficiency.
2. Inauguration expenses of Rs. 25 lakhs incurred on the opening of a new manufacturing unit in an existing business.
3. Compensation of Rs. 2.5 crores paid to workers, who opted for voluntary retirement.
SOLUTION:
1. Overhauling expenses are incurred for the engine of a motor car to derive better fuel efficiency. These expenses will reduce the running cost in future and thus the benefit is in form of endurable long-term advantage. So this expenditure should be capitalised.
2. Inauguration expenses incurred on the opening of a new unit may help to explore more customers. This expenditure is in the nature of revenue expenditure, as the expenditure may not generate any enduring benefit to the business over more than one accounting period.
3. The amount paid to workers on voluntary retirement is in the nature of revenue expenditure. Since the magnitude of the amount of expenditure is very significant, it may be better to defer it over future years.
ILLUSTRATION 5
Classify the following expenditures and receipts as capital or revenue:
(i) Rs. 10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital assets.
(ii) Amount received from Trade receivables during the year.
(iii) Amount spent on demolition of building to construct a bigger building on the same site.
(iv) Insurance claim received on account of machinery damaged by fire.
SOLUTION:
(i) Capital expenditure.
(ii) Revenue receipt.
(iii) Capital expenditure.
(iv) Capital receipt.
ILLUSTRATION 6
Are the following expenditures capital in nature?
(i) M/s ABC & Co. Runs a restaurant. They renovate some of the old cabins. Because of this renovation some space was made free and number of cabins was increased from 10 to 13. The total expenditure was Rs. 20,000.
(ii) M/s New Delhi Financing Co. Sold certain goods on installment payment basis. Five customers did not pay installments. To recover such outstanding installments, the firm spent Rs. 10,000 on account of legal expenses.
(iii) M/s Ballav & Co. Of Delhi purchased a machinery from M/s Shah & Co. Of Ahmedabad. M/s Ballav & Co. Spent Rs. 40,000 for transportation of such machinery. The year ending is 31st Dec, 2015.
SOLUTION:
(i) Renovation of cabins increased the number of cabins. This has an effect on the future revenue generating capability of the business. Thus the renovation expense is capital expenditure in nature.
(ii) Expense incurred to recover installments due from customer does not increase the revenue generating capability in future. It is a normal recurring expense of the business. Thus the legal expenses incurred in this case are revenue expenditure in nature.
(iii) Expenses incurred on account of transportation of fixed asset are capital expenditure in nature.
Part B: Final Accounts of Manufacturing Concern
The term ‘Final Accounts’ is a broader term. The four following financial statements are prepared for the preparation of final accounts of a Manufacturing Proprietor:
- Manufacturing account: It shows the Cost of Goods Produced.
- Trading account: It shows gross profit/loss of the business.
- Profit & loss account: It shows the net profit/loss of the business.
- Balance sheet: It shows the financial position of the business.
Out of the above four statements, manufacturing account if prepared first, trading, profit & loss accounts are prepared, together, and balance sheet is prepared, independently. Here, it is very necessary to remember that these accounts are not prepared in the ledger rather than on the plain sheets or papers. Theses papers are filed for future reference. The method of preparing these accounts is different from other accounts like personal, real, nominal accounts.
As stated above, the term ‘final accounts’ refer to manufacturing account, trading account, profit & loss account and balance sheet. Balance sheet is a statement but even then it is included in final accounts. Now, here the question arises that why they are named final accounts?
Every businessman is, ultimately, interested to know the final result of the business. These are called final accounts because they are the last accounts, prepared at the end of the year. They serve the ultimate purpose of keeping accounts. Their purpose is to analyze the effect of various incomes and expenses during the year and the resultant profit or loss.
Manufacturing, Trading, profit & loss account and balance sheet, all these together, are called as final accounts. Final result of Manufacturing account is transferred to Trading account. Final result of trading is known through Profit and Loss Account. Financial position is reflected by Balance Sheet. These are, usually, prepared at the close of the year hence known as final accounts.
