Adjustment Entries:

CHAPTER 10 FINAL ACCOUNTS & ADJUSTMENTS

10.4 Adjustment Entries:

Before an accountant can proceed to prepare the financial statements from the trial balance, he has to process some additional information, which he either already knows or receives from some other divisions or departments. The following are a few examples showing where adjustment entries would be required:

a. The accountant may know (or be instructed by the Accounts Manager) that the depreciation on building is to be charged at the rate of 5%.

b. The accountant would ascertain that the salary of three workers for January is unpaid at the end of the month.

c. The accountant is informed by the storekeeper that the goods lying unsold in the store (representing closing stock) is worth Rs.17,000 at cost.

In view of the above information, certain “adjustment entries” will have to be made in the Journal. Adjustment entries usually represent the recording of additional information and not actual transactions. Different types of adjustment entries are discussed below.

1. Closing Inventory:

Closing stock refers to the stock of unsold goods at the end of current accounting period which is carried forward to next accounting period as opening stock. It is valued at cost or net realizable value whichever is lower. Adjustment Entrynt for the same is given below:

Closing Inventory a/c Dr To Trading a/c

While the closing inventory appears on the credit side of the trading account to reduce the cost of goods sold, it also appears as an asset in the balance sheet.

2. Outstanding or Accrued Expense

The nominal accounts record the actual expense paid during the accounting period. However, prior to the preparation of the financial statements, it must be ensured that all expenses which have fallen due to be paid but which have not been paid during the accounting period are also brought into the books to help in the proper matching of revenues and expenses. For example, ABC Trading Company has the practice of paying the salaries of the employees on the 4th of the subsequent month. During the financial year ending 31st March, 2001 the salaries account shows a debit balance of Rs.55,000. The salaries of Rs.6,000 pertaining to March, 2001 were paid on 4th April, 2001.

While preparing the financial statements for the year ending 31st March, 2001, the salaries of Rs.6,000 of March must also be included. This is done with the following adjusting journal entry:

Salaries a/c Dr 6,000

To Outstanding Salaries a/c 6,000

The above journal entry increases the salaries to the correct amount of Rs.61,000 and the outstanding salaries of Rs.6,000 will be shown as a liability in the balance sheet.

The adjusting journal entry to record any outstanding or accrued expense is Expense a/c Dr

To Outstanding Expense a/c

While the amount of expense taken from the trial balance will be increased by the amount outstanding and shown in the trading and profit and loss account, the actual amount outstanding will be shown as a liability in the balance sheet.

In the subsequent accounting period, the outstanding expense liability will be transferred to the expense or nominal account and will be set-off by the entry of actual payment when it is made.

3. Prepaid Expense:

Certain expenses paid may relate to more than one accounting period. In such cases, it is necessary to identify that portion of the expenditure for which the benefit is yet to be received by the concern and treat that part of the expenditure as prepaid.

ABC Trading Company took an insurance cover for all assets against fire on 1st October, 2000 and paid the annual premium of Rs.2,400 on the same day. Since the benefit of the entire expenditure will expire only on 30th September, 2001, it becomes necessary to recognize this aspect while preparing the financial statements as on 31st March, 2001.

The amount of expense prepaid on 1st October, 2000 = (1/2) 2,400 = Rs.1,200

The adjusting entry to record the prepaid insurance is,

Prepaid Insurance a/c Dr 1,200 To Insurance a/c 1,200

This entry ensures that the insurance expense is reported at the correct figure of Rs.1,200 in the profit and loss account and the prepaid amount is shown as an asset in the balance sheet.

The journal entry to record any prepaid expense is,

Prepaid Expense a/c Dr To Expense a/c

In the subsequent accounting period, the balance in the prepaid expense account will be transferred back to the expense account.

An income appearing in the ledger account may not represent the income that must have been received during the year. If a portion of an income has not yet been received or is outstanding as at the end of the accounting period then the outstanding amount must be brought into books. ABC Trading Company holds 14% Debentures of the face value of Rs.5,000 in Bright Limited as investments. The interest is payable on 30th June and 31st December of every year. The debentures were purchased on 1st July, 2000.

