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Financial Statements - II

Financial Statements - II

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Study Action Plan (Sorted by Difficulty)
Accrual Basis of Accounting
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Adjustments in Financial Statements
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Depreciation
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Financial Statement Preparation
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Interest on Capital
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Manager's Commission
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Provision for Bad and Doubtful Debts
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Provision for Discount on Debtors
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Learning Objectives

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Learning Objectives

  • Describe the need for adjustments while preparing the financial statements.
  • Explain the accounting treatment of adjustments for outstanding and prepaid expenses, accrued and advance receipts of incomes.
  • Discuss the adjustments to be made regarding depreciation, bad debts, provision for doubtful debts, provision for discount on debtors.
  • Explain the concepts and adjustment of manager's commission and interest on capital.
  • Prepare profit and loss account and balance sheet with adjustments.

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Revision Notes & Summary

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Financial Statements - II

Learning Objectives

  • Describe the need for adjustments while preparing the financial statements.
  • Explain the accounting treatment of adjustments for outstanding and prepaid expenses, accrued and advance receipts of incomes.
  • Discuss the adjustments to be made regarding depreciation, bad debts, provision for doubtful debts, provision for discount on debtors.
  • Explain the concepts and adjustment of manager's commission and interest on capital.
  • Prepare profit and loss account and balance sheet with adjustments.

Need for Adjustments

  • The accrual concept of accounting necessitates adjustments to reflect true profitability and financial position.
  • Items requiring adjustments include:
    • Outstanding expenses
    • Prepaid expenses
    • Accrued incomes
    • Income received in advance

Key Terms Introduced in the Chapter

  • Outstanding / Accrued expenses: Unpaid expenses at the end of the accounting period.
  • Prepaid/Unexpired expenses: Expenses paid in advance for future periods.
  • Accrued Incomes: Income earned but not yet received.
  • Income received in advance: Income received for future periods.
  • Depreciation: Reduction in the value of an asset over time.
  • Bad Debts: Debts that are unlikely to be collected.
  • Provision for doubtful debts: An estimate of debts that may not be collected.
  • Provision for discount on debtors: An estimate of discounts expected to be given to debtors.
  • Manager's Commission: A fee paid to the manager based on profits.
  • Interest on Capital: Interest payable to partners on their capital contributions.

Adjustments and Their Treatment

Adjustment TypeAdjustment EntryTreatment in Trading and Profit and Loss AccountTreatment in Balance Sheet
Closing stockClosing stock A/c Dr. <br> To Trading A/cShown on the credit sideShown on the assets side
Outstanding expensesExpense A/c Dr. <br> To outstanding expense A/cAdded to the respective expenseShown on the liabilities side
Prepaid/Unexpired expensesPrepaid expense A/c Dr. <br> To Expenses A/cDeducted from the respective expenseShown on the assets side
Accrued incomeAccrued income A/c Dr. <br> To Income A/cAdded to the respective incomeShown on the assets side
Income received in advanceIncome A/c Dr. <br> To Income received in advance A/cDeducted from the respective incomeShown on the liabilities side
DepreciationDepreciation A/c Dr. <br> To Assets A/cShown on the debit sideDeducted from the value of asset
Provision for bad debtsProfit and Loss A/c Dr. <br> To Provision for doubtful debtsShown on the debit sideShown as deduction from debtors
Provision for discount on debtorsProfit and Loss A/c Dr. <br> To Provision for discount on debtorsShown on the debit sideShown as deduction from debtors
Manager's commissionManager's commission A/c Dr. <br> To outstanding commission A/cShown on the debit sideShown on the liabilities side
Interest on capitalInterest on capital A/c Dr. <br> To capital A/cShown on the debit sideShown as addition to capital
Further bad debtsBad debts A/c Dr. <br> To Sundry Debtors A/cShown on the debit sideDeducted from debtors

Example Adjustments

  • Bad debts: Further bad debts ₹300, maintain provision for bad debts at 10%.
  • Closing Stock: Closing stock valued at ₹20,000.
  • Depreciation: Depreciate furniture by 10%.
  • Manager's Commission: Provide for manager's commission at 10% on net profit before charging such commission.
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Practice Test – MCQs, True/False

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Multiple Choice Questions

A.

On the total amount of debtors.

B.

On the amount of debtors after deducting further bad debts and provision for doubtful debts.

C.

On the amount of debtors before deducting any bad debts.

D.

On the amount of debtors after adding accrued income.
Correct Answer: B

Solution:

Provision for discount on debtors is calculated on the amount of debtors after deducting further bad debts and provision for doubtful debts.

Chapter Concept:

Provision for Discount on Debtors

A.

As an asset in the balance sheet

B.

As a liability in the balance sheet

C.

As an expense in the profit and loss account

D.

As income in the profit and loss account
Correct Answer: C

Solution:

Depreciation is recorded as an expense in the profit and loss account, reducing the asset value in the balance sheet.

Chapter Concept:

Adjustments in Financial Statements

A.

₹ 13,500

B.

₹ 14,000

C.

₹ 15,000

D.

