UNIT

Structure
18.0 18.1

ADJUSTMENTS IN FINAL ACCOUNTS

18.2
18.3 18.4 18.5 18.6 18.7 18.8 18.9 18.10 18.11 18.12 18.13 18.14 18.15 18.16 18.17 18.18

18.19

Objectives Introduction Need for Adjustments Closing Stock Outstanding Expenses Outstanding Incomes Prepaid Expenses Income Received in Advance Depreciation Interest on Capital Interest on Drawings Bad Debts Provision for Bad Debts Provision for Discount on Debtors Provision for Discount on Creditors Let Us Sum Up Key Words Some Useful Books Answers to Check Your Progress Tcr~ninal Qucslions/Excrciscs

18.0 OBJECTIVES
After studying this unit you should be able to: explain why adjustment entries are necessary at the time of preparing the final accounts list the items in respect of which adjustments are usually made pass adjustment entries.

18.1 INTRODUCTION
You have learnt about the preparation of final accounts (Trading and Profit and Loss Account and the Balance Sheet) without any adjustments. Before preparing the final accounts, it is necessary to find out whether the books of account contain a complete record of all transactions relating to the year for which they are being prepared. In practice, generally, the accounts d o not contain all items of expenses and incomes which relate to the current year. They may, on the other hand, contain certain items which relate to the next year. Therefore, while preparing the final accounts it becomes necessary to make certain adjustments in respect of some items of expense3 and incomes. In this unit you will learn (i) which are the items that need adjustment, (ii) how such adjustments are made in the books of account, and (iii) how final accounts are prepared with various adjustments.

18.2 NEED FOR ADJUSTMENTS

While preparing the final accounts it is necessary to ensure that all items of incomes and expenses relating to the current year are fully accounted for. In practice there are a number of items which are still to be brought into the books of account. Suppose a concern closes its books in December. The wages of its workers for the month of

Final Accounts-11

December have not yet.been paid. They are payable in January next ye&. It means the Wages Account does not include the wages for the month of December. Such unpaid wages have to be brought into account and shown in the Trading Account along with wages already paid. Take another example. The insurance premium had been paid in July for twelve months ending June 30. It means that a portion of the insurance premium (amount relating to the period from January to June) has been paid in advance. Such prepaid portion of the insurance must be adjusted while debiting insurance to the Profit and Loss Account for the year. Similarly, alterations in accounts have to be made in respect of incomes which have been earned during the current year but not received, and also the incomes which have been received in advance. The alterations thus made in various items are called 'adjustments'. The purpose of making various adjustments is to ensure that the final accounts reveal the true profit or loss and the true financial position of the business. The items which usually need adjustment are: 1 Closing Stock 2 Outstanding Exptnses 3 Outstanding or Accrued Incomes 4 Prepaid Expenses 5 Incomes Received in Advance or Unearned Incomes 6 Depreciation 7 Interest on Capital 8 Interest on ~ i a w i n ~ s 9 Bad Debts 10 Provision for Bad Debts 11 Provision for Discount on Debtors 12 Provision for Discount on Creditors Let
US

now discuss these adjustments one by one.

18.3 CLOSING STOCK

You learnt in Unit 14 that all the goods purchased during the year are not completely sold out by the end of that year. Some goods may remain unsold known as closi'ng stock. You also learnt that usually closing stock is not given in the Trial Balance. It is mentioned as an adjustment item. So, while preparing the final accounts it is first credited to the Trading Account and then shown as an asset in the Balance Sheet.

Adjusted Purchases :When the closing stock is given in the Trial Balance, it would mean that both the opening and closing.stocks have been adjusted in the purchases. In such a situation, opening stock is not shown in the Trial Balance. The Trial Balance will show only the figures of adjusted purchases and the closing stock. Now you must know how to deal with these items in the final accounts. The adjusted purchases are in fact the cost of goods sold. It is worked out by adding the opening stock to purchases and deducting the closing stock therefrom. Hence adjusted purchases are shown on the debit side of the Trading Account. In this case, there is no need to show the closing stock on the credit side of the Trading Account as it has already been adjusted in purchases. It will be shown only on the asset side of the Balance Sheet.

18.4 OUTSTANDING EXPENSES

Outstanding expenses are those expenses which have become due in the currknt year but remain unpaid till the end of the year. They are also known as 'expenses accrued' or 'expenses due but not yet paid'. Example of such expenses are salaries payable, wages payable, interest dueson loans, etc. Since they remained unpaid by the end of the accounting year, no entry might have been passed in the books of account. So, they must be taken into account while preparing the Trading and Profit and Loss

Account otherwise it will not reveal the correct amount of profit or loss. The followingjournal entry is passed for adjustment of outstanding expenses. Concerned Expenses Account To OutstanQingExpenses Account (Being outstanding expenses brought into account) Dr.

Adjustments in Final Accounts

The effect of this entry will be: (i) the concerned expenses account will now show an increased amount, and (ii) a new account called 'Outstanding Expense Account' will be opened in the books. Thus, the Trading and Profit and Loss Account will be debited with the increased amount of expense and the 'Outstanding Expense Account' will be shown as a liability in the Balance Sheet. Look at lllustration 1 and study how an item of outstanding expense is treated at the time of preparing the final accounts.

lllustration 1 A businessman, on balancing his books on December 31, 1986, found that the wages amounting to Rs. 3,000 for the month of December have not been paid. The wages paid in the year amounted to Rs. 33,000. Thus, the Trial Balance shows Rs. 33,000 as the debit balance of Wages Account and Rs. 3,000 as outstanding wages under 'Adjustments'. Pass the necessary adjusting entry and show how the concerned ledger accounts would appear after the adjustment has been made. Also show how outstanding wages will appear in the final accounts. Solution: 1 The following adjusting entry is passed for bringing into account the outstanding wages for the month of December, 1986.
JOURNAL
1986 Dec.31 WagesA/c To Outstanding Wages A/c (Being the outstanding wages for the month of December, 1986 brought'into account) Dr. Rs. 3,(-"lo Rs. 3,000

