Financial Statements (with Adjustments)
This chapter teaches you how to adjust a business's accounts for timing gaps — expenses incurred but not paid, income earned but not received, unsold stock, depreciation, and doubtful debts — so that the final statements show true profit and a fair Balance Sheet.
Adjustments are not a technicality — they are the difference between accounts that tell the truth and accounts that mislead; every CA, B.Com, and business management course builds on this skill, and your board exam typically awards 8–10 marks just for adjustment entries.
Concept
Lots of students think…
"If an expense is outstanding (unpaid), I just add it to the expense in the P&L Account — that's the only adjustment needed."
Actually…
An outstanding expense is money the business still owes, so it is a liability too. You must show it on BOTH sides: debit the expense in the P&L Account (to record the cost) AND add it as 'Outstanding Expense Payable' on the liability side of the Balance Sheet. Skip the Balance Sheet entry and your Balance Sheet simply won't balance.
By the end of this, you will understand why a shopkeeper's accounts need small fixes before they tell the real truth — and exactly how to make those fixes so the profit figure is honest and the Balance Sheet is fair.
Why Adjustments Exist
Cash does not always move at the right time. A bill arrives in March but gets paid in April. Salary is earned in March but paid on the 5th of April. If you only record what cash moved, your profit for March is wrong. Adjustments fix this by matching every expense and income to the period it actually belongs to — that is the accrual principle.
Arun runs a stationery shop in Chennai. His March electricity bill is ₹4,000 but he pays it in April. Without an adjustment, March profit looks ₹4,000 too high. With the adjustment, he records the ₹4,000 as a March expense and shows it as money owed — giving the real picture.
Closing Stock
Closing stock is the goods left unsold at the end of the year. It is not in your trial balance because you only discover it after a physical count. You must record it in two places: credit side of the Trading Account (it reduces the cost of goods sold) and asset side of the Balance Sheet (it is something the business still owns). Miss either one and your accounts are wrong.
Priya's textile shop in Surat does a year-end stocktake on 31 March and finds unsold fabric worth ₹45,000. She records ₹45,000 on the credit side of the Trading Account and lists ₹45,000 as a current asset on the Balance Sheet.
Outstanding & Prepaid Expenses
Outstanding expenses: the service is done but you haven't paid yet — add the amount to the expense in P&L and show it as a current liability in the Balance Sheet. Prepaid expenses: you paid in advance for something that benefits next year — subtract the unused portion from the expense in P&L and show it as a current asset. A quick test: benefit already used = expense; benefit still to come = asset.
Priya paid ₹24,000 insurance for October to September (12 months). Only 6 months fall in this accounting year, so ₹12,000 is prepaid. She removes ₹12,000 from the P&L expense and records it as a current asset. Her March salaries of ₹6,000 are unpaid — she adds ₹6,000 to salary expense in P&L and lists it as 'Outstanding Salaries' (a liability) on the Balance Sheet.
Accrued & Unearned Income
Accrued income: you have earned it but the cash hasn't arrived yet — add it to income in P&L and show it as a current asset (money someone owes you). Unearned income: you received cash for work you haven't done yet — subtract it from income in P&L and show it as a current liability (an obligation you still owe). The logic mirrors the expense rules: if it belongs to this period, it goes to P&L; if it belongs to a future period, it is parked as a liability.
Priya collected ₹6,000 rent from her tenant in March for April's use. That ₹6,000 belongs to April, not March. She removes it from this year's P&L income and records it as 'Unearned Rent' — a current liability on her Balance Sheet.
Depreciation
A fixed asset like a van or machine loses value year by year as you use it. Depreciation spreads that cost across the asset's life so you charge a fair amount each year. Under the Straight-Line Method: Annual Depreciation = (Original Cost − Residual Value) ÷ Useful Life. Residual value is what you can sell the asset for at the very end — you subtract it first because that portion of cost is never 'used up'. Record depreciation as an expense in P&L and reduce the asset's value on the Balance Sheet.
