Introduction
Financial statements prepared from the Trial Balance alone may not reflect the true financial position of a business. Certain items that relate to the accounting period but are not recorded in the books require adjustments to present an accurate picture.
This chapter covers how various adjustments are treated in the Trading Account, Profit & Loss Account, and Balance Sheet to ensure that financial statements follow the accrual concept and matching principle.
Learning Objectives
- Understand why adjustments are necessary in financial statements
- Learn the treatment of common adjustments
- Apply adjustments correctly in Trading, P&L Account, and Balance Sheet
- Prepare final accounts with multiple adjustments
What are Adjustments?
Adjustments are entries made at the end of the accounting period to update accounts and ensure that all revenues and expenses relating to the period are properly recorded.
Key Reasons:
- Accrual Principle: Record revenues when earned and expenses when incurred, not when cash is received or paid
- Matching Principle: Match expenses with the revenues they help generate in the same period
- True & Fair View: Present accurate financial position to stakeholders
- Periodic Concept: Allocate items correctly between accounting periods
Most adjustments appear at TWO places:
- Once in Trading/P&L Account – to affect the profit calculation
- Once in Balance Sheet – to show the asset or liability position
Exception: Closing Stock appears at two places (Trading Account Credit side + Balance Sheet Assets), but both represent the same value.
Types of Adjustments
The most common adjustments encountered in final accounts preparation:
ADJUSTMENTS
Items requiring treatment at year-end
Closing Stock
Unsold inventory at year-end
Outstanding Expenses
Expenses due but not yet paid
Prepaid Expenses
Expenses paid in advance
Accrued Income
Income earned but not received
Unearned Income
Income received in advance
Depreciation
Decrease in asset value
Bad Debts
Irrecoverable debts written off
Provision for Doubtful Debts
Reserve for potential bad debts
Interest on Capital
Return on owner's investment
Adjustments in Trading Account
The Trading Account is used to calculate Gross Profit. Only adjustments related to purchase and sale of goods appear here.
Closing Stock
Value of unsold goods at year-end.
- Always valued at Cost or NRV (whichever is lower)
- Increases Gross Profit
Opening Stock
Value of unsold goods from previous year.
- Appears in Trial Balance
- Carried forward from last year
Goods Lost by Fire/Accident
Cost of goods destroyed (if uninsured).
- If insured: Insurance Claim A/c (Asset)
- Reduce from purchases or show separately
Goods Withdrawn for Personal Use
Goods taken by owner (Drawings).
- Reduces total purchases
- Added to Drawings in Capital section
Gross Profit Formula
Cost of Goods Sold (COGS)
Detailed Treatment: Closing Stock
Closing stock is one of the most important adjustments. Its treatment depends on where it appears.
Case 1: Given Outside Trial Balance
When closing stock is given as an adjustment (not in TB):
2. Asset side of Balance Sheet (Current Asset)
Appears at TWO places
Case 2: Given Inside Trial Balance
When closing stock already appears in Trial Balance:
(Already adjusted in Trading A/c)
Appears at ONE place only
Numerical Example: Closing Stock
Given: Opening Stock ₹25,000 | Purchases ₹1,50,000 | Sales ₹2,00,000 | Closing Stock ₹30,000 (not in TB)
Trading Account:
Debit: Opening Stock ₹25,000 + Purchases ₹1,50,000 = ₹1,75,000
Credit: Sales ₹2,00,000 + Closing Stock ₹30,000 = ₹2,30,000
Gross Profit = ₹2,30,000 - ₹1,75,000 = ₹55,000
Balance Sheet: Closing Stock ₹30,000 shown as Current Asset
Stock Valuation Rule
Outstanding & Prepaid Items (Detailed)
These adjustments ensure that only current period's expenses and incomes are considered.
Definition: Expenses that relate to the current accounting period but have not yet been paid.
Examples: Outstanding Salary, Outstanding Rent, Outstanding Wages, Outstanding Interest
Journal Entry
To Outstanding Expense A/c
Example: Salary given in TB = ₹48,000 | Outstanding Salary = ₹4,000
- P&L Account: Salary shown as ₹48,000 + ₹4,000 = ₹52,000 (Debit side)
- Balance Sheet: Outstanding Salary ₹4,000 shown as Current Liability
Definition: Expenses that have been paid in advance for the next accounting period.