2 After making the above adjusting entry the concerned ledger accounts will appear as follows:
Wages Account
Dr.
1986 Dec. 3 1 " 31 To Balance b/d To Outstanding Wages A / c Rs. 1986 33.000 Dec. 31 3,000 36,000 36,000 By Trading A / c (Transfer)

Cr.
Rs. 36,m

Outstanding Wages Account

1986 Dec. 31 To Balance c/d Rs. 1986 3,000 Dec. 31 1987 Jan. 1 By Wages A/ c By Balance b/ d Rs. 3,000 3,000

3 The item 'Outstanding Wages' will be shown in the final accounts as follows: i) Debit side of the Trading Account as addition to the Wages already paid.
Trading Account for the year ended December 31,1986 Dr.
Rs. To Wages Add Outstanding 33,000 3O ,w 36,000

Cr.

ii) Liabilities side of Balance Sheet as a separate item under the head 'Current Liabilities'.
Balance Sheet as on December 31, 1986 Rs. Current Liabilities: Outstanding Wages

3,000

18.5

OUTSTANDING INCOMES

Outstanding incomes are those incomes which have bee,n earned during the current year but have not been received till the end of the year. They are also called 'incomes accrued' or 'incomes earned but not yet received'. Examples of such incomes are rent receivable, commission receivable, interest receivable, etc. As in the case of outstanding expenses, the outstanding incomes will not appear in the books because they havemot been received. In order to ascertain the true profit or loss, such incomes must be taken into account while preparing the Profit and Loss Account. The following journal entry will be passed for the adjustment of outstanding incomes. Outstanding Income Account Dr. To Concerned Income Account (Being outstanding income brought into account) The effect of this entry will be: (i) the concerned income account will now show an increased amount, and (ii) a new account called 'Outstanding Income Acsount' will be opened in the books. Thus, the Profit and Loss Account will be credited with the increased amount of income and the outstanding income will be shown as an asset in the Balance Sheet. Look at 1llDstration 2 and study how an item of outstanding income is treated at the time of preparing the final accounts.
Illustration 2 A businessman has let a part of his business premises on a monthly rent of Rs. 500. Rent for the month of December, 1986 has not been received. He closes his books annually on December 31. Pass the necessary adjusting entry and shbw how the concerned ledger accounts would appear after the adjustment has been made. Also show how the outstanding rent will appear in the final accounts. Solution: 1 The following adjustment entry is required for bringing into account the outstanding rent for the month of December, 1986.
JOI'RN AL

1986 Dec. 31 Outstanding Rent A/c

To Rent A/c (Being the outstanding rent for the month of December brought into account)

2 After making ;the above adjusting entry the concerned ledger accounts will appear as follows:
Rent Account

Dr.
To Profit and Loss A/c (Transfer) Rs. 1986 Dec. 31 6,000 *' 31 By Balance bid By Outstanding Rent A/c

Cr.
Rs.

5,500 500

Outstandi'ng Rent Account

Adjustments in Final Accounts

3 The item 'Outstanding Rent' will appear in the final accounts as follows: i) Credit side of the Profit and Loss Account as addition to the rent already received.
Proflt and Loss Account for the year ended December 31,1986 Dr. Cr.

Rs. 5.500

ii) Assets side of the Balance Sheet as a separate item under the head 'Current Assets'.
Balance Sheet as on December 31,1986

Rs.
CurrenlAssets: Outstanding Rent
500

18.6 PREPAID EXPENSES

Sometimes, the benefit of some expenses will be available not only in the current year but also for the next year. That portion of an expense the benefit of which is yet to be received, is called prepaid expense. It is also called 'unexpired expense7.Examples of such expenses are unexpired insurance premium, rent paid in advance, taxes paid in advance, etc. In such situations, it is necessary to find out the portion of the expense which relates to the next year and deduct the same from the total amount of that expense before it is charged to the Profit and Loss Account. The adjustment for a prepaid expense is made with the following journal entry. Prepaid Expense Account Dr. To Concerned Expense Account (Being the adjustment of prepaid expense) The effect of this entry will be: (i) the concernec expense account will now show a reduced balance, and (ii) a new account called 'Prepaid Expense Account'will be opened in the books. Thus, the Profit and Loss Account will be debited with the reduced amount of expense and the Prepaid Erpense Account will be shown a* an asset in the Balance Sheet. Look at Illustration 3 and study how an item of prepaid expense is treated at the time of preparing the final accounts.
Illustration 3 On September 1, 1986 a sum of Rs. 1,200 was paid as premium towards a fire insurance policy for twelve months ending August 31, 1987. The books of the business are closed annually on December 31. Make necessary adjustment and show how the concerned ledger accounts would appear after the adjustment. Also show how the prepaid insurance will appear in the fina; a~counts. Solution: 1 The insurance premium amounting to Rs. 1,200 was paid for twelve months fropl September 1, 1986. Since the books are closed on December 31, 1986, the premium

Final Accounts-I1

for four months from September 1, 1986 to December 31, 1986 amounting to Rs. 400 (41 12 of Rs. 1,200) relates to the current year. The balance of Rs. 800 relating to eight months from January 1, 1987 to August 31, 1987 shall be treated as insurance paid in advance. The adjustment for the prepaid insurance will be made by means of the following Journal entry:

JOURNAL 1986 Dec. 31

Prepaid Insurance A / c To lnsurance A / c (Being the adjustment of insurance premium paid in advance)

Dr.