Priya bought a delivery van for ₹1,50,000. It will last 5 years and then be sold for ₹15,000 scrap. Annual depreciation = (₹1,50,000 − ₹15,000) ÷ 5 = ₹27,000. She charges ₹27,000 in the P&L every year and reduces the van's value on the Balance Sheet by the same amount.
Bad Debts & Provision for Doubtful Debts
A bad debt is money a customer owes you that you have given up on recovering — you write it off as a loss in P&L and reduce debtors on the Balance Sheet. A provision for doubtful debts is a safety estimate: even before any debt turns bad, you set aside a percentage of total debtors as a likely future loss. This follows the conservatism principle — never overstate assets. On the Balance Sheet, show the provision as a deduction from gross debtors so readers see the realistic amount you expect to collect.
Priya has debtors worth ₹50,000. She estimates 5% may not pay — so she creates a Provision for Doubtful Debts of ₹2,500. Her Balance Sheet shows: Debtors ₹50,000 less Provision ₹2,500 = Net Debtors ₹47,500. This is the realistic amount she expects to actually receive.
Manager's Commission
A manager's commission is a percentage of profit paid as a reward — it is an expense in P&L. When commission is 'on profit before charging commission', multiply profit by the rate. When it is 'on profit after charging commission', use the adjusted formula: Commission = Profit Before Commission × Rate ÷ (100 + Rate). The second formula exists because the commission reduces the very profit it is based on, so you need to account for that circular effect. Always read the question carefully — the two cases give different answers.
Net profit before commission is ₹1,05,000. The manager's commission is 5% on profit after charging commission. Commission = ₹1,05,000 × 5 ÷ 105 = ₹5,000. Net profit left = ₹1,00,000. The manager gets ₹5,000 which is exactly 5% of ₹1,00,000 — the formula works.
Notes
This chapter shows how to convert raw trial-balance figures into a true Trading Account, Profit & Loss Account and Balance Sheet by passing year-end adjustments. Every adjustment follows the accrual and matching principles and always has a DUAL effect — one in the Trading/P&L Account and one in the Balance Sheet — so that profit is honest and the Balance Sheet balances.
Key terms & definitions
- Adjustment
- A year-end correction that records an item not yet (or wrongly) reflected in the trial balance, so that income and expenses fall in the period they truly belong to.
- Closing Stock
- The value of goods left unsold at the end of the accounting year, found by physical stock-take and valued at cost or net realisable value, whichever is lower.
- Outstanding Expense
- An expense whose benefit has been received in the current year but which is still unpaid at year-end; it is a current liability.
- Prepaid (Unexpired) Expense
- An expense paid in advance whose benefit relates to the next year; the unexpired part is a current asset.
- Accrued (Outstanding) Income
- Income earned during the current year but not yet received in cash; it is a current asset.
- Income Received in Advance (Unearned Income)
- Income received in cash this year for a service to be rendered next year; it is a current liability.
- Depreciation
- The systematic allocation of the cost of a fixed asset over its useful life; it is a non-cash expense charged to the P&L Account that reduces the asset's book value.
- Bad Debts
- Debts that are definitely irrecoverable and written off as a loss against debtors.
- Provision for Doubtful Debts
- An estimated charge (usually a percentage of debtors) created in anticipation of future bad debts, in line with the principle of prudence/conservatism.
- Provision for Discount on Debtors
- An estimated reserve for cash discount likely to be allowed to debtors who pay promptly; calculated on good debtors AFTER deducting further bad debts and the provision for doubtful debts.
- Manager's Commission
- A reward paid to the manager as a percentage of profit; an expense of the firm and, if unpaid, a current liability.
- Goods Withdrawn for Personal Use (Drawings in Goods)
- Stock taken by the proprietor for private use; deducted from purchases and added to drawings, so the business is not charged for the owner's consumption.
Why adjustments are needed
- A trial balance only lists items already in the ledger; it ignores expenses incurred but unpaid, income earned but unreceived, unsold stock, fall in asset values and likely losses.
- Adjustments apply the accrual principle (record revenue when earned and expense when incurred, not when cash moves) and the matching principle (match the period's expenses to its revenues).
