Final Accounts with Year-End Adjustments

At the end of the fiscal year, the ledger holds hundreds of balances, but the owner wants three answers: what was the gross margin on goods, what was the net profit, and what does the business own and owe? The final accounts answer them: the Trading Account, the Profit and Loss Account and the Balance Sheet.

Before they can be prepared, the trial balance must be corrected for the adjustments that accrual accounting demands.

6.1 Trading Account

The Trading Account shows the gross result of buying and selling goods:

• Debit side: opening stock, purchases less purchases returns, direct expenses (carriage inwards, wages, freight, import duty).
• Credit side: net sales (sales less sales returns) and closing stock.

Cost of goods sold = opening stock + net purchases + direct expenses − closing stock. Gross profit = net sales − cost of goods sold. A gross loss arises if the balance is the other way.

6.2 Profit and Loss Account

The Profit and Loss Account starts with the gross profit and subtracts indirect (operating) expenses: salaries, rent, depreciation, bad debts, interest, advertising. It adds other incomes (interest and commission received).

The result is net profit, which is transferred to the owner's capital account. Items are included on an accrual basis for the period only.

6.3 Balance Sheet

The Balance Sheet is a statement of position at a date, not an account. Assets are listed (in the Nepali tradition, often in order of liquidity or permanence) on one side, liabilities and capital on the other.

Classification: non-current assets (fixed), current assets (cash, debtors, stock, prepaid), non-current liabilities (long-term loans), current liabilities (creditors, outstanding expenses, bank overdraft), and equity.

6.4 Year-end adjustments

Adjustments are not in the trial balance, so each affects two places in the final accounts, the income statement and the balance sheet.

Adjustment	Income statement	Balance sheet
Closing stock	Credit of Trading Account (reduces COGS)	Current asset
Outstanding expense	Added to the expense	Current liability
Prepaid expense	Deducted from the expense	Current asset
Accrued income	Added to the income	Current asset
Income received in advance	Deducted from income	Current liability
Depreciation	Expense	Deducted from the asset
Bad debts written off	Expense	Deducted from debtors
Provision for doubtful debts	Expense (change in the provision)	Deducted from debtors
Drawings of goods	Deducted from purchases	Deducted from capital

6.5 A complete worked example

The trial balance of a trader (in rupees) at 31 Ashad is processed with these adjustments: closing stock Rs 70,000; salaries outstanding Rs 10,000; rent prepaid Rs 5,000; depreciation of furniture Rs 25,000; and a provision for doubtful debts of 2% on debtors.

The program lists the trial balance, asserts that it agrees, applies the adjustments and builds the three statements.

dr = {"Opening stock": 40000, "Purchases": 600000, "Sales returns": 20000, "Carriage inwards": 5000,
      "Wages": 30000, "Salaries": 110000, "Rent": 60000, "Furniture (cost)": 300000,
      "Bad debts": 8000, "Debtors": 200000, "Drawings": 30000, "Cash and bank": 223000}
cr = {"Capital": 500000, "Sales": 1000000, "Purchases returns": 10000,
      "Creditors": 110000, "Interest income": 6000}
assert sum(dr.values()) == sum(cr.values())
closing_stock, out_sal, pre_rent, dep = 70000, 10000, 5000, 25000
prov = dr["Debtors"] * 2 // 100

net_sales = cr["Sales"] - dr["Sales returns"]
cogs = (dr["Opening stock"] + dr["Purchases"] - cr["Purchases returns"]
        + dr["Carriage inwards"] + dr["Wages"] - closing_stock)
gross = net_sales - cogs
print(f"gross profit: {gross}")
expenses = (dr["Salaries"] + out_sal) + (dr["Rent"] - pre_rent) + dep + dr["Bad debts"] + prov
net = gross + cr["Interest income"] - expenses
print(f"net profit: {net}")

equity = cr["Capital"] + net - dr["Drawings"]
assets = (dr["Furniture (cost)"] - dep) + closing_stock + (dr["Debtors"] - prov) + pre_rent + dr["Cash and bank"]
liabilities = cr["Creditors"] + out_sal
print(f"balance sheet total: {assets} = {equity + liabilities}")
assert assets == equity + liabilities

tax = net * 25 // 100
print(f"company: tax {tax}, profit after tax {net - tax}")

gross profit: 385000
net profit: 179000
balance sheet total: 769000 = 769000
company: tax 44750, profit after tax 134250

Cost of goods sold is Rs 595,000 and the gross profit is Rs 385,000.

Operating expenses total Rs 212,000 (salaries 1,20,000, rent 55,000, depreciation 25,000, bad debts 8,000 and the 4,000 provision), and after adding interest income of Rs 6,000 the net profit is Rs 179,000.