2 After making the above adjustment the concerned ledger accounts will appear as follows.

Dr.
1986 Sept. I

T
I

Insurance Account

1,200 Dec. 31

Cr.
Rs. By Prepaid Insurance A / c By Profit and Loss A / c (Transfer)

Repaid Insurance Account 1986 Dec. 31 1987 Jan. I

To Insurance A / c To Balance bld

ri I 81

:;1E:31/

ByBalancec/d

3 The item 'prepaid insurance' will appear in the final accounts as follows: i) Debit side of Profit and Loss Account as deduction from the total premium paid.
Profit md Loas Account for the yeru ended December 31,1986

Dr.
Rs. To Insurance Less Prepaid 1,200 800
400

Cr.

ii) Assets side o f the Balance Sheet as a separate item under the head 'Current Assets'.
Balance Sheet as on December 31,1986

Current Assets: Prepaid lnsurance

18.7 INCOME RECEIVED IN ADVANCE

Sometimes, certain income is received during the current year but the service in respect thereof has not yet been provided in full by the firm. The portion of income in respect of which the service is yet to be provided is known as 'income received in

advance'. It is also called 'unearned income'. Examples of such incomes are rent received in advance, interest receivdd in advance, etc. In such a situation, it is necessary to take into account only such portion of income in respect of which the 'service has been rendered during the current year. The unearned portion of such income should be adjusted before preparing the final accounts. This is done by passing the following journal entry: Concerned Income Account Dr. To Income Received in Advance Account (Being the adjustment of income received in advance) The effect of this entry will be: (ij the concerned income account will now show a reduced balance, and (ii) a new account called 'Income Received in Advance Account' will be opened in the books. Thus, the Profit and Loss Account will be credited with the reduced income, and the I n c m e Received in Advance Account will appear as a liability-in the Balance Sheet. Look at Illustration 4 and study how an item of income received in advance is treated at the time of preparing the final accounts.

Adjustments in Final Accounts

Illustration 4 A firm-received Rs. 1,200 from an apprentice as premium for six months from August 1, 1986 to January 31, 1987. Pass the adjusting entry and-show the necessary ledger accounts, assuming that the books are closed on December 31. Also show how the item 'apprentice premium received in advance' will appear in the final accounts. Solution: 1 The apprentice premium amounting to Rs. 1,200 has been received for six months from August 1, 1986 to January 31, 1987. Since the books are closed on December 31, 1986, the premium for five months from August 1, 1986 to December 3 1, 1986 . amounting to Rs. 1,000 (516 of Rs. 1,200) relates to the aurrent year and the balance of Rs. 200 relating to the month of January, 1987 shall be treated as apprentice premium received in advance. The following journal entry is passed for adjusting the unearned apprentice premium.
JOURNAL
1986

Dec. 31

Apprentice Premium A/c Dr. To Apprentice Premium Received in Advance A / c (Being the a$justment of one month apprentice premium received in advance)

Rs. 200

Rs.
200

2 After making the above adjusting entry the concerned ledger accounts will appear as follows:

Dr.
1986

Apprentice Premium Account

Rs. To Apprentice Premium Received in Advance A/ c To Profit and Loss A/c (Transfer)

Cr.

Dec. 3 1

200

1,000
1,200

Apprentice Premium Received in Advance Account

-

1986

1986

Rs. By Apprentice Premium A / c By Balance b/d

200

Dec. 31

To Balance c/d

Dec. 31
1987

Jan. 1

Final Accounts-I1

3 The item 'apprentice premium received in advance' will appear in the final accounts as follows: i) Credit side o f Profit and Loss Account as deduction from the total premium:
Profit and Loss Account for the year ended December 31,1986 Dr. By Apprentice Premium Less Received in Advance
Rs. 1,200 200 Rs. 1,000

ii) Liabilities side of Balance Sheet as a separate item under the head 'Current Liabilities.'
Balance Sheet as on December 31,1986
Rs. Current Liabilities: Apprentice Premium Received in Advance

200

Check Your Progress-A 1 What is an outstanding expense? Explain with an

2 What do you mean by prepaid expense? Give an example.

.....................................................................................................................

.......................................................................................................................

3 What do you mean by outstanding incomes?

4 What do you understand by incomes received in advance?

5 Choose one of the following alternatives and tick ( v ) the correct answer. a) Outstanding Salaries are shown in the Balance Sheet as i) a long-term liability ( ii) an asset ( iii) a current liability (

1 1 1

b) While making an adjustment entry in respect of closing stock, we debit i) Closing Stock Account ( ii) Trading Account ( iii) Purchases Account ( c) In case the cldsing stock appears in Trial Balance, it is shown in the i) Trading Account ( ii) Manufacturing Account ( iii) Balance Sheet ( d) While making an adjustment entry for prepaid expenses, we debit prepaid insurance and credit i) Profit and Loss Account ii) Insurance Account iii) Trading Account e) Incomes received in advance are shown in Balance Sheet as i) a current liability ii) a current asset iii) a fictitious asset

Adjustments in Final Accounts

1 1
1
)

1 1

18.8 DEPRECIATION
The term 'depreciation' means decrease in the value of a fixed asset resulting from normal wear and tear and the passage of time. You know that the fixed assets such as machinery, building, etc., are used for the purpose of earning revenue. Therefore, the fall in their value should be considered as an expense or loss incurred in realising such revenue. It must be charged to the Profit and Loss Account. The fixed assets will also be shown in the Balance Sheet at reduced values otherwise the Balance Sheet will fail to disclose the correct financial position. Depreciation is brought into account by means of the following journal entry: Depreciation Account Dr. To Concerned Asset Account (Being depreciation on fixed assets) The effect of the above adjustment entry will be: (i) the value of the concerned asset is reduced, and (ii) a new account called 'Depreciation Account' is opened in the books. The depreciation @ charged to the Profit and Loss Account as a separate item of expense and shown in the Balance Sheet by way of deduction from the value of the concerned fixed asset. Depreciation is generally calculated at the given rate for the period for which the asset has been used in the accounting year. Thus, if an asset is purchased during the year the depreciation should be calculated from the date of acquisition till the end of the , year. If the date on which the additions were made is not given, you should calculate depreciation on additions for the full year. In the case of old assets, depreciation is calculated on the opening balance. Look at Illustration 5 and study how depreciation . is treated at the time of preparing the final accounts.
Illustration 5 The following are the balances of assets as on January 1, 1986. Rs. Plant and Machinery 80,000 Furniture 12,000

'
,

A new machine costing Rs. 20,000 was acquired on October 1, 1986. Depreciation is to be provided on Plant and Machinery at 10% and on Furniture at 5% per annum. Pass the necessary adjustment entries and show the ledger accounts. Also show how depreciation will appear in the final accounts. The books are closed on December 31 each year.
Solution: 1. Depreciation on Furniture at 5% on Rs. 12,000 amounts to Rs. 600. In the case of Plant and Machinery, depreciation should be provided on the opening

Final Accounts-11.

balance of Rs. 80,000 for the whole year and on Rs. 20,000 (cost of the new machine) for three months i.:., from October 1 to December 31, 1986. Rs. 8,000 500

Depreciation at 10% on Rs. 80,000 for one months Depreciation at 10% on Rs. 20.000 for three years Total
T h e following is the adjustment entry for depreciation:

JOURNAL
1986 Dec. 3 1 Depreciation A / c To Plant and Machinery A / c To Furniture Alc (Being depreciation written off on Plant and Machinery and Furniture) Dr. Rs. 9,100 Rs. 8,500 600

2 After making the above adjustment entry, the concerned ledger accounts will appear as follows:
Plant and Machinery Account Dr.
1986 Jan. I Oct. I

Cr.