- GOLDEN RULE: an item that appears INSIDE the trial balance is recorded only ONCE in the final accounts; an item appearing only in the ADJUSTMENTS (below the trial balance) is recorded in TWO places — once in Trading/P&L and once in the Balance Sheet.
Closing Stock
- Effect 1 (Trading A/c): shown on the CREDIT side of the Trading Account; this arithmetically reduces the cost of goods sold and raises gross profit.
- Effect 2 (Balance Sheet): shown on the ASSETS side as a current asset.
- Closing stock is NEVER placed on the debit side of the Trading Account; opening stock (already in the trial balance) sits on the debit side.
- Exception: if closing stock already appears INSIDE the trial balance, it is shown only in the Balance Sheet (purchases would have been recorded net of it).
Outstanding Expenses
- Effect 1 (P&L / Trading A/c): ADD the outstanding amount to the relevant expense before charging it.
- Effect 2 (Balance Sheet): show as a CURRENT LIABILITY ('Outstanding ___').
- Wages outstanding are added in the Trading Account (direct), salaries/rent outstanding in the P&L Account (indirect).
Prepaid (Unexpired) Expenses
- Effect 1 (P&L / Trading A/c): SUBTRACT the prepaid (unexpired) portion from the expense.
- Effect 2 (Balance Sheet): show the prepaid amount as a CURRENT ASSET.
- Quick test: benefit already consumed = expense of this year; benefit still to come = asset carried forward.
Accrued (Outstanding) Income
- Effect 1 (P&L A/c): ADD the accrued amount to the relevant income on the credit side.
- Effect 2 (Balance Sheet): show as a CURRENT ASSET ('Accrued ___' / income receivable).
Income Received in Advance (Unearned Income)
- Effect 1 (P&L A/c): SUBTRACT the advance portion from the income on the credit side.
- Effect 2 (Balance Sheet): show as a CURRENT LIABILITY ('___ Received in Advance').
Depreciation
- Effect 1 (P&L A/c): charge depreciation as an indirect expense on the debit side.
- Effect 2 (Balance Sheet): DEDUCT depreciation from the asset's value on the assets side, showing the reduced (written-down) book value.
- Under the Straight-Line Method (NCERT Class 11): Annual Depreciation = (Cost − Residual/Scrap Value) ÷ Useful Life; charge for part of a year if the asset was bought mid-year.
- If an asset is purchased during the year and appears as an additional adjustment, calculate depreciation only for the months it was in use.
Bad Debts (further / additional)
- Bad debts already shown INSIDE the trial balance are simply taken to the debit of the P&L Account (no Balance Sheet effect on their own).
- FURTHER bad debts given in adjustments: Effect 1 — add to bad debts in the P&L Account (debit); Effect 2 — DEDUCT from sundry debtors in the Balance Sheet.
- Order of working on debtors: first deduct further bad debts from debtors, THEN compute the provision on the reduced figure.
Provision for Doubtful Debts
- Step 1: Good debtors = Sundry Debtors − Further Bad Debts.
- Step 2: New Provision = required % × good debtors.
- P&L charge = Further Bad Debts + Bad Debts already in trial balance + New (closing) Provision − Old (opening) Provision already in trial balance (this net amount is debited to the P&L Account).
- If the old provision exceeds the year's bad debts plus the new provision, the EXCESS is a gain — credited to the P&L Account.
- Balance Sheet: deduct the NEW provision from debtors (after deducting further bad debts) to show net realisable debtors.
Provision for Discount on Debtors
- Created only on GOOD debtors expected to pay (because discount is allowed only to those who actually pay).
- Base for the calculation = Debtors − Further Bad Debts − New Provision for Doubtful Debts; then apply the discount %.
- Effect 1 (P&L A/c): debit the new provision for discount (adjusted for any old provision, like doubtful debts).
- Effect 2 (Balance Sheet): deduct it from debtors after the provision for doubtful debts has been deducted.
