Chapter: Financial Statements – II (Adjustments)

1. Meaning of Adjustments

Financial statements are prepared according to the accrual basis of accounting. Therefore, all incomes and expenses relating to the current year must be recorded, whether cash has been received or paid or not.

Adjustments are made to ensure:

Correct profit or loss is calculated.
True financial position is shown.
Income and expenses are matched with the correct accounting period.

2. Important Adjustments

A. Closing Stock

Meaning

Goods remaining unsold at the end of the accounting year.

Journal Entry

Closing Stock A/c Dr.
     To Trading A/c

Treatment

Trading Account

Credit Side

Balance Sheet

Asset Side

Effect

Increases Gross Profit
Increases Assets

B. Outstanding Expenses

Meaning

Expenses incurred but not yet paid.

Examples

Outstanding Salary
Outstanding Wages
Outstanding Rent

Journal Entry

Expense A/c Dr.
      To Outstanding Expense A/c

Treatment

Profit & Loss/Trading Account

Add to related expense

Balance Sheet

Liability Side

Effect

Decreases Profit
Increases Liabilities

C. Prepaid Expenses

Meaning

Expenses paid in advance for future periods.

Examples

Prepaid Insurance
Prepaid Rent
Prepaid Salary

Journal Entry

Prepaid Expense A/c Dr.
      To Expense A/c

Treatment

Profit & Loss Account

Deduct from expense

Balance Sheet

Asset Side

Effect

Increases Profit
Increases Assets

D. Accrued Income

Meaning

Income earned but not yet received.

Examples

Interest Receivable
Rent Receivable
Commission Receivable

Journal Entry

Accrued Income A/c Dr.
      To Income A/c

Treatment

Profit & Loss Account

Add to income

Balance Sheet

Asset Side

Effect

Increases Profit
Increases Assets

E. Income Received in Advance

Meaning

Income received before it is earned.

Examples

Advance Rent
Advance Commission

Journal Entry

Income A/c Dr.
      To Income Received in Advance A/c

Treatment

Profit & Loss Account

Deduct from income

Balance Sheet

Liability Side

Effect

Decreases Profit
Increases Liabilities

F. Depreciation

Meaning

Reduction in the value of fixed assets due to use, wear and tear, or passage of time.

Examples

Machinery
Furniture
Building

Journal Entry

Depreciation A/c Dr.
      To Asset A/c

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Deduct from asset value

Effect

Decreases Profit
Decreases Asset Value

G. Bad Debts

Meaning

Amount that cannot be recovered from debtors.

Journal Entry

Bad Debts A/c Dr.
      To Debtors A/c

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Deduct from Debtors

Effect

Decreases Profit
Decreases Debtors

H. Provision for Doubtful Debts

Meaning

Estimated future loss from debtors who may fail to pay.

Journal Entry

Profit & Loss A/c Dr.
      To Provision for Doubtful Debts A/c

Formula

Provision = Debtors × Rate %

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Deduct from Debtors

Effect

Decreases Profit
Decreases Debtors

I. Provision for Discount on Debtors

Meaning

Expected discount to be allowed to debtors for prompt payment.

Journal Entry

Profit & Loss A/c Dr.
      To Provision for Discount on Debtors A/c

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Deduct from Debtors

Effect

Decreases Profit

J. Manager’s Commission

Meaning

Commission payable to the manager based on profit.

Journal Entry

Profit & Loss A/c Dr.
      To Manager's Commission A/c

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Liability Side (if unpaid)

Commission Before Charging Commission

Formula

Commission = Profit × Rate / 100

Example:

Profit = ₹50,000

Commission = 50,000 × 10%

= ₹5,000

Commission After Charging Commission

Formula

Commission =
Profit × Rate
------------------
100 + Rate

Example:

Profit = ₹50,000

Rate = 10%

Commission

= 50,000 × 10 / 110

= ₹4,545

K. Interest on Capital

Meaning

Interest allowed on owner’s capital invested in business.

