Financial Statements II Class 11 Notes

The trial balance is prepared from the ledger, and the ledger records only the transactions that have been entered. Several items are missing from it by their very nature: a bill has not yet fallen due, an expense has been incurred without being invoiced, and the stock on hand has never been entered because it is a physical count. The financial statements would be wrong without these adjustments, so they are made as a separate step before the statements are drawn up.

• Adjustments are needed for the period of the accounts, so that revenue and expenses fall in the period to which they relate and not the period in which the cash happened to move.
• The adjustments are recorded through a memorandum, the adjustments in a statement, and where a journal entry is required, one is made at the end of the year.
• Every adjustment affects the profit and loss account, the balance sheet, or both, and the question usually states which statements to prepare.

Closing stock is the value of unsold goods at the closing date, taken as a physical count valued at cost. It is the only adjustment that is both a trading account item and a balance sheet item, and it must appear in both places at the same figure.

• In the trading account, closing stock is deducted on the debit side and shown on the credit side, so it reduces the cost of goods sold and increases the sales figure.
• In the balance sheet, it appears under current assets at the same value.
• The value is the cost, not the selling price, so the margin is not brought into the accounts at this stage.
• If the question supplies a list of goods to be valued, take the cost of each item, add the direct expenses of bringing it in such as freight, and total them.

An expense is outstanding when it has been incurred before the closing date but has not yet been paid or recorded, which is why an unpaid bill is discovered only when the bills are counted. A prepaid expense is a payment already made for a period extending beyond the closing date, so part of it relates to the next year.

• Outstanding expense: add to the expense on the debit side of the profit and loss account, and show as a current liability in the balance sheet.
• Prepaid expense: deduct from the expense in the profit and loss account for the current year's share, and show the balance as a current asset.
• Insurance is the standard example of a prepaid expense, and outstanding wages, unpaid rent and an unpaid telephone bill are the standard outstanding expenses.
• When the adjustment is small, the difference is deducted directly from the trial balance figure instead of being shown separately, and the problem data usually say which method to use.

Accrued income is revenue earned before the closing date but not yet received or recorded, as when a customer owes the business for services already rendered. Income received in advance is cash already received for a service that is still to be performed, as when a customer has paid for a full year in advance.

• Accrued income: add to the revenue on the credit side of the profit and loss account, and show as a current asset in the balance sheet.
• Income received in advance: deduct from the revenue in the profit and loss account for the part not yet earned, and show the balance as a current liability.
• Accrued income is never shown in the trading account unless it arises from the sale of goods, and rent received in advance is a non-operating item on the profit and loss account, not the trading account.
• Both adjustments reduce the reported profit relative to the cash received, which is the accrual principle in action.

A debtor who cannot pay ceases to be an asset, and the amount must be written off. When specific debtors are known to be bad the amount is exact and is written off directly; when the question refers to a proportion of debtors being doubtful, a provision is created instead. The distinction is the difference between an adjustment and an estimate.

• Further bad debts, that is new bad debts in the current year: debit bad debts in the profit and loss account and credit debtors.
• Bad debts recovered: credit bad debts recovered in the profit and loss account and debit cash, and the amount received is not revenue.
• Provision for doubtful debts: a provision created on debtors for debts likely to become bad, the amount being the given percentage of debtors after further bad debts have been written off.
• The provision is debited in the profit and loss account as an expense and credited to the provision for doubtful debts account, and it appears in the balance sheet as a deduction from debtors.
• Percentage of debtors, not of sales. The provision is always calculated on the debtor figure after writing off further bad debts.

If the cash discount on debtors is known, a provision is created for it, on the debtors figure remaining after bad debts and the provision for doubtful debts have been deducted. It reflects a likely reduction in the amount actually collected, and it is created even though no specific debtor has been offered the discount.

• Calculate the provision on debtors after deducting further bad debts and the provision for doubtful debts.
• Debit the provision for discount on debtors in the profit and loss account and credit the same account, and show it as a second deduction from debtors in the balance sheet.
• The provision for discount on debtors is made even when the provision for doubtful debts is not required by the question, if the data provide the rate.
• The provision for discount on debtors is distinct from discount allowed, which is an actual discount given and recorded when the debtor pays.

Interest on capital and commission are both appropriations of profit, not expenses of running the business. They are transferred from the profit and loss account to capital, and they reduce the balance available for appropriation. This distinction is the whole of the section.

• Interest on capital is allowed to the proprietor on the capital invested, at the given rate, and it is an appropriation of profit rather than an expense, so it does not appear in the profit and loss account above the net profit.
• Interest on capital is calculated on the opening capital plus any additional capital introduced during the year, the additional capital being taken for the full year unless the data say otherwise.
• In the balance sheet, interest on capital is shown as a current liability, because it is an amount owing to the owner and not yet paid.
• Manager's commission is allowed to the manager, either as a fixed amount, as a percentage of net profit after charging that commission, or as a percentage of net profit before such commission.
• Where the commission is a percentage of net profit after charging commission, the rate is applied to the figure after the commission is deducted, which is what makes the calculation circular and requires a step to resolve.