Goods Withdrawn / Distributed (non-sale uses of stock)
- Goods taken by the proprietor for personal use: DEDUCT from purchases (Trading A/c) and ADD to drawings (deducted from capital in the Balance Sheet).
- Goods given as free samples / advertisement: DEDUCT from purchases and DEBIT advertisement (P&L expense).
- Goods distributed as charity: DEDUCT from purchases and DEBIT charity/donation (P&L expense).
- Goods lost by fire/theft (abnormal loss): DEDUCT the cost from purchases or credit the Trading A/c; the loss net of any insurance claim is debited to the P&L A/c, and any admitted insurance claim is a current asset in the Balance Sheet.
Interest on Capital and Interest on Drawings
- Interest on Capital: Effect 1 — debit the P&L Account (an expense/charge of the business); Effect 2 — ADD to capital in the Balance Sheet.
- Interest on Drawings: Effect 1 — credit the P&L Account (a gain to the business); Effect 2 — ADD to drawings (i.e. deduct from capital) in the Balance Sheet.
- These are notional entries for a sole proprietor — they redistribute the proprietor's own funds, so both legs touch the capital account in the Balance Sheet.
Manager's Commission
- Effect 1 (P&L A/c): debit as an expense after all other expenses and incomes are accounted for (it is computed on profit).
- Effect 2 (Balance Sheet): if unpaid at year-end, show 'Commission Payable / Outstanding Commission' as a current liability.
- Commission ON profit BEFORE charging commission = Net Profit (before commission) × Rate ÷ 100.
- Commission ON profit AFTER charging commission = Net Profit (before commission) × Rate ÷ (100 + Rate).
The dual-effect checklist
- For every adjustment ask two questions: (1) What is the Trading/P&L effect? (2) What is the Balance Sheet effect?
- Answer both, every time. An adjustment recorded in only one statement will leave the Balance Sheet out of balance.
- Memory aid for liabilities/assets: outstanding expense & income-in-advance = liabilities; prepaid expense & accrued income = assets.
Formulas & formats
- Closing Stock → (1) Credit side of Trading A/c; (2) Asset (current) in Balance Sheet.
- Outstanding Expense → (1) Add to expense in P&L (or Trading for wages); (2) Current liability in Balance Sheet.
- Prepaid Expense → (1) Subtract from expense in P&L; (2) Current asset in Balance Sheet.
- Accrued Income → (1) Add to income (credit) in P&L; (2) Current asset in Balance Sheet.
- Income Received in Advance → (1) Subtract from income (credit) in P&L; (2) Current liability in Balance Sheet.
- Depreciation → (1) Debit (expense) in P&L; (2) Deduct from the asset in Balance Sheet. SLM: (Cost − Residual Value) ÷ Useful Life.
- Further Bad Debts → (1) Add to bad debts (debit) in P&L; (2) Deduct from debtors in Balance Sheet.
- Provision for Doubtful Debts → P&L debit = Bad Debts + Further Bad Debts + New Provision − Old Provision; Balance Sheet = deduct new provision from (Debtors − further bad debts).
- New Provision for Doubtful Debts = % × (Sundry Debtors − Further Bad Debts).
- Provision for Discount on Debtors = % × (Debtors − Further Bad Debts − New Provision for Doubtful Debts); (1) debit P&L; (2) deduct from debtors in Balance Sheet.
- Goods withdrawn for personal use → (1) Deduct from Purchases (Trading A/c); (2) Add to Drawings (deduct from Capital in Balance Sheet).
- Goods as free samples/charity → (1) Deduct from Purchases; (2) Debit Advertisement/Charity in P&L.
- Abnormal loss of stock → (1) Reduce purchases / credit Trading A/c with cost; (2) Loss (net of claim) debited to P&L, insurance claim admitted = current asset.
- Interest on Capital → (1) Debit P&L; (2) Add to Capital in Balance Sheet.
- Interest on Drawings → (1) Credit P&L; (2) Add to Drawings / deduct from Capital in Balance Sheet.
- Manager's Commission before charging = Profit (before commission) × Rate ÷ 100.