Closing capital is 5,00,000 + 1,79,000 − 30,000 = Rs 649,000.

The balance sheet then reads:

Liabilities and equity	Rs	Assets	Rs
Capital (closing)	6,49,000	Furniture 3,00,000 − 25,000	2,75,000
Creditors	1,10,000	Closing stock	70,000
Salaries outstanding	10,000	Debtors 2,00,000 − provision 4,000	1,96,000
		Prepaid rent	5,000
		Cash and bank	2,23,000
Total	769,000	Total	769,000

6.6 Provision for doubtful debts

Bad debts actually written off are an expense. A provision estimates those still hidden in debtors. The provision is created at year end as a percentage of good debtors (after specific bad debts have been written off).

Only the change in the provision is charged each year: a first-time provision of Rs 4,000 is a full expense, whereas raising it to Rs 5,500 next year charges Rs 1,500 and lowering it credits the difference to Profit and Loss.

NFRS 9 (IFRS 9) goes further with expected credit losses, but the same logic of a charge and an offsetting contra-asset holds.

6.7 Final accounts of a company

A company's accounts differ in capital structure and distribution. Under the Companies Act 2063:

• Share capital (authorised, issued, paid-up), share premium, reserves and retained earnings replace the sole trader's capital.
• Profit before tax is reduced by income tax, taken here at the general corporate rate of 25% (banks and certain sectors carry different rates). The program shows tax of Rs 44,750 on a profit of 1,79,000, leaving profit after tax of Rs 134,250.
• Part of the after-tax profit may be distributed as dividend (cash or bonus shares), and statutory reserves may be required for some sectors. The rest is retained.
• Drawings do not exist; the owners are paid through dividends, and directors' pay is an expense.

Under NFRS the statements are renamed: Statement of Financial Position, Statement of Profit or Loss and Other Comprehensive Income, Statement of Changes in Equity and Statement of Cash Flows, with notes on policies.

The numbers computed here fit those headings directly.

6.8 Seeing the ideas: from sales to net profit, the balance sheet and the five adjustments

The three figures below redraw the worked example of 6.5 so that every rupee can be followed from sales to the balance sheet.

6.8.1 Eight checks before finalising the accounts

1. Agree the trial balance first. The totals must match before any adjustment starts. If they do not, find the error or place a labelled suspense balance. Final accounts built on a wrong trial balance are wrong from the start.
2. Count the closing stock. A physical count at the year end, valued at the lower of cost and net realisable value, gives the closing figure. In the example 70,000 of stock cut the cost of goods sold. A missed shelf changes profit.
3. Accrue what is owed. Expenses incurred but unpaid, like salaries due of Rs 10,000, belong to this year. Adding them lowers profit and creates a liability. Forgetting them overstates profit and understates debts.
4. Defer what is prepaid. Rent of Rs 5,000 paid for the next period is an asset today, not an expense. Deduct it from the rent expense and show it in the balance sheet. A shop that pays a year's rent in Shrawan shows only the used part.
5. Charge depreciation. Write down fixed assets by the policy method, here Rs 25,000 on furniture. This shows an honest book value. Skipping it inflates both profit and assets.
6. Make the provision for doubtful debts. Estimate the part of debtors that may not pay, here 2% of 2,00,000 or Rs 4,000, and charge it. Only the change in the provision goes to profit next year. This follows prudence.
7. Separate capital from revenue items. The purchase of furniture is capital and goes to the balance sheet, while carriage inwards is a cost of goods. Misplacing them shifts profit and hides assets. Check any large item again.
8. Prove the balance sheet. After all adjustments, assets must equal equity plus liabilities (7,69,000 each). Then compare ratios with last year to spot odd movements. A statement that balances and looks reasonable is ready for the auditor.

(a) A shop in Kathmandu

(b) Waterfall from sales to net profit (thousand rupees)

(a) A balance scale: both pans equal

(b) Effect of each adjustment (rupees)

6.9 Summary and exercises

The Trading Account measures gross profit, the Profit and Loss Account measures net profit after operating items and the Balance Sheet reports position; every year-end adjustment has a double effect, and a balancing balance sheet confirms that none was forgotten.

1. Define gross profit, net profit and operating expenses, and state which side of the Trading Account takes closing stock.
2. List the adjustment entries for outstanding wages, prepaid insurance and accrued interest.
3. A debtor balance of Rs 3,00,000 has Rs 10,000 of bad debts to write off, then a 5% provision. Compute the provision and show the balance sheet presentation.
4. Rerun the program with closing stock of Rs 50,000. By how much do gross profit, net profit and capital change?
5. Explain why net profit increases the owner's capital while drawings reduce it.
6. For a company with profit before tax of Rs 8,00,000, compute tax at 25% and the retained profit after a 20% cash dividend on the after-tax profit.