I987 Jan. 1

To Balance b / d I o Bank A'c

Rs. 1986 80,000 Dec. 3 1 20,000 " 31

By Depreciation A / c By Balance c / d

Rs. 8,500 91,500

1 ,oo,ooo

1 ,oo,ooo
To Balance b/ d 91,500

Furniture Account
1986 Jan. I Rs 1986 12,000 Dec 31 " 31
-

To Balance b/d
.

By Depreciation A / c By Balance cld

Rs. 600 11,400 12,000

12,000 1987 Jan. I To Balance b:d 11,400

Depreciation Account
i986 Dec. 3 1
RS.

7 o Plant and Mach~nery Alc To Furniture A / c

1986 Dec 31

RS.

8,500 600 9,100

By Profit and Loss A/c (Transfer)

9,100 9,100

3 Depreciation will appear in the final accounts as follows: i) Debit side o f the Profit and Loss Account as a separate item of expense
Profit and Loss Account lor the year ended December 31,1986 Dr.
To Depreciation on :. Plant and Machinery Furniture

Cr

Rs. 8,500 600

9,100

ii) Assets side o f the Balance Sheet : as deduction from the concerned asset.
Balance Sheet as oi ~ecember 31,1986
Rs. Fixed Assets: Furniture Less Depreciation at 5% Plant and Machinery Add Addition Less Depreciation at 10% 12,000 600 80,000 20,000 1,00,000 8,500

Adjustments in Final Accounts

1 1,400

91,500

18.9 INTEREST ON CAPITAL

You have learnt that the funds provided by the proprietor of the business constitute capital. Sometimes, the proprietor may like to know the profits made by the business after taking into consideration interest on his capital. The purpose is to find out the real profits of the business after deducting the interest on capital which the proprietor could have earned even otherwise by investing the amount elsewhere. Hence, interest is allowed at a certain rate on the capital. Such interest is treated as an expense to the business. The following adjustment entry is passed to bring interest on capital into the books of account. Interest on Capital Account Dr. To Capital Account (Being interest allowed on capital) Interest on capital is treated in the final accounts as follows: i) On the debit side Profit and Loss Account as a separate item of expenses. ii) On the liabilities side o f the Balance Sheet as addition to capital. Interest on capital should be calculated on the opening balance of Capital Account i.e., the balance at the beginning of the year. If any additional capital is introduced during the year, interest on the additional capital should be calculated from the date on which it was brought into the business.

18.10 INTEREST ON DRAWINGS

Drawings refer to the amounts withdrawn by the proprietor from the business for personal use. In case interest is allowed to the proprietor on his capital, it is usual practice to also charge interest on drawings. Interest on drawings is a gain to the business. The following adjustment entry is passed for interest on drawings: Capital Account or Drawings Account Dr. To Interest on Drawings Account (Being interest charged on drawings) Interest on Drawings will be treated in the final accounts as follows: i) On the credit side o f Profit and Loss Account as a separate item of income. ii) On the liabilities side o f the Balance Sheet as deductions from capital.
I

Interest on drawings should be calculated at a given rate from the date of withdrawal till the end of the year. In case the relevant information regarding the date of withdrawals were not given, the interest should be charged for six months assuming that the amounts were drawn evenly throughout the year.

"

Final Accounts-I1

Illustration 6 ' Capital on January 1, 1986 was Rs. 50,000. On October 1, 1986 proprietor introduced a further capital amounting to Rs. 6,000. His drawings during the year amounted to Rs. 3,000. Interest at 5% is to be allowed on capital and charged on drawings. Pass the necessary journal entries and show how these items will appear in the final accounts.

Solution: 1 ~alculation'of Interest On Capital : On Rs. 50,000 at 5% for one year On Rs. -6,000at 5% for three months Total Rs. 2,500 75 2,575

On Drawings : As the dates of withdrawals are not given in the problem, interest on drawings should be calculated for six months assuming that the amounts were withdrawn evenly throughout the year. Thus, interest on Rs. 3,000 at 5% for six months is Rs. 75.

2 The journal entries for interest on capital and interest on drawings will be as follows:
JOURNAL 1986 Dec. 31 Rs. 2,575 Rs.
2,575

Interest on Capital A/c To Capital A/ c (Being interest allowed on capital) Capital A / c To Interest on Drawings A / c (Being interest charged on drawings)

Dr.

"

31

Dr.

75 75

3 The relevant items will appear in the final accounts as follows:

Profit and Loss Account for the year ended December 31,1986 Dr. Cr

Rs.
To Interest on Capital
2,575 By Interest on Drawings

. Rs.

75

Balance Sheet (Liabilities side only) as on December 31,1986

Capital: Balance on 1-1-1986 Add Additional Capital Interest on Capital Less Drawings Interest on Drawings

1
.

Rs.
50,000

Rs.

Check Your Progress-B 1 What is depreciation?

2 Name the two causes of depreciation.

...............................................................................................................
........................................................................................................................

Adjustments in Final Accounts

........................................................................................................................ ........................................................................................................................

3 w h y do we bring interest on capital and interest on drawings into the booksof account'?
........................................................................................................................ ............................................................................. ...........................................
............. ...........................................................................................................