- Manager's Commission after charging = Profit (before commission) × Rate ÷ (100 + Rate); if unpaid, current liability.
Important questions & model answers
State the two effects of an outstanding expense in the final accounts.
1 mark- It is added to the related expense in the Trading/Profit & Loss Account (raising the expense).
- It is shown as a current liability on the liabilities side of the Balance Sheet.
Closing stock is not shown in the trial balance but appears in the final accounts. Explain why and give its treatment.
3 marks- Opening stock is already in the trial balance (it is last year's closing stock), but this year's closing stock is known only after a physical stock-take at year-end, so it is given as an adjustment.
- Effect 1: it is recorded on the credit side of the Trading Account, which reduces the cost of goods sold and increases gross profit.
- Effect 2: it is shown on the assets side of the Balance Sheet as a current asset.
- It is valued at cost price or net realisable value, whichever is lower (prudence).
Distinguish between a prepaid expense and an outstanding expense, with the treatment of each.
3 marks- Outstanding expense: benefit received this year but not yet paid — it is an expense due. Prepaid expense: paid this year but benefit relates to next year — it is paid in advance.
- Outstanding expense is ADDED to the expense in the P&L Account and shown as a current liability.
- Prepaid expense is SUBTRACTED from the expense in the P&L Account and shown as a current asset.
- Test: if the benefit is already consumed it is an expense; if the benefit is still to come it is an asset/liability carried to the next year.
A delivery van was bought for ₹1,50,000 with an estimated scrap value of ₹15,000 and a useful life of 5 years. Compute annual depreciation under SLM and state its two effects.
3 marks- Annual Depreciation = (Cost − Residual Value) ÷ Useful Life = (₹1,50,000 − ₹15,000) ÷ 5 = ₹27,000.
- Effect 1: ₹27,000 is debited to the Profit & Loss Account as an expense.
- Effect 2: ₹27,000 is deducted from the van's value on the assets side of the Balance Sheet, showing a written-down value of ₹1,23,000.
- Residual value is deducted first because that portion of the cost is expected to be recovered on sale and is never 'used up'.
Sundry Debtors are ₹2,00,000. Further bad debts ₹5,000; create a provision for doubtful debts at 5%. Show the P&L charge and the Balance Sheet presentation.
4 marks- Good debtors = ₹2,00,000 − ₹5,000 (further bad debts) = ₹1,95,000.
- New provision = 5% × ₹1,95,000 = ₹9,750.
- P&L Account (debit side) = Further Bad Debts ₹5,000 + New Provision ₹9,750 = ₹14,750 (assuming no old provision).
- Balance Sheet (assets): Debtors ₹2,00,000 − Further Bad Debts ₹5,000 = ₹1,95,000 − New Provision ₹9,750 = Net Debtors ₹1,90,250.
Trial balance shows Debtors ₹1,00,000; Bad Debts ₹2,000; Provision for Doubtful Debts (old) ₹4,000. Adjustment: write off further bad debts ₹3,000 and keep a provision of 5% on debtors. Calculate the amount charged to the P&L Account.
4 marks- Good debtors = ₹1,00,000 − ₹3,000 = ₹97,000; New provision = 5% × ₹97,000 = ₹4,850.
- Total provision required side = Bad Debts ₹2,000 + Further Bad Debts ₹3,000 + New Provision ₹4,850 = ₹9,850.
- Less: Old Provision ₹4,000.
- Amount debited to P&L Account = ₹9,850 − ₹4,000 = ₹5,850.
- Balance Sheet: Debtors ₹97,000 − New Provision ₹4,850 = ₹92,150 (net).
Net profit before commission is ₹2,10,000. The manager is entitled to 5% commission. Calculate the commission if it is (a) on profit before charging commission, and (b) on profit after charging commission.
4 marks- (a) Before charging: Commission = ₹2,10,000 × 5 ÷ 100 = ₹10,500.
- (b) After charging: Commission = ₹2,10,000 × 5 ÷ (100 + 5) = ₹2,10,000 × 5 ÷ 105 = ₹10,000.
