NCERT Solution: Financial Statements - II (Part- 1)

Short Question Answers

Q1: Why is it necessary to record the adjusting entries in the preparation of final accounts?
Ans: Adjusting entries are necessary in preparation of final accounts because: 

• It ensures that income and expenses are recorded in the period to which they belong, so the accounts show the true and fair view of business performance for the current year.
• It eliminates amounts that belong to prior years or to future years, so that profits are not overstated or understated for the current year.
• Omissions or errors identified at year end are corrected by adjusting entries, so final accounts are complete and reliable.
• Adjustments create necessary provisions (for doubtful debts, depreciation, etc.) and accrue or defer items where required, ensuring proper presentation in the balance sheet and profit & loss account.

Q2: What is meant by closing stock? Show its treatment in final accounts?
Ans: The closing stock (closing inventory) comprises goods unsold at the end of the accounting period. Closing stock is valued at cost or net realizable value, whichever is lower. For example, if the cost of unsold goods is Rs. 5,000 and the net realizable value is Rs. 4,500, the closing stock is valued at Rs. 4,500.
The treatment of closing stock in the final accounts is as follows:

• If closing stock already appears in the trial balance, it is shown as a current asset in the balance sheet at the reporting date.
• If closing stock is provided as an adjustment (not in the trial balance), it is shown on the credit side of the trading account (to determine gross profit) and also as a current asset in the balance sheet.

Q3: State the meaning of:
(a) Outstanding expenses
(b) Prepaid expenses
(c) Income received in advance
(d) Accrued income
Ans: 
(a) Outstanding expenses: These are expenses that relate to the current accounting period but remain unpaid at the balance sheet date. They are recognised as a liability in the balance sheet and as an expense in the profit & loss account for the period to which they relate.
(b) Prepaid expenses: Payments made in advance for expenses that will benefit future periods. These are treated as a current asset at the balance sheet date and the corresponding expense is reduced in the profit & loss account to reflect only the portion that relates to the current period.
(c) Income received in advance: Receipts of income before it is earned or due. Such amounts are treated as a liability because the business is obliged to provide goods or services in the future or refund the amount if services are not provided.
(d) Accrued income: Income that has been earned during the period but not yet received in cash. It is recognised as a current asset and shown in the profit & loss account as income for the period to which it relates.

Q4: Give the Performa of income statement and balance in vertical form.
Ans: 
Performa Income Statement 
Income statement for the year ending 

Balance sheet as on......

Q5: Why is it necessary to create a provision for doubtful debts at the time of preparation of final accounts?
Ans: A provision for doubtful debts is created to recognise the likelihood that some trade receivables may not be collected. It is a prudent and conservative practice which:

• Matches the expense of expected bad debts to the same period in which the related sales were made (matching principle).
• Prevents overstatement of assets by presenting debtors at their probable realisable value (net of provision).
• Provides realistic profit figures by recognising expected losses in advance rather than in the year when debts actually become irrecoverable.

Q6: What adjusting entries would you record for the following :
(a) Depreciation
(b) Discount on debtors
(c) Interest on capital
(d) Manager's commission
Ans: 
(a) Depreciation :

• Shown in debit of profit and loss account 
• Shown as deduction from asset in Balance sheet.

Profit & Loss Account  for the year ended 31.03.2017
Balance Sheet as on 31.03.17(b) Discount on debtors : 

• Shown in debit of profit and loss account 
• Shown as deduction from debtors in Balance sheet.

Profit & Loss Account  for the year ended 31.03.2017

Balance Sheet  as on 31.03.17

(c) Interest on Capital:

• Shown in debit of profit and loss account 
• Shown as addition to Capital in Balance sheet.

Profit & Loss Account  for the year ended 31.03.2017
Balance Sheet as on 31.03.17

(d) Manager's commission: 

• Shown in debit of profit and loss account 
• Shown as Outstanding liability in Balance sheet.

Profit & Loss Account  for the year ended 31.03.2017

Balance Sheet  as on 31.03.17

Q7: What is meant by provision for discount on debtors?
Ans: The provision for discount on debtors is an estimated amount set aside to cover discounts that the business expects to allow to its customers (debtors) for early or prompt payment. It is created so that the net amount shown against debtors in the balance sheet reflects the expected realisable value. Accounting treatment:

• Create provision by debiting Profit & Loss A/c and crediting Provision for Discount on Debtors (or a suitable allowance account).
• In the balance sheet, show it as a deduction from debtors to present debtors at the net expected recoverable amount.