Model answers: medium (5 marks) and long (10 marks) questions

Q1 (5 marks). Prepare a trading account and find the gross profit from: opening stock 40,000; purchases 6,00,000; purchases returns 10,000; carriage inwards 5,000; wages 30,000; sales 10,00,000; sales returns 20,000; closing stock 70,000.

Purpose. The trading account shows the gross profit or loss of buying and selling goods; it contains direct costs only.

Dr	Rs	Cr	Rs
To Opening stock	40,000	By Sales	10,00,000
To Purchases	6,00,000	Less returns	(20,000)
Less returns	(10,000)	Net sales	9,80,000
To Carriage inwards	5,000	By Closing stock	70,000
To Wages	30,000
To Gross profit c/d	3,85,000
	10,50,000		10,50,000

Cost of goods sold = 40,000 + 5,90,000 + 5,000 + 30,000 − 70,000 = Rs 5,95,000; gross profit = 9,80,000 − 5,95,000 = Rs 3,85,000 (Figure 6.1). Gross margin = 3,85,000 ÷ 9,80,000 = 39.29%.

Conclusion the trading account measures the trader's gross margin before running costs.

Q2 (5 marks). Explain the year-end adjustments with entries for: salaries outstanding 10,000; rent prepaid 5,000; depreciation 25,000; provision for doubtful debts 2% on debtors of 2,00,000.

Principle. Under the accrual concept, income and expense belong to the period in which they arise. Each adjustment is entered twice, in the income statement and in the balance sheet (Figure 6.3).

Adjustment	Journal entry	P&L effect	Balance sheet
Salaries due	Dr Salaries 10,000, Cr Outstanding salaries 10,000	expense rises	current liability
Rent prepaid	Dr Prepaid rent 5,000, Cr Rent 5,000	expense falls	current asset
Depreciation	Dr Depreciation 25,000, Cr Furniture 25,000	expense 25,000	asset reduced
Provision	Dr P&L 4,000, Cr Provision 4,000	expense 4,000	debtors shown net 1,96,000

Net effect on profit: −10,000 + 5,000 − 25,000 − 4,000 = −34,000 (plus the stock effect in trading). Conclusion: adjustments give a true profit and a true position.

Q3 (10 marks). Explain the final accounts of a trader and of a company. Using the worked example, prepare the income statement and balance sheet.

Introduction. Final accounts are the trading account, profit and loss account and balance sheet prepared at the year end after adjustments. They answer two questions: what was the profit, and what is owned and owed.

Trading and profit and loss account (Figure 6.1).

Item	Rs
Net sales (10,00,000 − 20,000)	9,80,000
Cost of goods sold	(5,95,000)
Gross profit	3,85,000
Add interest income	6,000
Salaries (1,10,000 + 10,000)	(1,20,000)
Rent (60,000 − 5,000)	(55,000)
Depreciation	(25,000)
Bad debts	(8,000)
Provision for doubtful debts	(4,000)
Net profit	1,79,000

Balance sheet (Figure 6.2).

Equity and liabilities	Rs	Assets	Rs
Capital 5,00,000 + 1,79,000 − 30,000	6,49,000	Furniture (3,00,000 − 25,000)	2,75,000
Creditors	1,10,000	Closing stock	70,000
Salaries outstanding	10,000	Debtors (2,00,000 − 4,000)	1,96,000
		Prepaid rent	5,000
		Cash and bank	2,23,000
Total	7,69,000	Total	7,69,000

Company accounts. A company has share capital, reserves and retained earnings in place of capital and drawings.

Income tax at 25% on Rs 1,79,000 is Rs 44,750, leaving profit after tax of Rs 1,34,250, from which dividends or bonus shares may be paid.

Under NFRS the statements are titled Statement of Financial Position, Statement of Profit or Loss and Other Comprehensive Income, Statement of Changes in Equity and Statement of Cash Flows.

The Companies Act 2063 requires audited statements.

Comparison.

Point	Trader	Company
Owner's claim	capital and drawings	share capital, reserves, retained earnings
Tax	on owner's income	corporate tax on profit
Distribution	drawings	dividend or bonus shares
Statements	trading, P&L, balance sheet	NFRS four statements plus notes
Audit	optional by size	compulsory

Conclusion. The final accounts tie all the earlier work together: adjusted balances become profit and position, and the balance sheet total (Rs 7,69,000) proves the process.