.........................................................................................................................
- -

1 8 . 1 BAD DEBTS
---

You know when goods are sold on credit, the personal account of the buyer is debited and so he becomes a debtor to the business. Later, when he pays the amount due from him, his personal account is credited. His account thus stands closed. Sometimes, a debtor fails to p$ his debt either partially or completely. The amount of debt which cannot be recovered from the debtor is called 'Bad Debt'. It is a loss to the business and so must be charged to Profit and Loss Account. The following journal entry is passed when a debt becomes bad. Bad Debts Account Dr. To Concerned Debtor's Account (Being bad debts) The effect of this entry will be: (i) debtor's personal account stands closed, and (ii) a new account called Bad Debts Account is opened in the books. The total amount of bad debts incurred during the year appears as a separate item in the Trial Balance and the Sundry Debtors appear at reduced amount. The Bad Debts Account, like any other account of expenses on losses, is transferred to the Profit and Loss Account by means of the following closing entry. Profit and Loss Account Dr. To Bad Debts Account (Being bad debts transferred to Profit and Loss Account)
,

Bad Debts Given Outside the Trial Balance : Sometimes, the bad debts to be written off may be stated outside the Trial Balance as an adjustment item. It means that such bad debts have not been written off. For convenience, we may call them 'further bad debts'. It is necessary to record such bad debts at the time of preparing the Final Accounts. This is done by passing the following adjustment entry. Bad Debts Account Dr. To Sundry Debtors (Being bad debts written off)
Such additional bad debts are treated in the final accounts as follows: i) On the debit side of Profit and Loss Account as addition to Bad Debts already written off.

ii) On the assets side o f the Balance Sheet as deduction from Sundry Debtors It is important to understand the difference between the treatment of bad debts given inside the Trial Balance and the bad debts given outside the Trial Balance. You know that the bad debts given in Trial Balance are those bad debts which have been written off during the accounting year. It means that the accounts of the concerned debtors have already been closed. Hence, such bad debts are .not to be deducted from Sundry Debtors in the Balance Sheet. They will be shown only in the Profit and Loss . . . .

Account. Bpt, the bad debts given outside the Trial Balance (further bad debts) are still to be written off. The entry for writing off such bad debts is to be recorded at the time of preparing final accounts and both the debit and the credit asfiects will appear in the final accounts as explained earlier. Thus, the bad debts given in the Trial Balance and also those given outside the Trial Balance will be shown in the Profit and Loss Account. But only those bad debts will be deducted from Sundry Debtors in the Balance Sheet which are given outside the Trial Balance. Look at Illustration 7 and study how bad debts given in Trial Balance and those given outside the Trial Balance are treated at the time of preparing the final.accounts.
Illustration 7 Following are the extracts of Trial Balance of a business firm:
Trial Balance as on December 31,1986 Dr. - Cr. 6,500

Name of the Account

Bad Debts Sundry Debtors

60,000

Adjustment : K. Gaur, a debtor became insolvent. It was learnt that the firm will receive only Rs. 3,000 as against the total amount of Rs. 6,000 due from him. Pass necessary adjustpent entry and show how the items will appear in final accounts. Solution:

JOURNAL
1986 Dec. 3 1

*
Bad Debts A / c To K. Gaur (Being the amount irrecoverable from him) Dr.

Rs.

Rs.

3,000 3,000

Profit and Loss Account for the year ended December 31,1986

To Bad Debts Add Further Bad Debts

6,500 3,000

Rs.

9,500

Balance Sheet
as on December 31,1986

Rs.
I

Current Assets: Sundry Debtors Less Further Bad Debts

60,000 3,000

57,000

18.12 PROVISION FOR B A D DEBTS

In any business where goods are sold on credit, bad debts usually occur. When it is certain that a debt will not be recovered, the amount is written off as bad debt. But, it is also likely that some of the remaining debts may not be recovered in full. From experience we know that certain percentage of amounts due from debtors may not be recovered. This will be a loss to the business. You have learnt that according to Conservatism Concept all possible loises must be provided for. Hence it is a common practice to make a suitable provision for doubtful debts at the time of preparing the final accounts. Otherwise, the Profit and Loss Account will not reveal the correct

amount of profit or loss and the Balance Sheet will not show t k t r u e position of Sundry Debtors. The provision for doubtful debts is usually cakulated as a certain percentage of the total amount due from Sundry Debtors after writing off all known bad debts. * Provision for doubtful debts is also called 'Provision for Bad Debts' or 'Provision for Bad and Doubtful Debts'. Such provision is made by debiting the amount of doubtful debts to the Profit and Loss Account thus, the journal entry for creating such provision will be as follows. Profit and Loss Account Dr. To Provision for Bad Debts Account / (Being the provision for doubtful debts)

Adjustments in Find Accounts

!
I

I
k

You will notice that when a debt is irrecoverable it is written off by crediting it to the personal account of the respective customer. But, when a debt is doubtful of recovery, the personal account of the customer will not be credited as the recovery is $till possible. Thus, the creation of provision far bad debts does not affect the balances of debtors' personal accounts. However, while showing Sundry Debtors in the Balance Sheet the amount of such provision is deducted therefrom. Look at Illustration 8 and study how provision for doubtful debts is made and treated in the final accounts.

Inustration 8 An extract from a trader's Trial Balance on December 31, 1986 is given below.
Name of the Account
Dr. Cr

i
1
Sundry Debtors Bad Debts Rs.

Rs.

Adjustment : Write off further bad debts of Rs. 2,000 and create a provision for dnuhtfiil rle b t at 5% on debtors. -------~ s Pass the necessary journal entries and show the Bad Debts-and Provision for Bad Debts Accounts. *Iso show the treatment in the final accounts.
C
i

Solution:

JOURNAL
Dr. (Being bad debts written off) Profit and Loss A / c To Bad Debts A/c (Being Bad Debts Account transferred to Profit and Loss Account) ~rofit'andLoss A/ c To Provision for Bad Debts A/ c (Being the provision required for doubtful debts) Dr.,

Rs . 2,000

Rs.
7 m

Dr.

Note : There are further bad debts of Rs. 2,000 given outside the Trial Balance. Hence, the provision for bad debts has been cakulated on Rs. 30,000 (total debts Rs. 32.000-further bad debts Rs. 2,000). The bad debts of Rs. 3,000 given inside the Trial Balance need not be deducted from Sundry Debtors as they have already been written off during the year. Thus, the provision on Rs. 30,000 at 5% will be Rs. 1,500.