Final balances of all the accounts in the ledger are transferred to trial balance. From trial balance, expenses and income accounts are transferred to manufacturing account, trading account and profit and loss account.
Accounts, with balances, which are to be carried forward to the next year, are shown in the balance sheet. The balance sheet constitutes the final stage of accounting.
Final accounts have to be prepared, every year, in every business. Final accounts are prepared, after all the accounts have been completely written and trial balance is extracted. Before preparing final accounts, it becomes necessary to examine whether all the expenses and incomes for the year for which accounts are prepared have been duly provided for and included in the accounts. Circumstances and items are common where adjustments, at the end of the accounting period, are to be made. In such items, no cash is involved hence no record has been kept till year-end.
Form of Final Accounts: There is a standard format of final accounts only in the case of a limited company. There is no fixed prescribed format of financial accounts in the case of a proprietary concern and partnership firm.
Cycle of Final Accounts
Transactions |
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Trial Balance |
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Final Accounts |
- MANUFACTURING ACCOUNT
The manufacturing entities generally prepare a separate Manufacturing Account as a part of Final accounts in addition to Trading Account, Profit and Loss Account and Balance Sheet. The objective of preparing Manufacturing Account is to determine manufacturing costs of finished goods for assessing the cost effectiveness of manufacturing activities. Manufacturing costs of finished goods are then transferred from the Manufacturing Account to Trading Account.
Purpose: A manufacturing account serves the following functions:
- It shows the total cost of manufacturing the finished products and sets out in detail, with appropriate classifications, the constituent elements of such cost. It is, therefore, debited with the cost of materials, manufacturing wages and expenses incurred directly or indirectly on manufacture.
- It provides details of factory cost and facilitates reconciliation of financial books with cost records and also serves as a basis of comparison of manufacturing operations from year to year.
- The Manufacturing Account may also be used for various other purposes. For example, if the output is carried to the Trading Account at market prices, it discloses the profit or loss on manufacture. Similarly, it may also be used to fix the amount of production of profit sharing bonus when such schemes are in force.
Manufacturing Costs:
Manufacturing costs are classified into : + Raw Material Consumed + Direct Manufacturing Wages + Direct Manufacturing Expenses + Direct Manufacturing Cost + Indirect Manufacturing expenses or + Manufacturing Overhead Total Manufacturing Cost |
Raw Material consumed is arrived at after adjustment of opening and closing Inventory of raw materials:
Raw Material Consumed = Opening inventory of Raw Materials + Purchases – Closing inventory of Raw Materials |
If there remain unfinished goods at the beginning and at the end of the accounting period, cost of such unfinished goods (also termed as Work-In-Process) is shown in the Manufacturing Account –
Opening inventory of Work-in-Process is posted to the debit of the Manufacturing Account and closing inventory of Work-in-Process is posted to the credit of the Manufacturing Account.
Direct Manufacturing Expenses
Direct manufacturing expenses are costs, other than material or wages, which are incurred for a specific product or saleable service.
Examples of direct manufacturing expenses are (i) Royalties for using license or technology if based on units produced, (ii) Hire charge of the plant and machinery used on hire, if based on units produced, etc.
When royalty or hire charges are based on units produced, these expenses directly vary with production.
Indirect Manufacturing Expenses or Overhead Expenses
These are also called Manufacturing overhead, Production overhead, Works overhead, etc. Overhead is defined as total cost of indirect material, indirect wages and indirect expenses.
Overhead = Indirect Material + Indirect Wages + Indirect Expenses
Indirect material means materials which cannot be linked directly with the units produced, for example, stores consumed for repair and maintenance work, small tools, fuel and lubricating oil, etc.
Indirect wages are those which cannot be directly linked to the units produced, for example, wages for maintenance works, holding pay, etc.
Indirect expenses are those which cannot be directly linked to the units produced, for example, training expenses, depreciation of plant and machinery, depreciation of factory shed, insurance premium for plant and machinery, factory shed, etc.