Examples: Prepaid Insurance, Prepaid Rent, Prepaid Subscription
Journal Entry
To Expense A/c
Example: Insurance in TB = ₹12,000 | Prepaid Insurance = ₹2,000
- P&L Account: Insurance shown as ₹12,000 - ₹2,000 = ₹10,000 (Debit side)
- Balance Sheet: Prepaid Insurance ₹2,000 shown as Current Asset
Definition: Income that has been earned during the current period but not yet received.
Examples: Accrued Interest, Accrued Commission, Accrued Rent Receivable
Journal Entry
To Income A/c
Example: Interest Received in TB = ₹8,000 | Accrued Interest = ₹1,500
- P&L Account: Interest shown as ₹8,000 + ₹1,500 = ₹9,500 (Credit side)
- Balance Sheet: Accrued Interest ₹1,500 shown as Current Asset
Definition: Income received for services/goods to be provided in the next period.
Examples: Rent Received in Advance, Subscription Received in Advance
Journal Entry
To Unearned Income A/c
Example: Rent Received in TB = ₹24,000 | Advance Rent = ₹3,000
- P&L Account: Rent shown as ₹24,000 - ₹3,000 = ₹21,000 (Credit side)
- Balance Sheet: Rent Received in Advance ₹3,000 shown as Current Liability
Memory Trick
Outstanding/Accrued: "O" and "A" = "Add" to the amount
Prepaid/Advance: "P" and "A" = "Put Away" (subtract) from the amount
Depreciation - Detailed Treatment
Depreciation represents the gradual decrease in the value of fixed assets due to use, wear and tear, or obsolescence.
On Which Assets?
Depreciation is charged on:
- Machinery & Plant
- Furniture & Fixtures
- Motor Vehicles
- Buildings (not Land!)
- Computer Equipment
- Office Equipment
Note: Land is NOT depreciated as its value appreciates over time.
Common Depreciation Rates
- Plant & Machinery: 10-15%
- Furniture: 10%
- Motor Vehicles: 15-20%
- Buildings: 5-10%
- Computers: 40-60%
Numerical Example: Depreciation
Given: Machinery ₹1,00,000 | Depreciation @ 10% p.a.
Calculation: Depreciation = ₹1,00,000 × 10% = ₹10,000
Treatment:
• P&L Account: Depreciation ₹10,000 on Debit side
• Balance Sheet: Machinery shown as ₹1,00,000 - ₹10,000 = ₹90,000
Journal Entry for Depreciation
To Machinery A/c ₹10,000
Bad Debts - Detailed Treatment
Bad debts are amounts owed by debtors that are considered irrecoverable.
Bad Debts in Trial Balance
When bad debts already appear in TB:
(Already deducted from Debtors)
Additional Bad Debts (Adjustment)
When extra bad debts are given in adjustments:
B/S: Deduct from Debtors
Bad Debts Recovered
Previously written off debts that are now recovered:
(It's an income/gain)
Complete Bad Debts Entry
In P&L Account, show as:
- Bad Debts (from TB): ₹X
- Add: Additional Bad Debts: ₹Y
- Total Bad Debts: ₹(X+Y)
Numerical Example: Bad Debts
Given: Debtors ₹80,000 | Bad Debts (in TB) ₹2,000 | Additional Bad Debts ₹3,000
P&L Account (Debit side):
Bad Debts ₹2,000 + ₹3,000 = ₹5,000
Balance Sheet:
Debtors: ₹80,000 - ₹3,000 = ₹77,000
(Note: TB bad debts already deducted from original debtors)
Interest on Capital & Drawings
These adjustments relate to the owner's investment and withdrawals from the business.
Interest on Capital
Definition: Return given to the owner on the capital invested in the business.
Nature: It's an expense for the business (reduces profit).
Interest on Drawings
Definition: Interest charged on the amounts withdrawn by the owner for personal use.
Nature: It's an income for the business (charged to owner).
Numerical Example
Given: Capital ₹2,00,000 | Drawings ₹30,000 | Interest @ 6% p.a.
Interest on Capital: ₹2,00,000 × 6% = ₹12,000
Interest on Drawings: ₹30,000 × 6% × 6/12 = ₹900 (assuming avg. 6 months)
Balance Sheet - Capital Section:
Capital: ₹2,00,000
Add: Interest on Capital: ₹12,000
Less: Drawings: ₹30,000
Less: Interest on Drawings: ₹900
Closing Capital: ₹1,81,100
Manager's Commission
Commission payable to manager based on profits requires special calculation.