While ABC Trading Company would have received the interest of Rs.350 (5,000 (14/100) 1/2) during the accounting period ending 31st March, 2000 the interest of Rs.350 for the next six months will be received only in the subsequent accounting period. However, while preparing the financial statements, the total interest revenue to be recognized is the amount of Rs.350 actually received plus the interest of Rs.175 pertaining to the period 1st January, 2001 to 31st March, 2001.

The following adjusting entry will bring into books the amount of outstanding interest: Outstanding Interest a/c Dr 175

To Interest Received a/c 175

While the interest received will be increased to Rs.525 and shown in the profit and loss account, the outstanding interest account will be listed as an asset in the balance sheet.

In the subsequent accounting period, the amount in the Outstanding Interest a/c will be transferred to Interest Received a/c and the actual receipt of the interest will offset the former transfer entry.

To record any outstanding income in the books of accounts, the journal entry is: Outstanding Income a/c Dr

To Income A/c

5. Income Received in Advance

While preparing the financial statements, adjustments may be necessary in respect of any incomes received in advance.

Law Publications has received subscriptions amounting to Rs.50,000 during the financial year ending 31st December, 2001. Out of this Rs.2,500 represent subscriptions relating to the next financial year.

The entry to adjust for the income received in advance will be, Subscriptions a/c Dr 2,500

To Subscriptions received in Advance a/c 2,500

With the posting of the above journal entry, the subscriptions account will be shown in the profit and loss account at the correct figure of Rs.47,500 and in the balance sheet, the subscriptions received in advance will be listed as a liability. Any income received in advance is a liability as benefits are yet to be conferred to the person from whom the amount has been received.

The journal entry to record the adjustment of any income received in advance is Income a/c Dr

6. INTEREST ON CAPITAL:

Interest on capital means the cost of using the capital invested in an enterprise by the proprietor or partners. It is accounting treatment is summarized as follows:

Interest on Capital A/c Dr. To Capital A/c

It is shown on debit side of P&L A/c & on liability side of Balance Sheet as addition to capital. 7. ADJUSTMENT OF ABNORMAL LOSS OF STOCK:

It is usually caused by fire, theft, abnormal spoilage/leakage/breakage/pilferage, etc. its accounting treatment is summarized as given below:

Loss of stock A/c Dr. To Trading A/c

Total value of abnormal loss (whether recovered or not) is shown on the credit side of trading account.

And total value of irrecovered loss of stock (i.e. total loss less amount if any recovered for insurance co) is shown on the debit side as a separate item in Profit & Loss A/c.

The amount if any due from the insurance co is shown on Asset Side as a „Current Assets‟ in the Balance Sheet.

8. PROVISIONS FOR BAD DEBTS, CASH DISCOUNTS PAYABLE AND CASH DISCOUNTS RECEIVABLE

(i) Bad Debts

The sales revenue recorded in the books of accounts of an organization represents the amount realized/to be realized from the sale of goods. When goods are sold on credit it may sometimes not be able to be realized. That unrealized sale is considered to be bad debt. For instance, if a customer, subsequent to the date of credit sales, is adjudged as insolvent and his estate cannot pay anything towards satisfaction of the amount due from him, then, logically, the entry passed at the time of sale should be removed by reversing it, as the situation is similar to the sale not having taken place. In practice, however, instead of reversing the previous entry, the amount which cannot be recovered is considered as a loss called “bad debts”.

The general journal entry for recording bad debts is Bad debts a/c Dr

To Accounts Receivable a/c (ii) Provision for Bad and Doubtful Debts:

When bad debts are expected to occur in the future, (a) the exact amount of loss may not be known and (b) a particular debtor‟s account cannot be identified to write-off the expected loss. To circumvent these problems, usually, a provision is made for the expected bad debts loss out of profits of the current year. This reduces the profit. For creating the provision for bad and doubtful debts, the journal entry is,

Profit and Loss a/c Dr

To Provision for Bad Debts a/c

Treatment of Bad Debts when a Provision for Bad Debts Exists

Let us extend the example of PQR Ltd., to the financial year ending 31st March, 2000.

The following details are available:

Bad debts during the year 3,500 Accounts receivable as on 31/3/1999 1,70,000

PQR Ltd., would like to maintain the provision at 5% of sundry debtors.

