Preparation of Final accounts with Adjustments!
The reporting information will not be accurate unless we take into consideration the adjustment entries. The treatment of various common adjustments such as closing stock, outstanding expenses, accrued incomes, prepaid expenses, incomes received in advance, bad debts, reserve for bad and doubtful debts, reserve for discount on debtors, reserve for discount on creditors, interest on capital, interest on drawings, depreciation, etc., the knowledge of which should be made use of while preparing final accounts.
There are some adjustments which are rare but special in their character and treatment. Let us consider such adjustments here.
1. Goods Distributed as Free Samples:
In order to promote a product, free samples are supplied to experts in the field. For example, free samples of books to professors, free samples of medicine to doctors.
Since, it is a promotional activity, the cost of such samples should be treated as promotional expenses, say, and advertisement. Free sample distribution amounts to reduction in purchases or sale without a monetary return.
Therefore the adjusting entry is as follows:
The net effect would be reduction in purchases and charge to profit and loss account as promotional expense.
2. Goods Sold on Sale or Approval Basis:
In order to gain confidence of the customers on quality of the goods, sometimes goods are sold on approval basis. If the customer approves it, then it becomes a sale. If the customer does not approve it, then the sale is not complete and hence cannot be treated as sales. Suppose at the end of the financial year certain goods sent on approval basis are with the customers, then there is a need to pass necessary entries for adjustment.
The adjusting entries are as follows:
The treatment is as follows:
(a) As a deduction from sales at sales price on credit side of trading account and as an addition to closing stock at cost price.
(h) As a deduction from sundry debtors on the assets side and the total stock to be shown at cost price (closing stock at cost + stock with the customers on approval) on the assets side of the balance sheet.
3. Goods Sent on Consignment:
Since consignment transaction is not a sale transaction it does not affect the trading and profit and loss accounts directly. A separate consignment account is opened and the goods sent on consignment are debited to consignment account. When the account sale is received, it is treated as consignment sales and credited to consignment account and debited to consignees account.
Any consignment stock remaining with the consignee will be credited to consignment account and profit on consignment is ascertained after charging the expenses on consignment, consignee’s commission, etc. However, closing stock of consignment will be shown on the balance sheet’s assets side and the profit on consignment is credited to profit and loss account (the entry will be reversed if there is loss on consignment).
The transfer entry for profit or loss on consignment is as follows:
4. Loss of Stock by Fire:
If the stock is destroyed by fire, then the loss incurred will be treated differently under the following three possible situations:
(a) If the stock is not insured – The entire value of the stock destroyed by fire will be treated as loss, with an entry –
(b) If stock is fully insured – When the stock which is fully insured is destroyed, the enterprise has a claim on the insurance company for the recovery of loss incurred due to goods being destroyed by fire. Therefore, the claim is preferred with an entry –
In effect, the claim on the insurance company is treated as ‘debtors’ and shown in the balance sheet assets side as due from the insurance company.
If the insurance company settles the dues, then the entry will be as follows –
In effect, the cash/bank balance in the balance sheet will increase to the extent of the claims settled and therefore, insurance company account will not appear in the balance sheet.
(c) If the stock is partly insured – In this case the total value of the stock destroyed is credited to trading account, and that part of the claim to be settled by the insurance company is debited to insurance company account and the difference between stock destroyed and insurance claim accepted is debited to profit and loss account as loss. The entry is as follows –
5. Deferred Revenue Expenditure:
Huge expenditure of revenue nature incurred at the initial stages of the business enterprise with the belief of deriving benefit from such expenditure during the subsequent years is regarded as deferred revenue expenditure provided the charging of such expenses is spread over the number of years during which the benefit is expected to be derived.
A part of such expenditure is charged as revenue in each year and the rest is capitalized based on matching concept. For example, huge expenditure on ‘advertisement’ is incurred in the initial years of business to derive the benefit over an estimated term of ten years. Then, each year one-tenth of that expenditure is charged to revenue over the term of ten years. The catch here is that the expenditure that is not charged to revenue is capitalized and shown as fictitious assets on the balance sheet.
Suppose, the advertisement expenditure incurred Rs.2,00,000 is able to yield benefit over five-year term. Then, one-fifth of 2,00,000, i.e., Rs.40,000 is charged to revenue in the first year and the rest Rs.1,60,000 is shown as fictitious assets. In the second year Rs.40,000 is charged to revenue and the balance 1,20,000 is shown as fictitious assets. This process goes on for five years till the complete expenditure is written off. The entries to be passed during the first year are as follows –
6. Creation of a Reserve Fund:
To strengthen the financial position of the enterprise, a part of the net profit may be transferred to reserve fund account by means of appropriation. The entry for creating a reserve fund is as follows –
7. Manager’s Commission:
Business enterprises sometimes offer profit incentive to managers in the form of commission to motivate the person to increase the profits of the business. This commission is given as a percentage on the net profits. There are two ways of offering this percentage on net profits.
(a) Percentage of commission on net profits before charging such commission.
(b) Percentage of commission on net profits after charging such commission.
8. Certain Hidden Adjustments:
Though adjustments are not explicitly given under the array of adjustments, they should be located and adjusted. For example, the trial balance shows the following items along with other items for the year ending on Dec 31, 2009.
If we observe carefully the loan is obtained on January 1, 2009 at the rate of 10% interest. That means, interest payable on loan for one year on December 31, 2009 is equal to (Rs.50,000 x 10/100) Rs.5,000. But the interest paid is only Rs.3,000 as shown in the trial balance. This indicates that interest due, but not paid is equal to (Rs.5,000 – Rs.3,000) Rs.2,000. Therefore, there is a need to consider this as an adjustment. The entry is –
Here, total interest to be charged to profit and loss account is Rs.3,000 given in the trial balance plus interest payable ? 2,000 totally amounting to Rs.5,000. Interest payable Rs.2,000 will appear as a liability in the balance sheet.
Note – We may come across many more adjustments of different kinds during the course of preparing final accounts. Their treatment will be explained as and when they appear.
When all the information required for financial reporting is ready (i.e., duly tallied trial balance without errors and information relating to adjustments), the accountant prefers to draft a work sheet. Work sheet is only a rough work and not a part of financial statements.
Work sheet is prepared for convenience to ensure that the financial statements prepared with debit and credit columns representing trial balance, adjustments, adjusted trial balance, trading account, profit and loss account and balance sheet are in order.