- Check for (b): profit left = ₹2,10,000 − ₹10,000 = ₹2,00,000; 5% of ₹2,00,000 = ₹10,000 — confirms the figure.
- In both cases the commission is debited to the P&L Account; if unpaid it is a current liability.
From the following, prepare adjustments and find net profit. Trial balance (31 March 2024): Opening Stock ₹40,000; Purchases ₹2,10,000; Sales ₹4,50,000; Rent Paid ₹24,000; Salaries Paid ₹60,000. Adjustments: Closing stock ₹55,000; Outstanding rent ₹2,000; Prepaid salary ₹5,000.
6 marks- Trading A/c: COGS = Opening Stock ₹40,000 + Purchases ₹2,10,000 − Closing Stock ₹55,000 = ₹1,95,000.
- Gross Profit = Sales ₹4,50,000 − COGS ₹1,95,000 = ₹2,55,000.
- Rent expense = ₹24,000 + Outstanding ₹2,000 = ₹26,000.
- Salary expense = ₹60,000 − Prepaid ₹5,000 = ₹55,000.
- Net Profit = Gross Profit ₹2,55,000 − Rent ₹26,000 − Salary ₹55,000 = ₹1,74,000.
- Balance Sheet: Outstanding Rent ₹2,000 = current liability; Prepaid Salary ₹5,000 and Closing Stock ₹55,000 = current assets.
Explain the treatment of goods withdrawn by the proprietor for personal use and goods distributed as free samples.
4 marks- Goods for personal use: DEDUCT the cost from Purchases in the Trading Account (the business is not charged for the owner's consumption) and ADD it to Drawings, which is deducted from Capital in the Balance Sheet.
- Free samples / advertisement: DEDUCT the cost from Purchases in the Trading Account and DEBIT it to Advertisement Expense in the P&L Account (it is a selling cost).
- Both keep purchases (and hence gross profit) correct by removing stock that was never sold.
- Journal idea — personal use: Drawings A/c Dr, To Purchases A/c; free samples: Advertisement A/c Dr, To Purchases A/c.
Why is a provision for discount on debtors calculated AFTER the provision for doubtful debts, and on what amount?
3 marks- Cash discount is allowed only to debtors who actually pay; doubtful debtors are not expected to pay, so no discount will be given to them.
- Therefore the provision for discount is computed only on the GOOD, paying debtors.
- Base = Debtors − Further Bad Debts − New Provision for Doubtful Debts; the discount % is then applied to this figure.
- It is debited to the P&L Account and deducted from debtors in the Balance Sheet after the provision for doubtful debts.
Exam tips
- First scan whether each item is INSIDE the trial balance (record once) or in the ADJUSTMENTS (record twice). This single check prevents most errors.
- Work debtors strictly in order: Debtors − Further Bad Debts → New Provision for Doubtful Debts → Provision for Discount. Never apply the percentage to the gross debtor figure.
- Wages outstanding go to the Trading Account (direct expense); salaries/rent/interest outstanding go to the P&L Account (indirect).
- Closing stock on the CREDIT side of the Trading Account only — writing it on the debit side is a classic mark-loser.
- For manager's commission, underline whether it is 'before' or 'after' charging commission; use ÷100 vs ÷(100+rate) accordingly.
- Show provisions and depreciation as DEDUCTIONS within the Balance Sheet (e.g. Debtors xxx less Provision xxx), not as separate liabilities.
- Label liabilities precisely: 'Outstanding Salary', 'Salary Received in Advance', etc. — vague labels lose presentation marks.
- Always state BOTH effects of an adjustment; examiners award marks for the Balance Sheet leg even if the P&L leg is wrong.
Quick revision
- Adjustments exist to honour the accrual and matching principles — right item, right period.
- Inside trial balance = recorded once; in adjustments = recorded twice (P&L + Balance Sheet).
- Closing stock → credit Trading A/c + current asset.
- Outstanding expense → add to expense + current liability; Prepaid → subtract from expense + current asset.
