Financial Statements - II

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XI (Financial Accounting Part II), Chapter 9.

Paid is not the same as expensed

Rohit runs a trading firm. In February he pays ₹8,000 for a full year of insurance, running from February to January. In March his staff finish the month's work, but he will pay the March salaries only in April. A customer also owes him ₹3,000 of commission he has earned but not yet received. If Rohit prepared his accounts only from the cash he paid and received, his profit would be wrong in all three cases. The insurance paid includes cover that belongs to next year. The salary of March is a cost of this year even though no cash has gone yet. The commission is this year's income even though no cash has come.

Adjustments fix this. They bring the books in line with the accrual concept: income counts when it is earned, and expense counts when it is incurred, whatever the date of payment. Without them, the profit in the trial balance is only an "apparent" profit.

The dual effect rule

Every adjustment touches two places, one in the Trading or Profit and Loss Account and one in the Balance Sheet. That is the dual effect. But that is true only when the adjustment is given as additional information, outside the trial balance. If the item already appears in the trial balance, it was already recorded once, so it is shown in only one place.

The eleven adjustments in one table

This is the master table of the chapter. Learn it, because most questions are a variation on one row.

An easy way to hold the four time items. Whatever you owe is a liability: outstanding expenses and income received in advance. Whatever you are owed or have paid ahead is an asset: prepaid expenses and accrued income.

The running case: Rohit Traders

One trial balance will carry us through the chapter. Here it is, with the additional information below it.

Expenses and incomes that straddle the year end

Four adjustments share one idea: money and time do not line up. The test is always the same. Ask which year does this belong to?

Worked example: four straddle adjustments. Pass the adjusting entries for Rohit Traders and show the effect on each account.

Common wrong step. Adding the prepaid insurance to the expense (8,000 + 2,000) because "it was paid". A prepayment is taken off the expense, because that part belongs to next year, and is shown as an asset.

Pause and predict: the insurance account shows ₹8,000, of which ₹2,000 belongs to next year. What reaches the Profit and Loss Account, and what does the Balance Sheet show?

Check your answer: ₹6,000 is charged to profit, and ₹2,000 appears as prepaid insurance on the asset side. The ₹2,000 buys cover the firm still has, so it is something owned.

Beyond the textbook. For the exam: accrual accounting records income when earned and expense when incurred. In reality: it means profit is not the same as cash. A firm can show a healthy profit through accrued income and yet be short of cash because customers have not paid, and a firm can hold cash and show a loss. Why it matters: this gap is the reason a separate cash flow statement is prepared in Class XII.

Bad debts, provision for doubtful debts and discount on debtors

A bad debt is money that will never be collected. A provision for doubtful debts is an estimate of how much of the remaining debtors may turn bad. A provision for discount on debtors is an estimate of the cash discount the firm will allow when good debtors pay early.

Why discount uses good debtors. Discount can only be claimed by customers who actually pay. Debts that are bad, and debts that are doubtful, will not pay, so they are taken out first.

Old provision. If the trial balance already shows an old provision, only the difference between the new and old provision goes to the Profit and Loss Account. If the new one is bigger, the difference is a charge. If it is smaller, the difference is a gain.

Worked example: debtors, provisions and the charge to profit. Rohit's debtors are ₹1,02,000. The trial balance has bad debts ₹3,000 and an old provision of ₹4,000. Further bad debts are ₹2,000, the new provision is 5%, and the provision for discount is 2%. Find the amount charged to Profit and Loss and the debtors figure in the Balance Sheet.

Common wrong step. Charging the discount provision at 2% of ₹1,02,000, the gross debtors. That ignores the debts that will not pay. The correct base is ₹95,000, which gives ₹1,900, not ₹2,040. A second slip is to charge the whole new provision of ₹5,000 and forget that ₹4,000 of it already exists.

Pause and predict: the old provision is ₹4,000 but the new one required is ₹3,000. What happens in the Profit and Loss Account?