Case 1: Commission on Net Profit BEFORE charging commission
Simple calculation - calculate directly on Net Profit.
Example: NP = ₹50,000 | Rate = 10%
Commission = ₹50,000 × 10% = ₹5,000
Case 2: Commission on Net Profit AFTER charging commission
Use the formula method - commission is part of the denominator.
Example: NP = ₹55,000 | Rate = 10%
Commission = ₹55,000 × 10 ÷ 110 = ₹5,000
Balance Sheet: Current Liability (Commission Payable)
Special Goods Adjustments
Various situations where goods need special treatment in final accounts.
Goods Withdrawn for Personal Use
Owner takes goods for personal consumption (Drawings in Kind).
Balance Sheet: Add to Drawings
To Purchases A/c
Goods Distributed as Free Samples
Goods given away for advertising/promotional purposes.
P&L A/c: Debit Advertisement A/c
To Purchases A/c
Goods Lost by Fire (Uninsured)
Goods destroyed by fire/accident with no insurance.
P&L A/c: Debit Loss by Fire A/c
Goods Lost by Fire (Insured)
Goods destroyed but covered by insurance policy.
Balance Sheet: Insurance Claim (Asset)
If claim < loss: Show difference as Loss in P&L A/c
Comprehensive Worked Example
Let's prepare final accounts with multiple adjustments.
Question
From the following Trial Balance of M/s Sharma Traders as on 31st March 2024, prepare Trading and Profit & Loss Account and Balance Sheet with the given adjustments.
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| Capital | - | 2,00,000 |
| Drawings | 24,000 | - |
| Machinery | 80,000 | - |
| Opening Stock | 30,000 | - |
| Purchases | 1,50,000 | - |
| Sales | - | 2,50,000 |
| Sundry Debtors | 60,000 | - |
| Sundry Creditors | - | 40,000 |
| Salary | 36,000 | - |
| Rent | 18,000 | - |
| Bad Debts | 2,000 | - |
| Commission Received | - | 10,000 |
| Cash at Bank | 50,000 | - |
| Provision for Doubtful Debts | - | 3,000 |
| Furniture | 53,000 | - |
| Total | 5,03,000 | 5,03,000 |
Adjustments
- Closing Stock valued at ₹40,000
- Outstanding Salary ₹4,000
- Prepaid Rent ₹3,000
- Depreciation on Machinery @ 10% and Furniture @ 10%
- Additional Bad Debts ₹2,000
- Create provision for doubtful debts @ 5% on debtors
- Accrued Commission ₹1,500
Working Notes
1. Depreciation:
Machinery: ₹80,000 × 10% = ₹8,000
Furniture: ₹53,000 × 10% = ₹5,300
Total Depreciation = ₹13,300
2. Provision for Doubtful Debts:
Debtors (from TB): ₹60,000
Less: Additional Bad Debts: ₹2,000
Good Debtors: ₹58,000
New Provision @ 5%: ₹58,000 × 5% = ₹2,900
Old Provision: ₹3,000
Decrease in Provision: ₹3,000 - ₹2,900 = ₹100 (Credit P&L)
3. Total Bad Debts:
Bad Debts (TB): ₹2,000 + Additional: ₹2,000 = ₹4,000
| Trading and Profit & Loss Account | |
|---|---|
| Particulars (Dr.) | Particulars (Cr.) |
|
Trading Account Opening Stock: ₹30,000 Purchases: ₹1,50,000 Gross Profit c/d: ₹1,10,000 |
Trading Account Sales: ₹2,50,000 Closing Stock: ₹40,000 |
| Total: ₹2,90,000 | Total: ₹2,90,000 |
|
P&L Account Salary (₹36,000 + ₹4,000): ₹40,000 Rent (₹18,000 - ₹3,000): ₹15,000 Bad Debts: ₹4,000 Depreciation: ₹13,300 Net Profit: ₹49,200 |
P&L Account Gross Profit b/d: ₹1,10,000 Commission (₹10,000 + ₹1,500): ₹11,500 Provision Written Back: ₹100 |
| Total: ₹1,21,500 | Total: ₹1,21,500 |
| Balance Sheet as on 31st March 2024 | |
|---|---|
| Liabilities | Assets |
|
Capital: Opening Capital: ₹2,00,000 Add: Net Profit: ₹49,200 Less: Drawings: ₹24,000 Closing Capital: ₹2,25,200 Current Liabilities: Sundry Creditors: ₹40,000 Outstanding Salary: ₹4,000 Total: ₹44,000 |
Fixed Assets: Machinery: ₹80,000 Less: Depreciation: ₹8,000 = ₹72,000 Furniture: ₹53,000 Less: Depreciation: ₹5,300 = ₹47,700 Current Assets: Closing Stock: ₹40,000 Debtors: ₹60,000 Less: Bad Debts: ₹2,000 = ₹58,000 Less: Provision: ₹2,900 = ₹55,100 Prepaid Rent: ₹3,000 Accrued Commission: ₹1,500 Cash at Bank: ₹50,000 |
| Total: ₹2,69,200 | Total: ₹2,69,300 |
Adjustments in Profit & Loss Account
The Profit & Loss Account calculates Net Profit by considering all indirect expenses and incomes.
