Chapter 2 — Financial Statements — II

The chapter covers adjustments needed while preparing financial statements under the accrual basis — including outstanding and prepaid expenses, accrued and advance income, depreciation, bad debts, provisions for doubtful debts and discount on debtors, manager's commission, and interest on capital — and shows how to prepare a profit and loss account and balance sheet incorporating all these adjustments.

According to the accrual concept, profit or loss is not based on cash receipts and payments alone. Some revenues may be earned but not yet received, some expenses may be incurred but not yet paid, and certain items such as depreciation are not recorded daily. Without adjustments, the final accounts would not reflect the true profit or loss and the true financial position of the business.

Outstanding expenses are expenses that relate to the current accounting period but remain unpaid at the end of the year. They are added to the concerned expense on the debit side of the profit and loss account and shown as a current liability on the liabilities side of the balance sheet.

Prepaid expenses are amounts paid in advance whose benefit will be received in the next accounting period. The prepaid portion is deducted from the related expense in the profit and loss account and shown on the assets side of the balance sheet as a current asset.

Depreciation is debited to the profit and loss account as an expense. In the balance sheet, the asset is shown at cost minus the accumulated depreciation, effectively reducing the book value of the concerned asset.

Bad debts are amounts that the firm has actually failed to recover from debtors and are recorded as a confirmed loss. Provision for doubtful debts is a reasonable estimate of future bad debts on the remaining debtors; it is debited to the profit and loss account and shown as a deduction from debtors in the balance sheet.

The total charge to the profit and loss account is: bad debts plus further bad debts plus new provision required, minus the old provision brought forward from the previous year. The new provision is calculated on the debtors remaining after writing off further bad debts.

Provision for discount on debtors is created to account for discounts likely to be allowed to customers for prompt payment. It is calculated only on good debtors — the debtors figure after deducting further bad debts and the provision for doubtful debts.

When commission is on profit before charging commission, it is simply: net profit before commission multiplied by the rate percentage. When commission is on profit after charging commission, the formula is: profit before commission multiplied by rate divided by (100 + rate). In the absence of specific information, commission is assumed to be on profit before charging.

Interest on capital is debited to the profit and loss account as an expense, reducing net profit. In the balance sheet, it is added to the capital account on the liabilities side, so its effect on net worth is neutralised.

Accrued income is income that has been earned during the current accounting year but has not yet been received. It is added to the related income on the credit side of the profit and loss account and shown on the assets side of the balance sheet as a current asset.

Income received in advance, also called unearned income, is the portion of income received in the current year that belongs to the next accounting period. It is deducted from the related income in the profit and loss account and shown as a liability in the balance sheet.

Every adjustment is reflected at two places in the final accounts to complete the double entry — once in the trading and profit and loss account and once in the balance sheet.

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