Q8: Give the journal entries for the following adjustments :
(a) Outstanding salary ` 3,500.
(b) Rent unpaid for one month at ` 6,000 per annum.
(c) Insurance prepaid for a quarter at ` 16,000 per annum.
(d) Purchase of furniture costing ` 7,000 entered in the purchases book.
Ans: 

Long Question Answers

Q1: What are adjusting entries? Why are they necessary for preparing final accounts?
Ans: The adjusting entries are journal entries made at the end of an accounting period to allocate income and expenses to the period in which they were incurred or earned. They correct and update balances so that the final accounts reflect the correct financial position and results of operations. Adjustments are needed for items such as accruals, prepayments, depreciation, provisions and corrections of errors.
It is necessary to make adjusting entries while preparing final accounts because:

• They ensure that revenue and related expenses are recognised in the same period so profit is correctly measured.
• They remove amounts that belong to other periods (prior or future), preventing misstatement of financial results.
• They correct omissions and provide for necessary allowances (for doubtful debts, depreciation), improving reliability of financial statements.
• They ensure compliance with accounting principles (matching and prudence), enabling fair presentation to users of accounts.

Q2: What is meant by provision for doubtful debts? How are the relevant accounts prepared and what journal entries are recorded in final accounts? How is the amount for provision for doubtful debts calculated?
Ans: The maintenance of the provision for discount on debtors is done in order to encourage the payment from the debtors of the business before the date which is due. The discount is hence made to encourage the timely payment by the debtors, especially those who have a bad record for doing so. It is considered to be the prudent practice for any business organisation as it reduces the scope of actual loss by the business.
Whenever the provision for bad debts is made, the bad debts which arise after the provision is made shall be adjusted firstly against the provision so made and not the debtors. 
For example: The trial Balance of a company is extracted as follows
Adjustment: 
(i) Further Bad debt amounting to Rs.400 
(ii) Create a provision for doubtful debts @ 8% on debtors.
In the above example the Bad debts is Rs.1000 and further Bad debts Rs.400 is known at the year end. Provision for doubtful debts is created after deducting the further bad debts from the debtors. It is shown as addition to Bad debts in Profit & Loss account and as a deduction from debtors. It is illustrated below:
Profit & Loss Account  for the year ended 31.03.2017
Balance Sheet as on 31.03.17

Q3: Show the treatment of prepaid expenses depreciation, closing stock at the time of preparation of final accounts when:
(a) When given inside the trial balance?
(b) When given outside the trial balance?
Ans: 
Prepaid expense:
(a) When given in Trial Balance: Will be shown in asset side of balance sheet.

(b) When given Outside trail balance: 

• Will be shown as deduction from particular expense in Profit and loss account and 
• Will be shown in asset side of Balance sheet 

Profit & Loss Account  for the year ended 31.03.2017

Balance sheet as on 31.03.2017

Depreciation:

(a) If already in Trail Balance: Then depreciation is shown in Debit side of Profit and loss account. The asset figure in Trail balance will be after depreciation. 
(b) If outside the trial balance : 

• Shown in debit of profit and loss account 
• Shown as deduction from asset in Balance sheet.

Profit & Loss Account  for the year ended 31.03.2017

Closing stock:
(a) If given in Trail Balance: It will be shown only in asset side of balance sheet. The Purchases would be already adjusted for closing stock in Profit & loss account. Hence closing stock will not be shown in Trading and Profit and loss account. 
(b) If given outside Trial Balance: 

• It will be shown in credit side of Trading Account
• And shown in asset side of the Balance sheet.

Trading Account  for the year ended 31.03.2017
Balance Sheet as on 31.03.17

Numerical Question Answers

Q1: Prepare a trading and profit and loss account for the year ending March 31, 2017. from the balances extracted of M/s Rahul Sons.  Also prepare a balance sheet at the end of the year.

Adjustments 
1. Commission received in advance Rs.1,000. 
2. Rent receivable Rs. 2,000. 
3. Salary outstanding Rs. 1,000 and insurance prepaid Rs. 800.
4. Further bad debts Rs. 1,000 and provision for doubtful debts @ 5% on debtors and discount on debtors @ 2%. 
5. Closing stock Rs. 32,000. 
6. Depreciation on building @ 6% p.a.
Ans: 
Books of M/s. Rahul Sons.

Q2: Prepare a trading and profit and loss account of M/s Green Club Ltd. for the year ending March 31, 2017. from the following figures taken from his trial balance :

Adjustments 
1. Depreciation charged on machinery @ 5% p.a. 
2. Further bad debts Rs.1,500, discount on debtors @ 5% and make a provision on debtors @ 6%. 
3. Wages prepaid Rs.1,000. 
4. Interest on investment @ 5% p.a. 
5. Closing stock 10,000.
Ans: 
Books of M/s. Green Club Ltd

Q3: The following balances has been extracted from the trial of M/s Runway Shine Ltd. Prepare a trading and profit and loss account and a balance sheet as on December 31, 2017.

Adjustments
1. Further bad debts Rs. 1,000. Discount on debtors Rs. 500 and make a provision on debtors @ 5%.
2. Interest received on investment @ 5%.
3. Wages and interest outstanding Rs. 100 and Rs. 200 respectively.
4. Depreciation charged on motor car @ 5% p.a.
5. Closing Stock Rs. 32,500.
Ans:

Balance Sheet