Check your answer: the provision is too large by ₹1,000, so ₹1,000 is credited to Profit and Loss as a gain. The balance of the provision falls to ₹3,000.

Beyond the textbook. For the exam: provisions use a flat percentage of debtors. In reality: many firms examine debtors by the length of time they have been outstanding (an ageing schedule) and assume a higher chance of loss for older balances. Why it matters: the flat percentage is a simplification for sums, and a longer outstanding debt is riskier than a recent one.

Manager's commission and interest on capital

A manager may be paid a percentage of the firm's net profit. The question is which profit. If the commission is a percentage of the profit before charging the commission, it is simply the rate times that profit. If it is a percentage of the profit after charging the commission, the commission itself is an expense that reduces the base. Writing $P$ for the profit before commission and $r$ for the rate:

$$\text{Commission (before charging)} = P \times \dfrac{r}{100} \qquad \text{Commission (after charging)} = P \times \dfrac{r}{100 + r}$$

Why the second formula looks like that. Let the commission be $C$. Then $C = \dfrac{r}{100}(P - C)$, so $C\left(1 + \dfrac{r}{100}\right) = \dfrac{rP}{100}$, and $C = \dfrac{rP}{100 + r}$.

Interest on capital is the return to the owner on his investment, treated as a business expense. It is calculated on the opening capital, and on any extra capital for the period it stayed in the business. The expense is debited to Profit and Loss and the interest is credited to Capital.

Worked example: commission and interest. A firm's net profit before manager's commission is ₹2,20,000, and the manager gets 10%. Separately, the proprietor's capital is ₹2,00,000 at the start of the year and he brings in ₹60,000 more on 1 October. The rate of interest on capital is 10% a year. Find the commission under both bases and the interest on capital.

Common wrong step. Using 22,000 when the question says the commission is on profit after charging it. If commission is ₹22,000 the profit after commission is ₹1,98,000, and 10% of that is not ₹22,000. The commission has to satisfy its own definition.

The balance sheet effect of interest on capital. Profit falls by the interest, but Capital rises by the same amount, so the total of the Balance Sheet does not change.

Special adjustments that appear in problems

Worked example: passing the special entries.

Common wrong step. Reversing the sale at the selling price but adding the goods back to stock at the same price. Stock is always carried at cost, so the goods go back at ₹4,500 and not ₹6,000.

Putting it together: the adjusted final accounts

Worked example: Rohit Traders. Using the trial balance and the additional information above, prepare the Trading and Profit and Loss Account and the Balance Sheet.

Capital in the Balance Sheet: 2,50,000 + 15,000 (interest) + 1,11,690 (profit) − 40,000 (drawings) = ₹3,36,690.

How profit changes from the "apparent" figure to the adjusted figure. Before any adjustment, the trial balance gives gross profit of 6,50,000 − 5,00,000 = 1,50,000, plus incomes of 39,000, less expenses of 1,01,000, an apparent profit of ₹88,000.

Apparent profit 88,000 + 23,690 = ₹1,11,690, which matches the Profit and Loss Account.

Common wrong step. Writing debtors as ₹1,02,000 in the Balance Sheet, or deducting depreciation from capital. Debtors are shown net of further bad debts and both provisions, and depreciation is deducted from the machinery.

Exam traps

Formats and formula sheet

Here $D$ is gross debtors, FBD is further bad debts, $P$ is profit before commission and NP is net profit.

60-second revision

Where this chapter connects

• Previous: Financial Statements I builds the Trading and Profit and Loss Account and the Balance Sheet that these adjustments correct.
• Earlier idea reused: Theory Base of Accounting introduced the accrual concept, which is the reason for every entry here.
• Also revisit: Depreciation, Provisions and Reserves explains the depreciation methods and the difference between a provision and a reserve.
• Class XII link: Accounting for Partnership: Basic Concepts uses interest on capital and the appropriation of profit in firms with more than one owner, and Cash Flow Statement shows why accrual profit differs from cash.