Financial Statements – II Part 1

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Every business enterprise records its transactions as per accounting principles and procedures which have taken place during the accounting period. These transactions, first, recorded in Journal Books based on nature of transactions. Then those entries passed on to ledger accounts. Trial Balance is prepared based on Ledger accounts. This Trial Balance is used to prepare two important financial statement i.e. Trading and Profit and Loss A/c and Balance Sheet.

But, Trial Balance does not provide entire information. E.g. Income or Expenditures do not pertain to accounting period and amount accrued but not been accounted. Financial statements, without considering such information are not accurate. In order to provide true financial statements we need to take whole information. This is done by making necessary adjustments in accounts.

Image of Financial Statements

Image of Financial Statements

Image of Financial Statements

  • Income/Expenses do not pertain to accounting period need to be excluded from Financial Statements.

  • Some left items in trial balance need to be considered and they should be included in Financial Statements.

  • Adjustments are done as per accounting procedures and principles i.e. double entry system.

  • Number of adjustments depends on nature and volume of activities of business.

Adjustments and Their Incorporation:

Some of the items of adjustment and their treatment in financial statements –

Closing Stock:

Closing stock refers to the unsold goods at the end of the accounting period. Closing stock does not appear in Trial Balance but that should be considered while preparing financial statements. Closing Stock will be sold in future, so, that is an asset for the business enterprise. Thus, closing stock will appear on credit side of both Trading and P&L A/c and Balance Sheet.

Image of Adjustment Entry Closing Stock

Image of Adjustment Entry Closing Stock

Image of Adjustment Entry Closing Stock

Effect of adjustment on Financial Statement:

  • Closing Stock will appear on Credit Side in Trading A/c

  • Closing Stock will appear on Credit Side in Balance Sheet

Outstanding Expenses:

Expenses relating to current accounting period but not yet paid are considered as Outstanding Expenses. E.g. Rent is not paid for current accounting period and it is paid in the beginning of next accounting year. In such situation, those expenses need to be added to the current accounting period while preparing Financial Statements.

Image of Adjustment Entry

Image of Adjustment Entry

Image of Adjustment Entry

Effect of entry on Financial Statements:

  • Outstanding expenses should be added to the expenses under particular heads. And they appear on debit side in Profit & Loss A/c

  • Outstanding expenses are liabilities to the firm and they will appear on debit side of the Balance Sheet.

Prepaid Expenses:

Sometimes, firms need to pay in advance in order to get services in upcoming days. E.g. Rent paid in advance, Insurance premium paid in advance, Salaries paid in advance etc. Those advances are expenditures for the current accounting period but in reality they are not expenses for this current period. So, they should not be considered as expenses while preparing financial statements.

Image of Prepaid Expenses

Image of Prepaid Expenses

Image of Prepaid Expenses

Effect of Adjustment entry on Financial Statements:

  • Prepaid expenses should be deducted from the expenses under particular heads. And, they will appear on Debit side of the P&L A/c.

  • Prepaid expenses are assets to the firm and they will appear on credit side of the Balance Sheet.

Accrued Income

Sometimes, income earned by the business firm but the payment not received in the same accounting period. Such kind of transactions will not appear in Trial Balance but in reality those earning should be considered for the current accounting period. E.g. Rent received as accrued income, interest received on securities as accrued income etc.

Adjustment Entry:

Rent Received (Accrued) A/c Dr.

To Rent Received A/c

(Amount of rent due but not received)

Image of Accrued Income

Image of Accrued Income

Image of Accrued Income

Effect of Adjustment entry on Financial Statements:

  • Accrued incomes should be added as accrued income under particular heads. And, they will appear on Credit side of the P&L A/c.

  • Accrued incomes are assets to the firm and they will appear on Credit side of the Balance Sheet.