LEDGER Bad bebts Account Dr. 1986 Dec. 3 1 " 31 To Balance b/ d To Sundry Debtors
I

Cr. 1986 3,000 Dec. 31

~4

I
I

By Profit and Loss A/c

Rs. 5,000

*.""-I

*,YYV

3J

Final Accounts-I1

Provision for Bad Debts Account

The items 'bad debts' and 'provision for bad debts' will appear in the final accounts as follows:
Profit and Loss Account for the year ended December 31,1986

Dr.
T o Bad Debts To Provision for Doubtful Debts Rs. 5,000

1,500

Balance Sheet as on December 31,1986 Current Assets: Sundry Debtors Less Further Bad Debts

Less Provision for Doubtful Debts

When Provision for Bad Debts already Exists in the Books: The provision created for doubtful debts at the end of a particular year will be carried forward to the next year and it will be used for meeting the loss due to bad debts incurred during the next year. The Provision for Bad Debts brought forward from the previous year is called the 'opening provision' or 'old provision'. So when such provision already exists, the loss due to bad debts during the current year will be adjusted against the provision and not charged to the Profit and Loss Account. If however, bad debts during the current year are more than the old provision, the excess can be debited to profit and Loss Account. The provision for bad debts required at the end of the current year which can now be called 'new provision' will be created by debiting the Profit and Loss Account. Suppose the balance of old provision for bad debts on January 1, 1986 is Rs. 1,000. The bad debts written off during 1986 amounted to Rs. 1,200 and the new provision required on December 31, 1986 is Rs. 1,500. In such situation, Profit and Loss Account will be debited with Rs. 1,700 as calculated below:
Rs. 1,200 1,000 200 1,500

Total Loss due to Bad Debts Less Old Provision for Bad Debts Excess Loss on account of Bad Debts Add Provision required at the end of the year Amount to be debited to Profit and Loss Account

But if the old provision is more than the loss due to bad debts, the surplus provision will be adjusted against the new provision required at the end of the current year. Thus the Profit and Loss Account will be debited with the difference only. Suppose, in the example given above, the bad debts written off during 1986 were Rs. 600 (not Rs. 1,200). In that case, the Profit and Loss Account would be debited with Rs. 1,100 as calculated below:

36

Existing Provision for Bad Debts Less Bad Debts Surplus provision available Provision required at the end of the year Less Surplus of Old Provision Amount to be debited to Profit and Loss Accbunt

Rs. 1,000 600

Adjustments in Final Accounts

If, however, the new provision is less than the surplus of old provision available, difference will be shown on the credit side of the profit and Loss Account. In this connection it is necessary to note that only the further bad debts given outside the Trial Balance and the new provision for bad debts should be deducted from Sundry Debtors in the Balance Sheet. A summary of various points discussed above is given below for your benefit. i) Find out the actual bad debts during the current year. This will be the total of bad debts appearing both inside and outside the Trial Balance. ii) Calculate the new provision for doubtful debts as given in the adjustments. iii) Work out the total of actual bad debts and the new provision. vi) Deduct the old provision for bad debts as given in the Trial Balance from the above total and debit the Profit and Loss Account with the net amount thus arrived at.
!

The above aspects will be shown on the debit side of the Profit and Loss Account as follows:
Rofit and Loss Account for the year ended Dr.

............
Cr.

Rs.
To Provision for Bad Debts: Provision Required (new) Add Bad Debts Less Existing Provision (old)

........ ........

........

If the total of new provision and the actual bad debts are less than the old provision, all the above details will be shown on the credit side of the Profit and Loss Account as follows.
Roiit and Loss Account for the year ended Dr.

..............
Cr.

Rs. Provision for Bad Debts: Existing Provision (old) Less Bad Debts Less Provision Required (new)

Rs.

.......
....... ......

........

Final ~ccounts-11

The following are the journal entries required when the provision for bad debts exists in the books: a) For writing off further bad debts given outside the Trial Balance: Bad Debts Account 'To Sundry Debtors b) For transferring the total Bad Debts Account to Provision for Bad Debts Account: Provision for Bad Debts Account Dr. To Bad Debts Account c) For debiting the Profit and Loss Account with the excess of the total bad debts plus new provision over the old provision: Profit and Loss Account Dr. To Provision for Bad Debts Account For crediting the Profit and Loss Account with the excess of the old provision over the total bad debts plus new provision: Provision for Bad Debts Account Dr. To Profit and Loss Account

Illustration 9 On January 1, 1986 the provision for bad debts stood at Rs. 1,100. During the year bad debts totalled to Rs. 900. At the end of the year the sundry debtors were Rs. 20,000. The provision is to be maintained at 5% of the debtors. Pass the necessary journal entries and show the Bad Debts Account and the Provision for Bad Debts Account. Also show how these items will appear in the final accounts.

Solution:
JOURNAL
1986 Dec. 31 Provision for Bad Debts A / c To Bad Debts A / c (Being the transfer of Bad Debts Account to Provision for Bad Debts Account) Profit and Loss A / c To Provision for Bad Debts A / c (Being the additional provision made) Dr. Rs. 900 Rs. 900

Dr.

Note: The amount chargeable to the Profit and Loss Account has been worked out as follows:

Bad Debts New Provision at 5% on Sundry Debtors (Rs. 20,000) Total of actual and expected loss Provision already existing Additional Provision reqiired

Rs. 900

800

LEDGER
Bad Debts Account

Dr.
1986 Dec. 31 To Balance b/d Rs. 900 1986 Dec. 3 1 Rs. By Provision for Bad Debts A / c 900

Cr.

38

Provision for Bad Debts Account

Adjustments in Final Accoull.,

1986 Dec. 31 " 31

To Bad Debts A / c To Balance cld

Rs. 1986 900 Jan. I 1,000 Dec. 31 1,900

By Balance b/ d By Profit and Loss A/c

Rs. 1,100 800

98i Jan. 1

By Balance b / d

Profit and Loss Account for the year ended December 31,1986

Rs. To Provision for Bad Debts: Provision Required Add Bad Debts Less Existing Provision 1,000 900 1,900 1,100

Balance Sheet as on December 31,1986 Rs. Current Assets: Sundry Debtors Less Provision for Doubtful Debts 20,000 1,000 19.000 Rs. *.