Journal Entry

Interest on Capital A/c Dr.
      To Capital A/c

Formula

Interest = Capital × Rate × Time

Treatment

Profit & Loss Account

Debit Side

Balance Sheet

Added to Capital

Effect

Reduces Profit
Increases Capital

Quick Revision Table

Adjustment	P&L Effect	Balance Sheet Effect
Closing Stock	Credit	Asset
Outstanding Expense	Add Expense	Liability
Prepaid Expense	Less Expense	Asset
Accrued Income	Add Income	Asset
Income Received in Advance	Less Income	Liability
Depreciation	Expense	Reduce Asset
Bad Debts	Expense	Reduce Debtors
Provision for Doubtful Debts	Expense	Reduce Debtors
Provision for Discount	Expense	Reduce Debtors
Manager’s Commission	Expense	Liability
Interest on Capital	Expense	Add to Capital

One-Day Exam Revision

Assets

Cash
Bank
Debtors
Stock
Furniture
Machinery

Liabilities

Creditors
Bills Payable
Outstanding Expenses
Loan
Income Received in Advance

Golden Rule

Outstanding Expense
→ Add to Expense + Liability

Prepaid Expense
→ Less from Expense + Asset

Accrued Income
→ Add to Income + Asset

Income Received in Advance
→ Less from Income + Liability

Most Important Formulas

Gross Profit

Net Sales – Cost of Goods Sold

Net Profit

Gross Profit + Other Incomes – Indirect Expenses

Provision for Doubtful Debts

Debtors × Rate%

Interest on Capital

Capital × Rate × Time

Manager’s Commission (Before)

Profit × Rate / 100

Manager’s Commission (After)

Profit × Rate / (100 + Rate)

Questions

PART A: Multiple Choice Questions (MCQs)

1. Unsold goods at the end of the year are called:

A. Purchases
B. Closing Stock
C. Sales
D. Drawings

Answer: B

2. Outstanding expenses are shown on:

A. Asset side
B. Liability side
C. Capital side
D. Trading account credit side

Answer: B

3. Prepaid expenses are:

A. Assets
B. Liabilities
C. Losses
D. Incomes

Answer: A

4. Accrued income is:

A. Income received in advance
B. Income earned but not received
C. Income not earned
D. Capital

Answer: B

5. Depreciation is:

A. Income
B. Liability
C. Expense
D. Asset

Answer: C

6. Bad debts are:

A. Gain
B. Loss
C. Asset
D. Capital

Answer: B

7. Provision for doubtful debts is created on:

A. Creditors
B. Capital
C. Debtors
D. Cash

Answer: C

8. Income received in advance is:

A. Asset
B. Liability
C. Expense
D. Drawings

Answer: B

9. Interest on capital is:

A. Expense of business
B. Income
C. Asset
D. Liability

Answer: A

10. Closing stock appears in:

A. Trading Account only
B. Balance Sheet only
C. Both Trading Account and Balance Sheet
D. Cash Book

Answer: C

PART B: Fill in the Blanks

Unsold goods at year end are called __________.
Answer: Closing Stock
Expenses incurred but unpaid are called __________ expenses.
Answer: Outstanding
Income earned but not received is __________ income.
Answer: Accrued
Depreciation reduces the value of __________.
Answer: Assets
Bad debts reduce the amount of __________.
Answer: Debtors
Prepaid expenses are shown as __________.
Answer: Assets
Income received in advance is a __________.
Answer: Liability
Provision for doubtful debts is created on __________.
Answer: Debtors
Manager’s commission is charged to __________ Account.
Answer: Profit and Loss
Interest on capital is added to __________.
Answer: Capital

PART C: True or False

Closing stock is an asset.
True
Outstanding expenses are assets.
False
Prepaid expenses increase profit.
True
Depreciation is an expense.
True
Accrued income is a liability.
False
Income received in advance is a liability.
True
Bad debts increase profit.
False
Provision for doubtful debts reduces debtor value.
True
Interest on capital is shown on debit side of P&L Account.
True
Manager’s commission decreases profit.
True

PART D: Match the Following

Column A	Column B
Closing Stock	Asset
Outstanding Salary	Liability
Prepaid Insurance	Asset
Depreciation	Expense
Accrued Rent	Asset

Answers

Closing Stock → Asset
Outstanding Salary → Liability
Prepaid Insurance → Asset
Depreciation → Expense
Accrued Rent → Asset

PART E: One Word Answers

Expense paid in advance.
Prepaid Expense
Income earned but not received.
Accrued Income
Decline in asset value.
Depreciation
Amount irrecoverable from debtors.
Bad Debt
Unsold goods.
Closing Stock
Income received before earning.
Unearned Income
Estimated future bad debts.
Provision
Person owing money to business.
Debtor
Interest allowed on owner’s investment.
Interest on Capital
Reward paid to manager from profits.
Commission

PART F: Very Short Answer Questions

1. What is closing stock?

Goods remaining unsold at the end of the accounting year.

