To ensure that the final accounts disclose the true trading results, it is necessary to lake into account the whole of the expenses incurred, whether paid or not, and whole of the losses sustained. Likewise the incomes and gains earned, whether actually received or not, during the period covered by the trading and profit and loss account under consideration must also be recorded.
In mercantile system of accounting, it is essential to adjust different accounts before the preparation of final accounts. It is quite common to adjust expenses paid in advance, incomes received in advance, income accrued but not received, bad debts, provision for bad debts depreciation on assets and soon. Journal entries are passed to effect the required adjustments; these entries are known as adjusting entries.
Certain expenses relating to a particular period may not have been paid in that accounting period. All such expenses which are due for payment in one accounting year but actually paid in future accounting years or payment of which is postponed are all outstanding or unpaid expenses. All such expenses must be accounted for in that accounting year in which they are incurred, irrespective of the fact whether they are paid or not. In other words, all paid and also unpaid expenses must be recorded in an accounting year if they relate to that accounting year only with a view to ascertain true trading results e.g. if salaries for the last month are not paid, no entry will appear in books of accounts unless these are paid. So profit and loss account in respect of salaries will thus be under charged than the actual expenditure, therefore the profit will be more.
The, benefit of some of the expenses already spent will be available in the next accounting year also, Such a portion of the expense is called pre-paid expense; since such expenses are already paid, they are also recorded in the books of accounts of that period to which they do not relate. The result shown by the final accounts of a particular period will not be correct because such expenses relate to future periods. Therefore, such prepaid expenses must be adjusted in the books of accounts to arrive at true profit. Generally insurance, taxes, telephone subscriptions, rent etc. are paid in advance, thus requiring adjustment e.g. Rent paid by x for one year on 1.7.79 when his accounting year is calendar year; thus rent for 6 months will remain unexhausted and will be c/f to the next year.
There may be certain incomes which have been earned during the year but not yet received till the end of the year. Income like interest on investments, rent and commission etc. are normally earned by merchant during a particular accounting period but actually not received during that period. Such income items need adjustments before the preparation of final accounts. Such incomes should be credited to that particular income account. At the same time the income so -earned but not received is an asset because the amount is still to be received.
Income Received in Advance
Sometimes, traders receive certain amounts during a particular trading period which are to be earned by them in future periods. Such incomes though actually received and therefore, recorded i.e. not yet earned. Such incomes should be credited to the profit and loss account of the year in which these are earned. Therefore, such income though received is not the income but a liability of that period
It represents the unsold stock at the end of the year. Closing stock is valued and following entry is passed at the end of the year: Closing Stock account To Trading Account Closing stock at the end appears in the balance sheet and is carried forward to the next year. At the end of the next year it appears in the trial balance as opening stock and from there it is taken to debit side of trading account and thus closed.
The value of fixed assets diminishes gradually with their use for business purposes. Although this decrease in the value happens every day but its accounting is done only at the end of accounting period with the help of following entry .Depreciation account To Particulars asset
Interest on Capital
The proprietor may wish to ascertain his profit after considering the interest which he losses by investing his money in the firm. Interest to be charged is an expense for the business on one hand and income to the proprietor on the other hand. Following adjusting entry is recorded at the end of accounting period: Interest on capital a/e To Capital a/c Interest on capital being an expense is debited to profit and loss account and same amount of interest on capital is added to capital.
Interest on Drawings
As business allows interest on capital it also charges interest on drawings made by the proprietor. Interest so charged is an income for the business on one hand and expense for the proprietor on the other hand. Following adjusting entry is passed at the end. of accounting period: Capital ale Dr. To Interest on drawings a/e The interest on drawings being an income is credited to profit and loss account is shown as a deduction from the capital.
Bad Debt to be written off
Bad debts are irrecoverable debts from customers, during the course of the financial year. These are recorded as follows: Bad debts a/c To Sundry Debtors a/c It results in the reduction of customers debit balance and addition to the loss i.e. Bad Debts. At the end of the year when the trial balance is drawn, these two accounts show debit balances. The balance on sundry debtors account, thus arrived, is the net balance, after deduction of any bad debts recorded during the year. But after the trial balance is prepared and before the final accounts are drawn trader may find that there are additional bad debts. Such bad debts must be recorded with the same adjusting entry and giving it following effect in ledger and final accounts.