- Accrued income → add to income + current asset; Income in advance → subtract from income + current liability.
- Depreciation → debit P&L + deduct from asset; SLM = (Cost − Scrap) ÷ Life.
- Provision for doubtful debts: % on (Debtors − further bad debts); P&L = bad debts + further bad debts + new provision − old provision.
- Provision for discount on debtors: % on (Debtors − further bad debts − new doubtful-debt provision).
- Goods withdrawn → deduct from purchases + add to drawings; free samples/charity → deduct from purchases + debit relevant expense.
- Interest on capital → debit P&L + add to capital; Interest on drawings → credit P&L + add to drawings.
- Manager's commission: ×rate/100 (before) or ×rate/(100+rate) (after); unpaid = current liability.
- Final self-check: for every adjustment, did I record a P&L effect AND a Balance Sheet effect?
The full picture
Raw ledger balances alone cannot tell the full story of a business. Suppose Arun runs a stationery shop in Chennai. In March he receives an electricity bill for ₹4,000 but pays it in April. His workers earned ₹8,000 in March but get paid on the 5th of April. If Arun simply lists what he paid during March, his profit looks inflated — he has not charged the real expenses of running the shop that month. Adjustments fix this. They shift each item into the accounting period it actually belongs to, following the accrual principle: record revenue when earned and expenses when incurred, regardless of when cash moves.
Closing stock is the goods remaining unsold at year-end. Opening stock is already in the trial balance (carried forward from last year), but closing stock is not — it is only known after a physical stocktake. You must record it in two places: on the credit side of the Trading Account (which mathematically reduces the cost of goods sold) and on the asset side of the Balance Sheet (as a current asset). This is one of the most tested points in your exam — forgetting either entry is a guaranteed mark loss.
Outstanding expenses are amounts for which the service has been received in the current period but the payment will come later — for example, rent for March that is paid in April. Add the outstanding amount to the expense in the Profit and Loss Account and show it as a current liability in the Balance Sheet (labelled 'Outstanding [Expense Name]'). Prepaid expenses are the opposite: you paid in advance for a benefit that extends into the next period. Subtract the unexpired portion from the current expense in the P&L Account and carry it as a current asset in the Balance Sheet. A simple test: if the benefit is already consumed this period, it is an expense; if it will be consumed next period, it is an asset.
Accrued income is revenue you have earned this period but have not yet received in cash — for example, interest on a fixed deposit due but not credited yet. Add it to income in the P&L Account and show it as a current asset (debtor) in the Balance Sheet. Unearned income (or advance income) is cash received now for a service you will deliver next period — for example, rent collected in March for April. Subtract it from the current income in the P&L Account and show it as a current liability in the Balance Sheet. The pattern is consistent: if the income belongs to this period, it goes to P&L; if it belongs to a future period, it is parked as a liability.
Depreciation is the allocation of a fixed asset's cost over its useful life. Under the Straight-Line Method (SLM) — the method used in NCERT Class 11 — the annual charge is: (Original Cost − Estimated Residual Value) ÷ Estimated Useful Life. Residual value (also called scrap value) is the expected sale price of the asset at the very end of its life; it is subtracted before you divide because that portion of cost is never 'consumed'. Record depreciation as an expense in the P&L Account and reduce the asset's value in the Balance Sheet. Bad debts are amounts you write off as unrecoverable from debtors. A provision for doubtful debts is a pre-emptive estimate (often a fixed percentage of debtors) that follows the conservatism principle: do not overstate assets. Show the provision separately in the Balance Sheet, deducting it from the gross debtor figure to give the net realisable value.
Manager's commission is paid as a percentage of profit and appears as an expense in the P&L Account. The tricky part: it reduces the very profit it is being calculated on. When the commission is 'on net profit after charging such commission', you divide the profit before commission (PBC) by (100 + rate) and multiply by the rate. For example, at 5% on profit after commission: if PBC = ₹1,05,000, commission = 1,05,000 × 5 ÷ 105 = ₹5,000, leaving net profit of ₹1,00,000. Always read the question carefully — 'on net profit before commission' is a straightforward multiplication, while 'after commission' needs this adjusted formula.