18.13 PROVISION FOR DISCOUNT ON DEBTORS

You know cash discount is allowed to debtors as an incentive for prompt payment. When the discount is allowed, it is recorded through the Cash Book and posted to the credit side of the concerned debtors' personal accounts. But, in the case of debts outstanding at the end of the current year, discounts will be allowed in the next year if the debtors make prompt payments. So, as in the case of anticipated loss on account of doubtful debts, a provision must be made for the discount likely to be allowed to the debtors in the next year. Such a provision is known as the 'Provision for Discount on Debtors'. It is also calculated as a percentage on the net sundry debtors (remaining after deducting provision for bad debts). For example, if Sundry Debtors amount to Rs. 40,000 and the firm wants to create a provision for bad debts at 5% and a provision for discount at 2% on the debtors, they will be calculated as follows: i) The Provision for Bad Debts will be calculated at 5% on Rs. 40,000. It will amount to Rs. 2,000.

ii) The Provision for Discount at 2% will be calculated on the debtors after deducting the Provision for Bad Debts i.e., on Rs. 38,000 (40,000-Rs. 2,000). It will amount to Rs. 760. Note that when both Provision for Bad Debts and Provision for Discount on Debtors are to be calculated, the Provision for Bad Debts is calculated first and then Provision for Discount is worked out on debtors after subtracting the Provision for Bad Debts. The adjustment entry for Provision for Discount on Debtors is as follows: Profit and Loss Account Dr. To Provision for Discount on Debtors Account (Being the provision made for discount on debtors)

Final Accounts-11

The provision for discount on debtors will be shown in the final account as follows: i) On the debit side of Profit and Loss Account: as a separate item. ii) On the assets side of Balance Sheet: as a deduction from Sundry Debtors. The balance of the Provision for Discount on Debtors Account will be carried forward to the next year and the discounts allowed, if any, in the next year will be set off against the provision itself. The method of dealing with discounts allowed and provision for discount on debtors in the next year is similar to the method followed in case of bad debts and provision for vad debts.

18.14 PROVISION FOR DISCOUNT ON CREDITORS

When prompt payment is received vfe allow cash discount to debtors. Similarly we receive discount from the creditors when prompt payments are made by us. So the expected gain on account of discounts receivable from creditors in the next year should also be taken into account at the time of preparing the final accounts. Such a provision is called 'Provision for Discount on Creditors'. It is also calculated as a percentage on sundry creditors. The creation of such a provision however, goes against the convention of conservatism. Hence, it is usually avoided in practice. But you must learn how it is treated in final accounts if such a provision is required. The adjustment entry for provision for discount on creditors is passed as follows: Provision for Discount on Creditors Account Dr. To Profit and Loss Account (Being the provision made for discount on creditors) The provision for discount on creditors will appear in the final accounts as follows: i) On the credit side of Profit and Loss Account: as a separate item. ii) On the liabilities side of the Balance Sheet: as a deduction from sundry creditors. The balance of the Provision for Discount on Creditors Account willalso be carried forward to the next year and the discounts received, if any, in the next year will be adjusted against the provision itself.

Check Your Progress-C 1 . Fill in the blanks. a) If bad debts appear as an adjustment outside the Trial Balance, they are adjusted by debiting Bad Debts Account and crediting ........................... b) The amount of bad debts given in the Trial Balance is shown only in ....................... c) Provision for Bad Debts is calculated as a certain percentage on Sundry Debtors after deducting ................................... d) Provision for Bad Debts is created by .................................... the Profit and Loss Account. e) Provision for Discount on Debtors is calculated as a fixed percentage on Sundry Debtors after deducting ......................................... f) Provision for Discount on Creditors is made by ...........................Profit and Loss Account. 2. Following is an extract from Ttial Balance of a trader:
Rs.

Bad Debts Provision for Bad Debts Sundry Debtors

3,000
4,000 so7000

The adjustments required are i) Additional Bad Debts amounted to Rs. 2,000 ii) Provision for Bad Debts is to be maintained at 5% on Debtors Compute: a) New Provision for Bad Debts b) Amount to be debited to Profit and Loss Account c) Net amount of Debtors to be shown in the Balance Sheet

18.15

LET US SUM UP

Adjustments in Final Accounts

1 It is necessary to make adjustments with regard to certain items such as prepaid expenses, depreciation, etc. at the time of p r e p ~ n the final accounts so as to g arrive at the current profit or loss and the correct financial position. 2 The adjustments are always made by mean&of suitable journal entries known as 'adjustment entries'. 3 Every adjustment is shown at two places in the final accounts. Table 18.1 shows the adjustment entries and their treatment in the final accounts for different items.

Table 18.1 Adjustment of Various Items S.No.

1

Adjustment Closing Stock

Adjustment Entry Closing Stock A/c To Trading A/c

Treatment in the Final Accounts Dr. i) Credit side of Trading A/c: Shown as a separate item ii) Asset side of Balance Sheet: Shown as a separate item under Cumnt Assets

Dr. i) Debit side of Trading A/c or Profit and Outstanding Expenses Expense A/c Loss A/c: Added to the concerned expense. To Outstanding ii) Liabilities side of Balance Sheet: Shown Expense A/c as a separate item under Cumnt Liabilities.

Outstanding Incomes

Outstanding Income i) Credit side of Profit and Loss A/c: Added A/ c Dr. to the concerned income To Income A/c ii) Assets side of Balance Sheet: Shown as a separate item under Cumnt Assets. Prepaid Expenses i) Debit side of Profit and Loss A/c: Deducted A/c Dr. from the concerned expense ii) Assets side of Balana Sheet: Shown as a To Expense A/c separate item under Cumnt Assets. Income A/c Dr. i) Credit side of Profit and Loss A/c: DeducTo Income Received ted from the concerned income. ii) Liabilities side of Balance Sheet: Shown as a in Advance A/c separate item under Current Liabilitica Depreciation A/c To A m t A/c Dr. i) Debit side of Profit and Loss A/c: Shown as a separate item. ii) Assete side of Balance Sheet: Deducted from the concerned fixed asset