Accordingly, indirect manufacturing expenses comprise indirect material, indirect wages and indirect expenses of the manufacturing division.
By-Products
In most manufacturing operations, the production of the main product is accompanied by the production of a subsidiary product which has a value on sale. For example, the production of hydrogenated vegetable oil is accompanied by the production of oxygen gas and the production of steel yields scrap. The subsidiary product is termed as a by-product because its production is not consciously undertaken but results out of the production of the main product. It is usually very difficult to ascertain the cost of the product. Moreover, its value usually forms a very small percentage of the main product.
By-product is a secondary product. This is produced from the same raw materials, which are used for producing the main product and without incurring any additional expenses from the same production process in which the main product is produced. Some examples of by-product are given below:
(i) Molasses is the by-product in sugar manufacturing;
(ii) Butter milk is the by-product of a dairy which produces butter and cheese, etc.
By-products generally have insignificant value as compared to the value of main product. They are generally valued at net realizable value, if their costs cannot be separately identified. It is often treated, as “Miscellaneous income” but the correct treatment would be to credit the sale value of the by-product to Manufacturing Account so as to reduce to that extent, the cost of manufacture of main product.
Format of Manufacturing Account
Particulars | Units | Amount Rs. | Particulars | Units | Amount Rs. |
To Opening Work-in-process To Raw Material Consumed: Opening inventory Add: Purchases Less: Closing inventory To Direct Wages To Direct expenses: Prime cost To Factory overheads: Royalty Hire charges To Indirect expenses: Repairs & Maintenance Depreciation Factory cost |
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| By Sale of Scrap By-products at net realizable value By Closing Work-in- Process By Trading A/c (Cost of production) |
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The following general rules may be observed.
- The Manufacturing Account should have columns showing the quantities and values. Frequently, all the quantities are not given and the quantities applicable to one or more of the items would have to be worked out. For example, if the question does not state the total number of items sold, the quantity can be worked out by adding opening inventory and units manufactured and deducting closing inventory. It is, therefore, useful to have quantity columns in the account so that it can be seen that both sides balance.
- The Manufacturing Account will show the quantity of raw materials in inventory at the beginning and at the end of the year and the purchases during the year. As regards finished goods, it will only show the quantity manufactured and, as regards work-in-progress, the opening and closing amounts.
- The Trading Account will show the quantities of finished goods manufactured and sold and the opening and closing inventory. It will not show the quantity of raw materials or work-in-progress.
- For determining the value of closing inventory, in the absence of specific instruction to the contrary, it must be assumed that sales have been on “first in-first out” basis, that is, the closing inventory consists as far as possible of goods produced during the year, the opening inventory being sold out.
It may be mentioned here that nowadays no manufacturing business entity prepares manufacturing account as part of its final set of accounts. Even the items of manufacturing account are shown either in trading account (in case of non-corporate entities) or in Statement of profit and loss (in case of corporate entities).
The procedure of preparation of Trading Account, Profit and Loss Account and Balance Sheet has already been studied by students in the 11th standard. Students should refer the same for attempting the problems based on the preparation of complete set of final accounts of a sole proprietor.
