Adjustments (Outstanding, Prepaid, Depreciation and Closing stock)

Need for Adjustments

According to accrual concept of accounting, the profit or loss for an accounting year is not based
on the revenues realized in cash and the expenses paid in cash during that year. There may exist
some receipts and expenses in the current year which partially relate to the previous year or to
the next year. Also, there may exist incomes and expenses relating to the current year that still
need to be brought into books of account. Such items duly adjusted, the final accounts will not
reflect the true and fair view of the state of affairs of the business.

Similarly, adjustments may also become necessary in respect of certain incomes received in
advance or those which have accrued but are still to be received. Apart from these, there are
certain items which are not recorded on day-to-day basis such as depreciation on fixed assets,
interest on capital, etc. These are adjusted at the time of preparing financial statements. The
purpose of making various adjustments is to ensure that the final accounts reveal the true profit
or loss and the true financial position of the business. The items which usually need adjustments
are:

1. Closing stock

2. Outstanding/expenses

3. Prepaid/Unexpired expenses

4. Accrued income

5. Income received in advance

6. Depreciation

7. Bad debts

8. Provision for doubtful debts

9. Provision for discount on debtors

10. Manager’s commission

11. Interest on capital

Trial Balance of Ankit as on March 31, 2017

Account Title L.F Debit Amount Credit Amount

Cash 1,000
Bank 5,000
Wages 8,000
Salary 25,000
Furniture 15,000
Rent of Building 13,000
Debtors 15,500
Bad Debts 4,500
Purchase 75,000
Capital 12,000
Sales 1,25,000
Creditor 15,000
Long term loan (raised on 1.4.2013) 5,000
Commission received 5,000
Total 1,62,000 1,62,000
Additional Information : The stock on March 31, 2017 was ` 15,000.

Trading and Profit and Loss Account of Ankit

for the year ended March 31, 2017

Dr. Cr.

Expenses/Losses Amt Revenues/Gains Amt

Purchases 75,000 Sales 1,25,000
Wages 8,000 Closing Stock 15,000
GP c/d 57,000
1,40,000 1,40,000
Salary 25,000 GP b/d 57,000
Rent of Building 13,000 Commission received 5,000
Bad Debts 4,500
NP (transferred to Ankit Capital A/c) 19,500
62,000 62,000
 Balance Sheet of Ankit as at March 31, 2017

Liabilities Amt Assets Amt

Owners funds Non-Current Assets
Capital 12,000 31500 Furniture 15,000
NP 19,500
Non-Current Liabilities Current Assets
Long-term loan 5,000 Debtors 15,500
Current Liabilities Bank 5,000
Creditors 15,000 Cash 1,000
Closing Stock 15,000
51,500 51,500

Closing Stock

The closing stock represents the cost of unsold goods lying in the stores at the end of the
accounting period. The adjustment with regard to the closing stock is done by

(i) by crediting it to the trading and profit and loss account, and
(ii) (ii) by showing it on the asset side of the balance sheet.

The adjustment entry to be recorded in this regard is :

Closing stock A/c Dr.

To Trading A/c

The closing stock of the year becomes the opening stock of the next year and is reflected in the
trial balance of the next year.

Sometimes the opening and closing stock are adjusted through purchases account. In that case,
the entry recorded is as follows :

Closing stock A/c Dr.

To Purchases A/c

This entry reduces the amount in the purchases account and is also known as adjusted purchases
which are shown on the debit side of the trading and profit and loss account. In this context, it
may be noted, that the closing stock will not be shown on the credit side of the trading and profit
and loss as it has been already been adjusted through the purchases account. Not only, in such a
situation, even the opening stock will not be separately reflected in the trading and profit and loss
account, as it is also adjusted in purchases by recording the following entry:
Purchases A/c Dr.

To Opening stock A/c

Another important point to be noted in this context is that when the opening and closing stocks
are adjusted through purchases, the trial balance does not show any opening stock. Instead, the
closing stock shall appear in the trial balance (not as additional information or as an adjustment
item) and so also the adjusted purchases. In such a situation, the adjusted purchases shall be
debited to the trading and profit and loss account.

Outstanding Expenses

It is quite common for a business enterprise to have some unpaid expenses in the normal course
of business operations at the end of an accounting year. Such items usually are wages, salaries,
interest on loan, etc. When expenses of an accounting period remain unpaid at the end of an
accounting period, they are termed as outstanding expenses. As they relate to the earning of
revenue during the current accounting year, it is logical that they should be duly charged against
revenue for computation of the correct amount of profit or loss. The entry to bring such expenses
into account is :

Concerned expense A/c Dr.

To Outstanding expense A/c

The above entry opens a new account called Outstanding Expenses which is shown on the
liabilities side of the balance sheet. The amount of outstanding expenses is added to the total of
expenses under a particular head for the purpose of preparing trading and profit and loss account.

You will notice that wages are shown at 8,000. Let us assume that Ankit owes 500 as wages
relating to the year 2016-17 to one of his employees. In that case, the correct expense on wages
amounts to ` 8,500 instead of ` 8,000. Ankit must show 8,500 as expense on account of wages in
the trading and profit and loss account and recognise a current liability of 500 towards the sum
owed to his staff. It will be referred to as wages outstanding and it will be adjusted to wages
account by recording the following journal entry:

Wages A/c Dr. 500

To Wages outstanding A/c 500

The amount of outstanding wages will be added to wages account for the preparation of the
trading and profit and loss account as follows :
 Trading and Profit and Loss Account of Ankit

for the year ended March 31, 2017

Dr. Cr.