2. What are outstanding expenses?

Expenses incurred but not paid.

3. What are prepaid expenses?

Expenses paid in advance.

4. What is accrued income?

Income earned but not yet received.

5. What is depreciation?

Decrease in value of assets due to use and time.

6. What are bad debts?

Amounts not recoverable from debtors.

7. Why is provision for doubtful debts created?

To cover expected future bad debts.

8. What is manager’s commission?

Commission paid to manager based on profits.

9. What is income received in advance?

Income received before it is earned.

10. What is interest on capital?

Interest allowed on owner’s capital.

PART G: Short Answer Questions (2–3 Marks)

1. Why are adjustments necessary?

Adjustments are necessary to:

Calculate correct profit.
Show true financial position.
Follow accrual accounting.

2. Explain prepaid expenses.

Prepaid expenses are payments made in advance for future periods. They are treated as assets and deducted from expenses.

3. Explain accrued income.

Accrued income is income earned but not yet received. It is added to income and shown as an asset.

4. Explain outstanding expenses.

Outstanding expenses are expenses due but unpaid. They are added to expenses and shown as liabilities.

5. Explain bad debts.

Bad debts are amounts that cannot be recovered from customers and are treated as losses.

PART H: Long Answer Questions (5 Marks)

1. Explain treatment of closing stock.

Credited to Trading Account.
Shown on asset side of Balance Sheet.
Increases gross profit.
Increases total assets.

2. Explain accounting treatment of depreciation.

Debit Depreciation Account.
Credit Asset Account.
Shown on debit side of P&L Account.
Deducted from asset value in Balance Sheet.

3. Explain provision for doubtful debts.

Provision is created to cover possible future losses from debtors.
It is:

Debited to P&L Account.
Deducted from debtors in Balance Sheet.

PART I: Assertion–Reason Questions

1.

Assertion: Outstanding expenses are added to expenses.

Reason: They relate to current accounting year.

A. Both true and reason explains assertion.

Answer: A

2.

Assertion: Prepaid expenses are assets.

Reason: Benefit will be received in future.

Answer: A

3.

Assertion: Bad debts increase profits.

Reason: They represent gain.

Answer: Both False

4.

Assertion: Depreciation is charged every year.

Reason: Assets lose value with use and time.

Answer: A

5.

Assertion: Income received in advance is liability.

Reason: Service is yet to be provided.

Answer: A

PART J: Case Study Questions

Case Study 1

A business paid insurance ₹12,000 for one year. At year end, ₹3,000 relates to next year.

Questions

What type of adjustment is this?
Prepaid Expense
Amount of prepaid insurance?
₹3,000
Amount charged to P&L?
₹9,000
Where is prepaid insurance shown?
Asset Side

Case Study 2

A business has debtors of ₹50,000. Further bad debts ₹2,000 and provision @5%.

Questions

Debtors after bad debts?
₹48,000
Provision amount?
₹2,400
Nature of provision?
Expected loss
Where shown?
Deducted from Debtors

PART K: HOTS (Higher Order Thinking Questions)

Why is depreciation charged even when asset is not sold?
Why is income received in advance treated as liability?
Why is accrued income treated as asset?
Why are bad debts deducted from debtors?
Why is provision created before actual loss occurs?

PART L: Important Numerical Practice

1.

Outstanding Salary = ₹2,000
Salary Paid = ₹18,000

Salary shown in P&L = ₹20,000

2.

Insurance Paid = ₹10,000
Prepaid = ₹2,000

Insurance Expense = ₹8,000

3.

Debtors = ₹40,000
Bad Debts = ₹2,000

Debtors in Balance Sheet = ₹38,000

4.

Capital = ₹50,000
Interest Rate = 10%

Interest on Capital = ₹5,000

5.

Profit Before Commission = ₹80,000
Commission = 10%

Commission = ₹8,000