2. TRADING ACCOUNT
Particulars | Amount | Particulars | Amount |
To Opening Stock Finished Goods |
| By Sales |
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To Purchases |
| Less : Return Inward |
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Less : Return Outward |
| By Goods distributed as free samples |
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To Carriage Inward |
| By Goods lost by fire |
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To Freight |
| By Goods lost in Accident |
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To Dock Charges |
| By Goods lost by theft |
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To Custom Duty |
| By Goods withdrawn by Proprietor |
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To Wages Productive |
| By Closing Stock Finished Goods |
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To Manufacturing Wages |
| By Gross Loss c/d |
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To Wages & Salaries |
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To Import Duty |
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To Coal/Coke/Gas/ Motive Power/Oil/ Water /Grease |
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To Royalty on Purchase/Production |
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To Factory Rent & Rates |
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To Factory Insurance |
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To Works Manager's Salary |
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To Primary Packaging |
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To Gross Profit c/d |
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Total |
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3. PROFIT & LOSS ACCOUNT
Particulars | Amount | Particulars | Amount |
To Salaries To Salaries & Wages To Rent & Rates To Insurance To Electricity/Lighting To Telephone, Postage To Printing & Stationery To Travelling Expenses of Salesman To Depreciation on Assets To Loading Charges To Audit Fees To Entertainment Exp. To Repairs / Renewals / Maintenance |
| By Gross Profit b/d By Commission Received By Discount Received/ Earned By Interest Received By Dividend Received By Rent Received By Sundry/Miscellaneous Receipts By Profit on Sale of Asset By Net Loss transferred to Balance Sheet
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To Interest on Loan To Sundry/Miscellaneous Expenses To Conveyance To Loss by Fire To Loss by Theft To Loss in Accident To Goods distributed as free sample To Commission Allowed/ Given To Discount allowed To Allowances To Advertisement To Carriage Outward To Sale Charges To Bad Debts To Export Duty To Taxes To General Expenses To Trade Expenses To Legal Charges To Professional Charges To Bank Charges To Solicitor's Fees To Secondary Packing Charges To Loss on sale of Fixed Assets To Net Profit transferred to Balance Sheet |
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Total |
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4. BALANCE SHEET
Particulars | Amount | Particulars | Amount |
Capital Bank Loan |
| Goodwill |
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Loan from Relatives |
| Patents |
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Bills Payable |
| Copyrights |
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Bank Overdraft |
| Trade Marks |
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Sundry Creditors |
| Furniture & Fittings |
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Less: Provision for Discount on Creditors |
| Less: Depreciation |
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Outstanding Expenses |
| Plant & Machinery |
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Income received in Advance |
| Less: Depreciation |
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Provision for Taxes |
| Land & Building |
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| Less: Depreciation |
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| Premises |
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| Less: Depreciation |
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| Equipment |
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| Less: Depreciation |
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| Delivery/Motor Van |
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| Less: Depreciation |
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| Loose Tools/Spare Parts |
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| Less: Depreciation |
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| Investments |
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| Sundry Debtors |
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| Less: Bad Debts |
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| Less: R.D.D |
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| Less: Provision for Discount on Debtors |
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| Bills Receivable |
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| Cash In Hand |
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| Cash at Bank |
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| Loans & Advances |
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| Prepaid Expenses |
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| Income Receivable |
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| Closing Stock |
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Total |
| Total |
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Sometimes, it is seen that after preparation of trial balance, but, prior to preparation of final accounts, it may be noticed some business transactions have been, completely or partially, omitted to be recorded or entered wrong. Besides this, there are some incomes or expenses, which are related to the next year but have been received or paid during the current year. Before preparing trading and profit & loss accounts, adjustment entries are necessary in these accounts.
Transactions omitted relate to the current year must be entered in books. If a transaction entered is not related to the current year, fully or partly, that portion of income or expense must be excluded. This process is made through adjustment entries in the books of accounts. If we ignore to make the necessary adjustments, the trading, profit & loss accounts do not show the true profit or loss and in consequence balance sheet fails to depict true financial position of the business. This situation defeats the very purpose of final accounts. Hence, adjustment entries play an important role in presenting correct picture of accounts.
Final Accounts are prepared, normally, for a complete period. It must be kept in mind that expenses and incomes for the relevant accounting period are to be taken, while preparing final accounts. If an expense has been incurred but not paid during the period, a liability for the unpaid amount should be created, before finding out the operating result and financial position of a concern. In order to prepare the final accounts on mercantile system of accounting, all expenses and incomes relating to the period, whether incurred or not, received or not, should be brought into the books. For doing this, a concern is required to pass certain entries at the end of the year to adjust the various items of incomes and expenses. Such entries are called adjusting entries.
Accounting Treatment: Trading and Profit and Loss and Balance sheet, together, are called as final accounts. Item appearing in the trial balance appears only once in final accounts, either on the debit or credit. Any adjustment entry requires two postings, debit and credit for the same amount. Important point is students should do the posting (debit and credit) in the concerned accounts, simultaneously. Care is to be exercised that the amount is the same for the total debit and credit.