The accounts receivable of Rs.1,70,000 as on 31/3/2000 is after accounting for the bad debts of Rs.3,500.

When bad debts occurred, the following entry would have been passed. Bad Debts a/c Dr 3,500

To Sundry Debtors a/c 3,500

Since a provision for bad debts to the extent of Rs.5,000 already exists, the actual bad debts of Rs.3,500 will be transferred at the end of the year to this provision account and not to the profit and loss account. The entry for the transfer will be,

Provision for Bad Debts a/c Dr 3,500

To Bad Debts a/c 3,500 At this point the provision account will appear as under:

Provision for Bad Debts Account

Particulars Rs. Particulars Rs. 31.3.2000 To Bad Debts a/c 3,500 1.4.1999 By Balance b/d 5,000

Since the provision has been utilized to the extent of Rs.3,500, only Rs.1,500 is left for setting off any bad debts in the forthcoming year. However, PQR Ltd. wishes to maintain the provision at 5% on debtors. So, the balance required in the provision account as on 31.3.2000 is, (5/100) 1,70,000 = Rs.8,500

To bring up the provision to the required balance a further appropriation of Rs.7,000 (8,500 – 1,500) will have to be made from the profit and loss account. Entry will be,

Profit and Loss a/c Dr 7,000

To Provision for Bad Debts a/c 7,000

The provision account, after posting this entry, will appear as follows: Provision for Bad Debts Account

Dr. Cr. Particulars Rs. Particulars Rs. 31.3.2000 To Bad Debts 31.3.2000 To Balance c/d 3,500 8,500 1.4.1999 By Balance b/d 31.3.2000

By Profit and Loss a/c

5,000

7,000

12,000 12,000

Balance Sheet of PQR Ltd. as on 31.3.2000

Liabilities Assets Rs. Rs

Accounts Receivable 1,70,000

Less: Provision for 8,500 1,61,500 Bad Debts

(iii) Recovery of Bad Debts Written off

Sometimes, an amount written off as bad debts may be subsequently recovered. Any such recovery must be treated as a windfall and transferred to the Profit and Loss account as a gain.

The journal entries will be,

At the time of receipt of the amount

Cash a/c Dr

To Bad Debts Recovered a/c

At the end of the financial year,

Bad Debts Recovered a/c Dr To Profit and Loss a/c

(iv) Provision for Discounts on Debtors/Accounts Receivable

The organizations which allow the facility of making payments before the due date and enable their debtors to avail of cash discounts, must take into account the possible amount of discounts that may be allowed on closing debtors in the forthcoming year.

The principles for creation and maintenance of the provision for discounts on debtors are the same as those discussed in the section on provision for bad debts. The only additional point to be noted is that discounts will be estimated on debts considered good, i.e. closing sundry debtors minus provision for bad debts. Adjusting entry for the same is as follows:

Profit & Loss A/c Dr.

To Provision for discount on debtors A/c

The following illustration clearly explains the mechanics of maintaining a provision for discounts on debtors.

Illustration :

Following are the extracts from Trial Balance of a firm as at 31st March,2002: Name of account Dr Balance Rs Cr Balance Rs Sundry Debtors Bad debts Discount 2,05,000 3,000 1,800

(ii) Credit a provision for discount on debtors @2% on debtors. (iii) Additional discount given to the debtors Rs 5000.

Required: Pass necessary journal entries & show the relevant accounts.

Solution:

Journal entries

Particulars L.F. Dr (Rs) Cr (Rs)

Discount allowed A/c Dr. To sundry Debtors A/c

(Being the additional discount allowed to debtors)

5,000

Profit & Loss A/c Dr. To Bad Debts A/c

To Discount Allowed A/c

(Being the transfer of bad debts & discount to P&L A/c)

9.800

3,000 6,800

Profit & Loss A/c Dr.

To provision for doubtful debts A/c

(being the provision for DD created @10% on 2,00,000)

20,000

Profit & Loss A/c Dr.

To Provision for discount on debtors A/c

(being the provision for discount created @2% on debtors of Rs 1,80,000 (i.e. Rs 2,00,000 – Rs 20,000)

3,600

Sundry Debtors Account

Dr Cr.