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Accountancy: Class 11 (Part 2) — Chapter 9: Financial Statements - II

Introduction & Need for Adjustments

In business operations, determining the true income and financial position at the end of an accounting year requires following the accrual basis of accounting. This means revenues are recognized when earned (not when received) and expenses are recognized when incurred (not when paid).

Why Adjustments are Needed

  • To ensure that the financial statements reflect a true and fair view of the business's state of affairs.
  • To account for expenses and incomes that relate to the current year but have not yet been paid or received.
  • To exclude transactions that relate to the previous or next accounting periods.
  • To record non-cash items such as depreciation, bad debts, and provisions.

Common Items Requiring Adjustments

  1. Closing Stock
  2. Outstanding Expenses
  3. Prepaid/Unexpired Expenses
  4. Accrued 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
Adjustments for Expenses and Incomes

1. Closing Stock

Closing Stock represents the value of unsold goods remaining at the end of the accounting period.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Closing Stock A/c
    To Trading A/c		[Value]
[Value]
  • Trading Account: Shown on the credit side.
  • Balance Sheet: Shown on the assets side under Current Assets.

2. Outstanding Expenses

Outstanding Expenses are those expenses which have been incurred during the current accounting year but remain unpaid at the end of the year.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Concerned Expense A/c
    To Outstanding Expense A/c		[Amount]
[Amount]
  • Trading/P&L Account: Added to the respective expense on the debit side.
  • Balance Sheet: Shown on the liabilities side under Current Liabilities.

3. Prepaid Expenses

Prepaid Expenses (or Unexpired Expenses) are expenses paid in advance for which the benefit will be received in the next accounting year.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Prepaid Expense A/c
    To Concerned Expense A/c		[Amount]
[Amount]
  • Trading/P&L Account: Deducted from the respective expense on the debit side.
  • Balance Sheet: Shown on the assets side under Current Assets.

4. Accrued Income

Accrued Income (or Income Earned but not Received) is income that has been earned during the current accounting year but has not been received by the end of the year.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Accrued Income A/c
    To Concerned Income A/c		[Amount]
[Amount]
  • Profit & Loss Account: Added to the respective income on the credit side.
  • Balance Sheet: Shown on the assets side under Current Assets.

5. Income Received in Advance

Income Received in Advance (or Unearned Income) is income received during the current year that relates to the next accounting period.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Concerned Income A/c
    To Income Received in Advance A/c		[Amount]
[Amount]
  • Profit & Loss Account: Deducted from the respective income on the credit side.
  • Balance Sheet: Shown on the liabilities side under Current Liabilities.
Asset Valuation & Debtors Adjustments

1. Depreciation

Depreciation is the decline in the value of a fixed asset due to wear and tear, passage of time, or obsolescence.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Depreciation A/c
    To Concerned Asset A/c		[Amount]
[Amount]
  • Profit & Loss Account: Debited as an expense.
  • Balance Sheet: Deducted from the cost of the respective asset on the assets side.

2. Bad Debts & Further Bad Debts

Bad Debts represent the amount that cannot be recovered from debtors. If discovered after preparing the trial balance, they are termed as further bad debts.

Adjustment Entry for Further Bad Debts:

ParticularsL.F.Debit (₹)Credit (₹)
Bad Debts A/c
    To Sundry Debtors A/c		[Amount]
[Amount]
  • Profit & Loss Account: Debited (added to existing bad debts).
  • Balance Sheet: Deducted from Sundry Debtors on the assets side.

3. Provision for Doubtful Debts

A provision created at a certain percentage on debtors to cover expected future losses from non-recovery of debts.

The provision is calculated on "good debtors" after deducting further bad debts:

$$\text{New Provision} = (\text{Sundry Debtors} - \text{Further Bad Debts}) \times \text{Rate of Provision}$$
  • Profit & Loss Account: Debited with $(\text{Bad Debts} + \text{Further Bad Debts} + \text{New Provision} - \text{Old Provision})$.
  • Balance Sheet: Deducted from Sundry Debtors on the assets side.

4. Provision for Discount on Debtors

Created to account for discounts likely to be allowed to debtors for prompt payment. It is calculated only on good debtors after deducting further bad debts and the new provision for doubtful debts:

$$\text{Provision for Discount} = (\text{Debtors} - \text{Further Bad Debts} - \text{New Provision for Doubtful Debts}) \times \text{Rate of Discount}$$
Capital & Management Adjustments

1. Manager's Commission

Managers are sometimes entitled to a commission calculated as a percentage of net profits.

  • Case A: On profits before charging such commission:$$\text{Commission} = \text{Net Profit before Commission} \times \frac{\text{Rate}}{100}$$
  • Case B: On profits after charging such commission:$$\text{Commission} = \text{Net Profit before Commission} \times \frac{\text{Rate}}{100 + \text{Rate}}$$

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Profit & Loss A/c
    To Outstanding Manager's Commission A/c		[Amount]
[Amount]

2. Interest on Capital

To find the true profit of the business, interest is sometimes allowed on the proprietor's capital at a given rate.

Adjustment Entry:

ParticularsL.F.Debit (₹)Credit (₹)
Interest on Capital A/c
    To Capital A/c		[Amount]
[Amount]
  • Profit & Loss Account: Debited as an expense.
  • Balance Sheet: Added to the Capital account on the liabilities side.
Summary of Adjustments
AdjustmentAdjustment EntryTreatment in Trading / P&L AccountTreatment in Balance Sheet
Closing StockClosing Stock A/c Dr.
To Trading A/c		Credited to Trading AccountShown on Assets side
Outstanding ExpensesExpense A/c Dr.
To Outstanding Expense A/c		Added to respective expense (Debit side)Shown on Liabilities side
Prepaid ExpensesPrepaid Expense A/c Dr.
To Expense A/c		Deducted from respective expense (Debit side)Shown on Assets side
Accrued IncomeAccrued Income A/c Dr.
To Income A/c		Added to respective income (Credit side)Shown on Assets side
Income in AdvanceIncome A/c Dr.
To Income Received in Advance A/c		Deducted from respective income (Credit side)Shown on Liabilities side
DepreciationDepreciation A/c Dr.
To Asset A/c		Debited to Profit & Loss AccountDeducted from Asset (Assets side)
Further Bad DebtsBad Debts A/c Dr.
To Sundry Debtors A/c		Debited to Profit & Loss AccountDeducted from Debtors (Assets side)
Provision for Doubtful DebtsProfit & Loss A/c Dr.
To Provision for Doubtful Debts A/c		Debited to Profit & Loss AccountDeducted from Debtors (Assets side)
Interest on CapitalInterest on Capital A/c Dr.
To Capital A/c		Debited to Profit & Loss AccountAdded to Capital (Liabilities side)