Every adjustment you make touches exactly two statements: the Trading or P&L Account (for income/expense impact) and the Balance Sheet (for the resulting asset or liability). If an adjustment only appears in one statement, your accounts will not balance. Treat this as a checklist: for each adjustment, ask yourself 'what is the P&L impact?' and 'what is the Balance Sheet impact?' Answer both, and you will never lose marks for an incomplete entry.
An Indian example
Priya runs a small textile shop in Surat. Her accounting year ends 31 March. On that date, her trial balance shows: Salaries Paid ₹72,000; Insurance Paid ₹24,000; Rent Received ₹30,000. After stocktake, closing stock is ₹45,000. A delivery van she bought for ₹1,50,000 has a residual value of ₹15,000 and a useful life of 5 years. March salaries of ₹6,000 are still unpaid. The insurance covers October to September — only 6 months fall in this year. A tenant paid ₹6,000 rent in advance for April. Adjustments: she adds ₹6,000 outstanding salaries to P&L and records a current liability; she moves 6 months' insurance (₹12,000) out of P&L as a prepaid asset; she removes the ₹6,000 advance rent from income and records it as unearned income (a liability); she records closing stock of ₹45,000 in the Trading Account and Balance Sheet; and she charges annual depreciation of (₹1,50,000 − ₹15,000) ÷ 5 = ₹27,000 in P&L while reducing the van's book value. Without these five adjustments, Priya's profit would be overstated by tens of thousands of rupees, her Balance Sheet would misrepresent what she owns and owes, and any bank or investor reading her accounts would be misled.
Key concepts covered
- Closing stock, outstanding & prepaid expenses
- Accrued & unearned income
- Depreciation, bad debts, provisions for doubtful debts
- Manager's commission
Common misconceptions to watch for
- Closing stock is already in the ledger, so it needs no adjustment. This is wrong. Opening stock is in the ledger (it was last year's closing stock), but this year's closing stock is only known after a physical count at year-end. It must be recorded as a fresh entry — credit side of the Trading Account and asset side of the Balance Sheet. If you skip it, both gross profit and the Balance Sheet total will be wrong.
- Outstanding expenses only affect the P&L Account; they do not appear in the Balance Sheet. This is wrong. An outstanding expense is money the business still owes — it is a liability. The accounting equation (Assets = Liabilities + Capital) demands that every liability appears on the Balance Sheet. The correct entry debits the expense account (P&L impact) and credits an 'Outstanding [Expense] Payable' account (Balance Sheet liability). Both sides must be recorded.
- Manager's commission is always calculated by simply multiplying net profit by the commission rate. This is only correct when the question says 'on net profit before charging commission'. When the question says 'on net profit after charging commission', use the adjusted formula: Commission = Net Profit Before Commission × Rate ÷ (100 + Rate). Mixing up the two formulas — the most common error in this topic — will give a wrong figure every time.
Video
Final Accounts of a Sole Trader — Trading, P&L & Balance Sheet
Questions
Raj Trading Company's trial balance at 31 March 2024: Opening Stock ₹40,000; Purchases ₹2,10,000; Sales ₹4,50,000; Rent Paid ₹24,000; Salaries Paid ₹60,000. Physical count shows closing stock ₹55,000. Outstanding rent for March: ₹2,000. Prepaid salaries for April: ₹5,000. Find Net Profit and Balance Sheet liability for outstanding rent.
- 1Identify adjustments needed: closing stock, outstanding rent, prepaid salary.The trial balance reflects only items already in the ledger. Closing stock is discovered only after physical count and is absent from the trial balance. Outstanding rent and prepaid salary are accrual adjustments — expenses must be matched to the period in which they are incurred, not when cash moves.
Question 1 of 5 · easy
Which statement about closing stock is correct?
Quiz
Test yourself — pick an answer, then hit "Check" to see the explanation and your running score.
Question 1 of 5 · easy
Which statement about closing stock is correct?
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