₹ 1,500
Correct Answer: A

Solution:

Depreciation is calculated as 10% of ₹ 15,000, which is ₹ 1,500. The net book value is ₹ 15,000 - ₹ 1,500 = ₹ 13,500.

Chapter Concept:

Financial Statement Preparation

A.

₹ 650

B.

₹ 1,300

C.

₹ 500

D.

₹ 1,000
Correct Answer: A

Solution:

The provision for doubtful debts is calculated as 5% of ₹ 13,000, which is ₹ 650.

Chapter Concept:

Provision for Bad and Doubtful Debts

A.

Accrued income in assets, income received in advance in liabilities

B.

Both in assets

C.

Both in liabilities

D.

Accrued income in liabilities, income received in advance in assets
Correct Answer: A

Solution:

Accrued income is recognized as an asset because it is income earned but not yet received, while income received in advance is a liability as it represents money received for future services.

Chapter Concept:

Accrual Basis of Accounting

A.

₹ 13,000

B.

₹ 15,500

C.

₹ 11,000

D.

₹ 10,000
Correct Answer: A

Solution:

The new value of debtors is calculated by subtracting the additional bad debt from the existing debtors: ₹ 15,500 - ₹ 2,500 = ₹ 13,000.

Chapter Concept:

Provision for Bad and Doubtful Debts

A.

₹ 22,000

B.

₹ 20,000

C.

₹ 24,444

D.

₹ 18,000
Correct Answer: A

Solution:

The commission is calculated as 10% of the net profit before commission: ₹220,000×0.10=₹22,000\text{₹} 220,000 \times 0.10 = \text{₹} 22,000.

Chapter Concept:

Manager's Commission

A.

Debit Debtors A/c; Credit Provision for Doubtful Debts A/c with the estimated amount

B.

Debit Profit and Loss A/c; Credit Provision for Doubtful Debts A/c with the estimated amount

C.

Debit Provision for Doubtful Debts A/c; Credit Debtors A/c with the estimated amount

D.

Debit Cash A/c; Credit Provision for Doubtful Debts A/c with the estimated amount
Correct Answer: B

Solution:

The provision for doubtful debts is recorded by debiting the Profit and Loss A/c and crediting the Provision for Doubtful Debts A/c.

Chapter Concept:

Adjustments in Financial Statements

A.

On the total amount of debtors before any deductions.

B.

On the amount of debtors after deducting bad debts and provision for doubtful debts.

C.

On the net profit of the business.

D.

On the total sales of the business.
Correct Answer: B

Solution:

The provision for discount on debtors is calculated on the amount of debtors after deducting bad debts and provision for doubtful debts, as it applies to the good debtors.

Chapter Concept:

Provision for Discount on Debtors

A.

Expenses are recognized when cash is paid

B.

Expenses are recognized when they are incurred

C.

Expenses are recognized at the end of the year

D.

Expenses are recognized when the invoice is received
Correct Answer: B

Solution:

Under the accrual basis of accounting, expenses are recognized when they are incurred, regardless of when cash is paid.

Chapter Concept:

Accrual Basis of Accounting

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Financial Statements - II

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True or False

Correct Answer: False

Solution:

Provision for discount on debtors is calculated on good debtors, which are determined after deducting further bad debts and the provision for doubtful debts.

Chapter Concept :

Provision for Discount on Debtors

Correct Answer: True

Solution:

Adjustments such as outstanding expenses, prepaid expenses, depreciation, and accrued income are made to ensure that financial statements accurately reflect the business's financial position and performance.

Chapter Concept :

Financial Statement Preparation

Correct Answer: False

Solution:

Depreciation is not recorded as a liability; it is an expense that reduces the carrying value of an asset on the balance sheet.

Chapter Concept :

Depreciation

Correct Answer: False

Solution:

Prepaid expenses are deducted from the respective expense in the profit and loss account and shown as an asset in the balance sheet.

Chapter Concept :

Financial Statement Preparation

Correct Answer: False

Solution:

Income received in advance is a liability because it represents an obligation to provide goods or services in the future.

Chapter Concept :

Adjustments in Financial Statements

Correct Answer: False

Solution:

Prepaid expenses are shown as assets in the balance sheet because they represent payments made in advance for benefits to be received in future periods.

Chapter Concept :

Financial Statement Preparation

Correct Answer: True

Solution:

Depreciation is treated as a business expense because it represents the allocation of the cost of an asset over its useful life. It is debited to the profit and loss account to reflect the reduction in value of the asset.

Chapter Concept :

Depreciation

Correct Answer: False

Solution:

Manager's commission can be calculated on net profit either before or after charging the commission. In the absence of specific information, it is assumed to be on the net profit before charging the commission.

Chapter Concept :

Manager's Commission

Correct Answer: True

Solution:

Depreciation is treated as a business expense and is deducted from the asset value in the balance sheet to reflect the reduced value of the asset.

Chapter Concept :

Adjustments in Financial Statements

Correct Answer: False

Solution:

Prepaid expenses are deducted from the respective expenses in the profit and loss account but are shown as assets in the balance sheet, not liabilities.

Chapter Concept :

Adjustments in Financial Statements

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