Expenses/Losses Amt Revenues/Gains Amt

Purchases 75,000 Sales 1,25,000
Wages 8,000 8,500 Closing stock 15,000
Add Outstanding wages 500
Gross profit c/d 56,500
1,40,000 1,40,000
Salaries 25,000 Gross profit b/d 56,500
Rent of building 13,000 Commission received 5,000
Bad debts 4,500
Net profit (transferred to 19,000 Ankit’s capital 19,000
account)

61,500 61,500

The item relating to outstanding wages will be shown in balance sheet as follows :

Balance Sheet of Ankit as at March 31, 2017

Liabilities Amt Assets Amt

Owners funds Non-Current Assets
Capital 12,000 31,000 Furniture 15,000
NP 19,000
Non-Current Current Assets
Liabilities
Long-term loan 5,000 Debtors 15,500
Current Liabilities Bank 5,000
Creditors 15,000 Cash 1,000
Outstanding wages 500 Closing Stock 15,000
51,500 51,500

Prepaid Expenses

There are several items of expense which are paid in advance in the normal course of business
operations. At the end of the accounting year, it is found that the benefits of such expenses have
not yet been fully received; a portion of its benefit would be received in the next accounting year.
This portion of expense, is carried forward to the next year and is termed as prepaid expenses.
The necessary adjustment in respect of prepaid expenses is made by recording the following
entry:
Prepaid expense A/c Dr.

To concerned expense A/c

The effect of the above adjustment entry is that the amount of prepaid part is deducted
from the total of the particular expense, and the new account of prepaid expense is shown on the
assets side of the balance sheet. For example, in Ankit’s trial balance, let us assume that the
amount of salary paid by him to the employees includes an amount of ` 5,000 which was paid in
advance to one of his employees upon his joining the office. This implies that Ankit has overpaid
his staff by ` 5,000 on account of his salary. Hence, correct expense on account of salary during
the current period will be ` 20,000 instead of ` 25,000. Ankit must show ` 20,000 expense on
account of salary in the profit and loss account and recognise a current asset of ` 5,000 as an
advance salary to the employee. It will be termed as prepaid salary account and will be recorded
by the following journal entry :

Prepaid salary A/c Dr. 5,000

To salary A/c 5,000

The account of prepaid salary will be shown in the trading and profit and loss account as follows:

Trading and Profit and Loss Account of Ankit

for the year ended March 31, 2017

Dr. Cr.

Expenses/Losses Amt Revenues/Gains Amt

Purchases 75,000 Sales 1,25,000
Wages 8,000 8,500 Closing stock 15,000
Add Outstanding wages 500
Gross profit c/d 56,500
1,40,000 1,40,000
Salaries 25,000 20,000 Gross profit b/d 56,500
Less: Prepaid Salary (5,000)
Rent of building 13,000 Commission received 5,000
Bad debts 4,500
Net profit (transferred Ankit’s capital account) 24,000

61,500 61,500
 Balance Sheet of Ankit as at March 31, 2017

Liabilities Amt Assets Amt

Owners funds Non-Current Assets
Capital 12,000 36,000 Furniture 15,000
NP 24,000
Non-Current Current Assets
Liabilities
Long-term loan 5,000 Debtors 15,500
Current Liabilities Bank 5,000
Creditors 15,000 Cash 1,000
Outstanding wages 500 Closing Stock 15,000
Prepaid Salary 5,000
56,500 56,500

Depreciation

Depreciation is the decline in the value of assets on account of wear and tear and passage of
time. It is treated as a business expense and is debited to profit and loss account. This, in effect,
amounts to writing-off a portion of the cost of an asset which has been used in the business for
the purpose of earning profits. The entry for providing depreciation is :

Depreciation A/c Dr.

To Concerned asset A/c

In the balance sheet, the asset will be shown at cost minus the amount of depreciation.
For example, the trial balance in our example shows that Ankit has a furniture account with a
balance of ` 15,000. Let us assume that furniture is subject to a depreciation of 10% per annum.
This implies that Ankit must recognise that at the end of the year the value attached to furniture
is to be reduced by ` 1,500 (` 15,000 × 10%). Ankit needs to record an adjustment entry to give
effect to depreciation on furniture as follows :

Depreciation A/c Dr. 1,500

To Furniture A/c 1,500

Depreciation will be shown in the profit and loss account and balance sheet as follows :
 Trading and Profit and Loss Account of Ankit

for the year ended March 31, 2017

Dr. Cr.

Expenses/Losses Amt Revenues/Gains Amt

Purchases 75,000 Sales 1,25,000
Wages 8,000 8,500 Closing stock 15,000
Add Outstanding wages 500
Gross profit c/d 56,500
1,40,000 1,40,000
Salaries 25,000 20,000 Gross profit b/d 56,500
Less: Prepaid Salary (5,000)
Rent of building 13,000 Commission received 5,000 6,500
Add Accrued Commission 1,500
Depreciation-Furniture 1,500
Bad debts 4,500
Net profit (transferred Ankit’s capital 24,000
account)

63,000 63,000

Balance Sheet of Ankit as at March 31, 2017

Liabilities Amt Assets Amt

Owners funds Non-Current Assets
Capital 12,000 36,000 Furniture 15,000 13,500
NP 24,000 Less Depreciation (1,500)
Non-Current Liabilities Current Assets
Long-term loan 5,000 Debtors 15,500
Current Liabilities Bank 5,000
Creditors 15,000 Cash 4,000
Outstanding wages 500 Closing Stock 15,000
Rent received in advance 3,000 Prepaid Salary 5,000
Accrued commission 1,500
59,500 59,500