Introduction to Final Accounts with Adjustment

For the preparation of financial statements, it is necessary that all the adjustments arising out on the accrual basis of accounting are made at the end of the accounting period. Another important consideration in the preparation of final accounts with adjustments is the distinction between capital and revenue items. Entries which are recorded to give effect to these adjustments are known as adjusting entries.

Key Definitions and Features

• Adjusting Entries: Journal entries made at the end of the accounting period to update the accounts before preparing final accounts.
• Accrual Basis: Accounting method where revenues and expenses are recorded when they are earned or incurred, not when cash is received or paid.

Illustrative Example

Suppose salary of ₹5,000 for December is unpaid at the end of the year. An adjusting entry is made to record this outstanding expense.

Practice Set

• Level 1: Define adjusting entries and explain their importance.
• Level 2: Explain the difference between capital and revenue items with examples.
• Level 3: Prepare adjusting entries for outstanding expenses and prepaid expenses given a trial balance.

Answer Key

Adjusting entries ensure that all incomes and expenses are recorded in the correct accounting period, providing a true and fair view of financial statements.

Quick Reference

• Adjusting entries are essential for accrual accounting.
• They help in matching income and expenses.

Glossary

• Adjusting Entries: Entries made to update accounts before final accounts preparation.
• Accrual Basis: Recording transactions when they occur, not when cash changes hands.

Outstanding Expenses

Outstanding expenses are expenses that have been incurred but not yet paid at the end of the accounting period. These expenses must be added to the relevant expense account in the Trading or Profit & Loss Account and shown as a liability in the Balance Sheet.

Key Definitions and Features

• Outstanding Expenses: Expenses due but unpaid at the end of the accounting period.
• Shown as current liabilities in the Balance Sheet.
• Added to the expense in Profit & Loss Account to reflect true expense.

Illustrative Example

If salary of ₹10,000 is unpaid at year-end, it is recorded as outstanding salary.

Practice Set

• Level 1: Define outstanding expenses with an example.
• Level 2: Pass journal entry for outstanding rent of ₹2,000.
• Level 3: Prepare Profit & Loss Account and Balance Sheet extract showing outstanding expenses.

Answer Key

Journal Entry:
Rent Expense A/c Dr. ₹2,000
To Outstanding Rent A/c ₹2,000

Quick Reference

• Outstanding expenses increase expenses and liabilities.

Glossary

• Outstanding Expenses: Expenses incurred but not paid.

Prepaid Expenses

Prepaid expenses are payments made in advance for expenses relating to future accounting periods. At the end of the accounting year, the portion of the expense that benefits the next period is deducted from the relevant expense account and shown as an asset in the Balance Sheet.

Key Definitions and Features

• Prepaid Expenses: Expenses paid in advance for future periods.
• Shown as current assets in the Balance Sheet.
• Deducted from expenses in Profit & Loss Account.

Illustrative Example

If insurance premium of ₹12,000 is paid for 12 months starting October, then for the year ending December, only 3 months' expense is charged and 9 months' prepaid expense is shown as asset.

Practice Set

• Level 1: Define prepaid expenses with example.
• Level 2: Calculate prepaid insurance if ₹6,000 is paid for 6 months starting November.
• Level 3: Pass journal entries and prepare Profit & Loss Account and Balance Sheet extract for prepaid expenses.

Answer Key

Journal Entry:
Prepaid Insurance A/c Dr.
To Insurance Expense A/c (for prepaid portion)

Quick Reference

• Prepaid expenses reduce expenses and increase assets.

Glossary

• Prepaid Expenses: Payments made for expenses not yet incurred.

Advance or Unearned Income

Advance or unearned income is income received before it is earned. The portion of income that relates to the next accounting period is deducted from the income in the Profit & Loss Account and shown as a liability in the Balance Sheet.

Key Definitions and Features

• Unearned Income: Income received in advance for services or goods to be provided in the future.
• Shown as current liabilities in the Balance Sheet.
• Deducted from income in Profit & Loss Account.

Illustrative Example

If rent of ₹5,000 is received in advance for January next year, it is treated as unearned income.

Practice Set

• Level 1: Define unearned income with example.
• Level 2: Pass journal entry for ₹3,000 rent received in advance.
• Level 3: Prepare Profit & Loss Account and Balance Sheet extract showing unearned income.

Answer Key

Journal Entry:
Rent Received A/c Dr. ₹3,000
To Unearned Rent A/c ₹3,000

Quick Reference

• Unearned income increases liabilities and reduces income.

Glossary

• Unearned Income: Income received but not yet earned.

Accrued Income

Accrued income is income that has been earned but not yet received by the end of the accounting period. It is added to the relevant income in the Profit & Loss Account and shown as an asset in the Balance Sheet.

Key Definitions and Features

• Accrued Income: Income earned but not received.
• Shown as current assets in the Balance Sheet.
• Added to income in Profit & Loss Account.

Illustrative Example

Interest on investment of ₹1,00,000 at 6% for 2 months not received by year-end is accrued income.

Practice Set

• Level 1: Define accrued income with example.
• Level 2: Calculate accrued interest for ₹50,000 at 8% for 3 months.
• Level 3: Pass journal entries and prepare Profit & Loss Account and Balance Sheet extract for accrued income.

Answer Key

Journal Entry:
Accrued Interest A/c Dr.
To Interest Income A/c

Quick Reference

• Accrued income increases assets and income.

Glossary

• Accrued Income: Income earned but not yet received.

Depreciation

Depreciation is the decline in the value of an asset due to wear and tear or passage of time. It represents the allocation of the cost of an asset over its useful life. In the Balance Sheet, the asset is shown at cost less accumulated depreciation.

Key Definitions and Features

• Depreciation: Systematic allocation of the cost of a tangible asset over its useful life.
• Shown as an expense in Profit & Loss Account.
• Deducted from asset value in Balance Sheet.

Illustrative Example

If machinery costing ₹1,00,000 has a useful life of 10 years, annual depreciation by straight-line method is ₹10,000.

Practice Set

• Level 1: Define depreciation and state its purpose.
• Level 2: Calculate depreciation using straight-line method for an asset costing ₹50,000 with 5 years life.
• Level 3: Pass journal entries and prepare Profit & Loss Account and Balance Sheet extract showing depreciation.

Answer Key

Journal Entry:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c

Quick Reference

• Depreciation is a non-cash expense reducing asset value.

Glossary

• Depreciation: Allocation of asset cost over useful life.

Provisions for Bad and Doubtful Debts

Provision for bad and doubtful debts is an estimated amount set aside from profits to cover debts that may not be recovered. It is a normal business practice to anticipate some irrecoverable debts and provide for them to present a true financial position.

Key Definitions and Features

• Provision for Bad Debts: Estimated amount to cover potential losses from irrecoverable debts.
• Shown as a deduction from debtors in the Balance Sheet.
• Charged as an expense in Profit & Loss Account.

Illustrative Example

If debtors amount to ₹1,00,000 and provision is 5%, then provision for bad debts is ₹5,000.

Practice Set

• Level 1: Define provision for bad debts with example.
• Level 2: Calculate provision for bad debts at 2% on debtors of ₹80,000.
• Level 3: Pass journal entries and prepare Profit & Loss Account and Balance Sheet extract showing provision.

Answer Key

Journal Entry:
Bad Debts Expense A/c Dr.
To Provision for Bad Debts A/c

Quick Reference

• Provision reduces debtors and profits to reflect realistic values.

Glossary

• Provision for Bad Debts: Estimated loss on doubtful debts.