Provision for Bad Debts
At the end of the year, after writing off the bad debts about whom we were sure of becoming irrecoverable, there may still be some customer balances from whom it is doubtful to collect the entire amount. However, it cant be written off as bad because non-recovery of such amount is not certain. But at the same time the balance in sundry debtors account should be brought down to its net realizable figure so that balance sheet may not exhibit the debtors at more than their actual realizable value. Therefore, to show the approximately correct value of the sundry debtors in the balance sheet a provision or reserve is created for possible bad debts. Such an adjustment entry is recorded at the end of accounting year.
Provision for bad debts is an attempt to anticipate possible losses due to bad debts and to keep aside an amount out of profit to meet the loss estimated in the following years. When the provision for bad debts is created, following entry is recorded:
Profit and Loss A/c Dr. To Provision for bad debts A/c
Some important considerations while creating provision for bad debts
(i) Sundry debtors account should not be credited with the amount of provision for doubtful debts because the loss has not actually been incurred.
(ii) Treatment of bad debts or provision for bad debts appearing inside the trial balance. If some balance (credit) is already appearing in provision for doubtful debts account inside the trial balance, it is the previous years unutilized balance of this account. If some bad debts are also appearing on the debit side of the trial balance, these should be transferred to provision for bad debts account, with the help of following entry: Provision for bad debts a/e To Bad debts a/e. It is important to note that, as these items appear inside the trial balance, so these are to appear only in profit and loss account as debtors have already been reduced during the year.
(iii) When bad debts and provision for bad debts appear in trial balance, new provision is to be created and further bad debts are to be written off. If already bad debts and provision for bad debts are appearing in trial balance, these should be adjusted and only difference should be taken to profit and loss account.
If bad debts written off plus bad debts to be written off plus new provision for bad debts is more than the credit balance of old provision appearing in the trial balance, the difference should be debited to profit and loss account.
Provision for discount on Debtors
It is normal practice in trade to allow discount to customers for prompt payment and it constitutes a substantial sum. Sometimes the goods are sold on credit to customers in one accounting period where as the payment of the same is made by them in the next accounting period and so discount is to be allowed. It is a prudent policy to charge this expenditure to the period in which sales have been made, so a provision is created in the same manner, as in case of provision for doubtful debts
An important point to note is that no discount win be allowed on debts that become bad. Therefore, the provision required for discount will be in respect of the other debts only. So the amount of provision for discount be calculated after deducting the provision for bad debts from sundry debtors.
Provision for discount on creditors
Prompt payment, if made, enables a businessman to receive discount. The question arises whether this discount should be treated as income of the period in which purchases were made or of the period when the payment is made, if both events are in different accounting years, it has been well decided by accountants that it should be treated as income of the period in which purchases are made. So on last date of accounting period if some amount is still payable to creditors, a provision should be created for such probable income and amount should be credited to the profit and loss account of that year in which purchases are made. Following adjusting entry is passed for it .Provision for discount on creditors a/c Dr. To Profit and loss account
Losses by Accidents
Sometimes a business suffers certain losses not because of trading but because of certain accidents. These may destroy some fixed assets of the merchant. In such a case the asset account is credited and the profit and loss account is debited.
If goods (stock-in-trade) are lost by accident the value of closing stock win be lower than otherwise. This will reduce the amount of gross profit. So the cost of goods lost by accident is credited to the trading account and debited to the profit and loss account. The increase -in gross profit will be neutralized by the debit to the profit and loss account and thus the net profit will not be effected. The entries to the passed are as follows: Loss by accident a/c To Goods lost by accident a/c
Commission to manager payable on profits
Sometimes the manager is entitled to a commission on profits.. Such commission may be :
(a) Fixed percentage on net profits before charging such commission.
(b) Fixed percentage on net profits- after charging such commission.
Such commission being an expense is debited to commission account. However, as it has not yet been paid, so commission payable account is given the credit and finally it is shown in the balance sheet as a liability. Calculation of Commission First of all trading account should be prepared in usual manner and after transferring the gross profit or loss all expenses and incomes should be debited or credited except the commission which is still to be calculated.
Goods used in business
Sometimes goods purchased for the purpose of resale are used in business as giving them away for charitable purpose or distributing them as free samples. In these conditions purchases account should be credited with an amount equal to the cost of goods used in business and same amount is debited to charity or advertisement expenses account, as the case may be.
Source from MBA docs