Outstanding Expenses
Expenses incurred but not yet paid (e.g., outstanding salary, rent).
Prepaid Expenses
Expenses paid in advance for next period (e.g., prepaid insurance).
Accrued Income
Income earned but not yet received (e.g., accrued interest, commission).
Income Received in Advance
Income received for next period (e.g., rent received in advance).
Depreciation
Decrease in value of fixed assets due to use, wear & tear.
Bad Debts
Debts that are confirmed irrecoverable.
Provision for Doubtful Debts
A provision created for debts that may become bad in the future. It follows the principle of prudence/conservatism.
Steps to calculate:
- Step 1: Start with Debtors from Trial Balance
- Step 2: Deduct Additional Bad Debts (given in adjustments)
- Step 3: Calculate the required % on remaining debtors
- Step 4: Compare with Old Provision
New Provision Formula
If New Provision > Old Provision:
- Increase = New Provision − Old Provision
- Debit P&L A/c with the increase
If New Provision < Old Provision:
- Decrease = Old Provision − New Provision
- Credit P&L A/c with the decrease (as income)
Debtors in Balance Sheet:
- Sundry Debtors (from TB): ₹XX,XXX
- Less: Additional Bad Debts: ₹X,XXX
- Less: New Provision for Doubtful Debts: ₹X,XXX
- Net Debtors: ₹XX,XXX
Important Note
Provision for Doubtful Debts is calculated on Good Debtors only (after deducting bad debts). Never calculate provision on bad debts!
Summary: Treatment of All Adjustments
Quick reference table for all common adjustments:
| Adjustment | Trading / P&L Account | Balance Sheet |
|---|---|---|
| Closing Stock | Credit side of Trading A/c | Asset (Current Asset) |
| Outstanding Expenses | Add to expense (Debit side P&L) | Current Liability |
| Prepaid Expenses | Deduct from expense (Debit side P&L) | Current Asset |
| Accrued Income | Add to income (Credit side P&L) | Current Asset |
| Income Received in Advance | Deduct from income (Credit side P&L) | Current Liability |
| Depreciation | Debit side of P&L A/c | Deduct from Fixed Asset |
| Bad Debts (Additional) | Add to TB Bad Debts (Debit P&L) | Deduct from Debtors |
| Provision for Doubtful Debts (New > Old) | Debit P&L with increase | Deduct from Debtors |
| Provision for Doubtful Debts (New < Old) | Credit P&L with decrease | Deduct from Debtors |
| Interest on Capital | Debit side of P&L A/c | Add to Capital |
| Interest on Drawings | Credit side of P&L A/c | Add to Drawings (reduce Capital) |
| Goods Distributed as Free Samples | Deduct from Purchases / Debit Advertisement | No effect |
| Manager's Commission on Net Profit | Debit P&L A/c | Current Liability |
Key Points to Remember
Double Entry Principle
Every adjustment affects two places in the final accounts — this maintains the balance.
Outstanding vs Prepaid
Outstanding: Add to expense + Liability
Prepaid: Deduct from
expense + Asset
Accrued vs Unearned
Accrued: Add to income + Asset
Unearned: Deduct from income
+ Liability
Closing Stock Location
If given inside Trial Balance: Only Balance Sheet
If given outside: Trading A/c + Balance
Sheet
Manager's Commission
If on Net Profit before charging commission: Calculate on NP
If on Net Profit
after charging: Use formula method
Provision Calculation
Always calculate on Good Debtors = Debtors − Additional Bad Debts