Prepaid Expenses

Income Received in Advance

Depreciation

Interest on Capital

Intemt on Capital i) Debit side of Profit and Loss A/c: A/c Dr. Shown as a separate item To Capital A/c ii) Liabiities side of Balance Sheet: Added to Capital Capital A/c or i) Credit side of Profit and Loss A/c: Drawings A/c Dr. Shown as a separate item To Interest on ii) Liabilities side of Balana Sheet: Deducted from capital Drawings A/c

Interest on Drawings

Bad Debts (Additional) Bad Debts A/c Dr. i) Debit side of Profit and Loss A/c: To Sundry Debtors Added .o bad debts ii) Assets side of Balana Sheet: Deducted from Sundry Debtore '
Provision for Bad Debts Profit and Loss i) Debit side of Profit and Low A/c: A/c Dr. Shown as a separate item To Provision for ii) Assets side of Balana Sheet: Deducted Bad Debts A/c from Sundry Debtors Profit and Loss i) Debit side of Profit and Loss A/c: A/c Dr. Shown as a separate item To Provision for Dis- ii) Assets side of Balana Sheet: Deducted from Sundry Debtore count on Debtor A/c

10

I
I

11

Provision for Discount on Debtors

12

Provision for Discount Provision for Discount i) Credit side of Profit and Loss A/c: on Creditors on Creditors A/ c Dr. Shown as a Separate item. ii) Liabilities side of Balana Sheet: To Profit and Loss A/c Deducted from Sundry Creditors

Final Accounts-11

18.16 KEY WORDS

Adjustment Entry: Journal entry passed to make an adjustment in the relevant accounts. Adjustment Item: An item given outside the Trial Balance which requires adjustment at the time of preparing final accounts. Adjusted Purchases: Amount of purchases after adjusting both the opening and closing stocks. Bad Debts: Debts which cannot be recovered. Depreciation: A permanent decrease in the value of a fixed asset caused by wear and tear or the passage of time. Doubtful Debts: Debts of doubtful recovery. Outstanding Expenses: Expenses incurred during the accounting year but not yet paid. Outstanding Incomes: Incomes earned during the accounting year but not yet received. Prepaid Expenses: Expenses paid but the benefit of which is yet to be received. Provision for Bad Debts: A provision made for loss expected to arise from doubtful debts. Provision for Discount on creditors: A provision made for the anticipated gains on account of discounts receivable from creditors. Provision for Discount on Debtors: A provision made for discounts likely to be allowed to debtors. Unearned Incomes: Income in respect of which the services are yet to be rendered.

18.17 SOME USEFUL BOOKS

Grewal, T.S. 1987. Double Entry Book-keeping, Sultan Chand & Sons: New Delhi. (Chapter 9) Frank Wood. 1986. Book-kmping and Accounts, Pitman Publishing Ltd: London. (Chapters 21 and 22) Maheshwari, S.N. 1986. Principles and Practice of Accountancy, Arya Book Depot: New Delhi. (Chapter 14) Patil, V.A., and Korlahalli, J.S. 1985. Principles and Practice of Book-keeping, R. Chand & Co: New Delhi. (Chapter 20)

18.18 ANSWERS TO CHECK YOUR PROGRESS

A C 5 1 (a) iii (b) i (c) iii (d) a) Sundry Debtors b) Profit and Loss Account c) further or additional bad debts. d) .debiting e) Provision for Bad Debts f) Crediting a) Rs.2,400 b) Rs. 3,400 c) Rs. 45,600 ii (e) i

18.19 TERMINAL QUESTIONSIEXERCI'SES

Questions 1 Why adjustment entries are necessary at the time of preparing final accounts?

Name any two items of adjustment and explain how they will be shown in the final accounts. 2 Distinguish between: a) Outstanding Expenses and Prepaid Expenses b) Interest on Capital ahd Interest on Drawings c) Outstanding Income and Unearned Income. 3 What is meant by Provision for Bad Debts? Explain the treatment of Provision for Bad Debts in the final accounts. 4 What do you mean by Provision for Discount on Debtors and Creditors. Explain their treatment in the final accounts.
Exercises 1 Give Journal entries for the following adjustments: a) Salaries Outstanding Rs. 3,000. b) Prepaid Rent Rs. 600. c) Commission earned but not yet received Rs. 500. d) Depreciation at 5% on Furniture of Rs. 20,000.

Adjwtmtats in Final Accounts

2 Give Journal entries for the following adjustments: a) Interest at 5% on Capital of Rs. 80,000. b) Interest on Drawings Rs. 120. c) Provision for Discount at 2% on Debtors totalling Rs. 30,000. d) Prokisian for Discount at 1.5% on Creditors totalling Rs. 20,000. 3 On January 1, 1987 the provision for Bad Debts stood at Rs. 1,000. The total debtors on December 31, 1987 as Rs. 20,600 but out of which Rs. 600 were bad apd had to be written off. The provision is to be maintained at 5% of the debtors. Give journal entries and show the Bad Debts Account and the Provision for Bad Debts Account. Also show how these items will appear in the final accounts. (Answer: New Provision for Bad Debts Rs. 1,000; Debit Profit and Loss Account with Rs. 600) 4 On January 1, 1987 the Provision for Bad Debts stood at Rs. 3,000. During the year bad debts totalled to Rs. 1,000. At the end of the year the total debtors were Rs. 24,000. The provision is to be maintained at 5% on the debtors. Prepare Provision for Bad Debts Account and show how Bad Debts and Provision for Bad Debts will appear in the final accounts. (Answer: New Provision for Bad Debts Rs. 1,200; Credit Profit and Loss Account with Rs. 800)

5 State the effect of the following adjustments on the profits of a trader. i) Rs. 2,400 for salaries owing t~ staff ii) Insurance prepaid Rs. 710 iii) Furniture valued at Rs. 12,000 to be depreciated by 10% iv) Create Provision for Bad Debts Rs. 2,000 v) Rent Receivable Rs. 350 Before making the above adjustments the net profit was Rs. 20,000. (Answer: i) Reduction in profit ii) Addition to profit iii) Reduction in profit iv) Reduction in profit v) Addition to profit Net Effect: Profits will decrease to Rs. 15,460)

Note: These questions will help you to understand the unit better. Try to write answers for them. But do not submit your answers to the University. These are for your practice only.

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43