The following is the summary of important adjustments, which are, normally made at the end of accounting period:
Sr No | Adjustment | Effect 1 | Effect 2 |
1 | Closing Stock- Raw Materials | Less from RC- Mfg A/c | BS- Asset Side |
| Closing Stock- Work In Progress | Mfg A/c- Cr Side | BS- Asset Side |
| Closing Stock- Finished Goods | Trading A/c- Cr Side | BS- Asset Side |
2 | Outstanding Expenses or Payable | Add to Expense | BS- Liability Side |
3 | Prepaid Expense | Less from Expenses | BS- Asset Side |
4 | Outstanding Income or Receivable | Add to Income | BS- Asset Side |
5 | Income received in Advance | Less from Income | BS- Liability Side |
6 | Depreciation on Assets used in Mfg | Less from Asset in BS | Mfg A/c Dr Side |
| Depreciation on Office Assets | Less from Asset in BS | P/L A/c Dr Side |
7 | Interest on Capital | P & L A/c Dr Side | Add to Capital in BS |
8 | Interest on Drawings | P & L A/c Cr Side | Less from Capital in BS |
9 | Bad or Doubtful Debts | P & L Dr Side (Formula) | Less From Debtors |
10 | Provision/Reserve for Doubtful Debts (RDD) | P & L Dr Side (Formula) | Less From Debtors |
11 | Provision for Discount on Debtors | Add to Discount (P & L Dr Side) | Less From Debtors |
12 | Provision for Discount on Creditors | Add to Discount (P & L Cr Side) | Less From Creditors |
13 | Unrecorded Sales | Add to Debtors | Add to Sales |
14 | Unrecorded Purchases | Add to Creditors | Add to Purchases |
15 | Uninsured Goods lost by Fire/theft | P & L Dr Side | Trading A/c Cr Side |
16 | Insured Goods lost by Fire/theft | P & L Dr Side- Actual Loss Amount
BS Asset Side - Insurance Claim Receivable | Trading A/c Cr Side- Amount of Goods Lost |
17 | Goods Distributed as Free Samples | P & L Dr Side | Trading A/c Cr Side |
18 | Goods taken for Personal use by proprietor | Add to Drawings | Trading A/c Cr Side |
19 | Bills Receivable Dishonoured | Less from Bills Receivable | Add to Debtors |
20 | Bills Payable Dishonoured | Less from Bills Payable | Add to Creditors |
21 | Interest on Loan Payable | Add to Loan Liability Side | P & L Dr Side |
22 | Interest on Investment Receivable | Add to Investment Asset Side | P & L Cr Side |
‘Closing Entries’ are essential to ascertain the correct operating results. Accounts relating to expenses and incomes are to be closed to find out the operating profit. So, balances in the expenses and income accounts have to be transferred to Manufacturing, Trading and Profit and Loss Accounts. Process of closing expenses and income accounts is done through closing entries.
‘My balance sheet is not tallied, though I have made all the adjustment entries, correctly’ – this is the common statement often heard from the students, coming out of the examination hall.
Follow the following to tips to avoid this situation:
Entry appearing in Trial balance finds place at one place only, debit or credit.
Give a special identification (giving reference to the adjustment number in the problem), while reading the trial balance, against the entry, which requires adjustment. You would not forget to do the adjustment as the symbol reminds you to do adjustment! This is ‘Time Management’ too.
All adjustment entries have to be made at two places for the same amount. Students think that they can make entries at their convenience. This is a wrong approach. Once you debit, make credit for the same amount, simultaneously. Students know the adjustment entry, yet they do not make both the adjustments (changes) at the same time.
After making the adjustment, before you move to the next entry, check, again, that adjustment has been done at both the places for the same amount.
Do not forget to check that the debit amount and credit amount are the same.
Once you follow meticulously, your balance sheet would always tally.
