SUMMARY: This chapter focuses on the preparation and analysis of financial statements with adjustments for a sole proprietorship. KEY TOPICS: adjustments in financial statements, closing stock, outstanding expenses, prepaid expenses, accrued income, income received in advance, depreciation, bad debts, provision for doubtful debts, provision for discount on debtors
Correct answer: Option 2 — At the time of preparing financial statements
Q21 Mark
Outstanding rent at year-end is:
AAsset
BLiability
CIncome
DExpense
Check answerHide answer
Correct answer: Option 2 — Liability
Q31 Mark
Provision for doubtful debts is calculated on:
AClosing debtors
BClosing debtors after deducting bad debts
CSales
DTotal revenue
Check answerHide answer
Correct answer: Option 2 — Closing debtors after deducting bad debts
Q41 Mark
Manager's commission is generally calculated on:
ASales
BNet profit before commission
CCapital
DGross profit
Check answerHide answer
Correct answer: Option 2 — Net profit before commission
Q51 Mark
Income received in advance is shown on the:
AAsset side
BLiability side
CTrading account
DProfit and loss account
Check answerHide answer
Correct answer: Option 2 — Liability side
Q61 Mark
What is the treatment of closing stock in the financial statements?
AIt is added to the purchases
BIt is deducted from the total sales
CIt is shown as an asset in the balance sheet
DIt is ignored in the financial statements
Check answerHide answer
Correct answer: Option 3 — It is shown as an asset in the balance sheet
Q71 Mark
Which of the following is an example of a prepaid expense?
ARent paid for the next month
BSalaries payable
CInterest accrued on a loan
DSales tax collected
Check answerHide answer
Correct answer: Option 1 — Rent paid for the next month
Q81 Mark
How is accrued income treated in the financial statements?
AIt is recorded as a liability
BIt is recorded as an asset
CIt is ignored in the financial statements
DIt is deducted from total income
Check answerHide answer
Correct answer: Option 2 — It is recorded as an asset
Q91 Mark
What does the provision for bad debts represent?
AThe amount expected to be received from debtors
BThe amount expected to be lost due to uncollectible accounts
CThe total sales made on credit
DThe cash expected to be received in the future
Check answerHide answer
Correct answer: Option 2 — The amount expected to be lost due to uncollectible accounts
Q101 Mark
Which of the following statements is true regarding outstanding expenses?
AThey are expenses that have been paid in cash
BThey are expenses incurred but not yet paid
CThey are recorded as income in the current period
DThey are shown as a liability in the income statement
Check answerHide answer
Correct answer: Option 2 — They are expenses incurred but not yet paid
Q111 Mark
What is the effect of depreciation on the financial statements?
AIt increases the net income
BIt reduces the value of assets
CIt has no effect on cash flow
DIt is recorded as a current liability
Check answerHide answer
Correct answer: Option 2 — It reduces the value of assets
Q121 Mark
Income received in advance is classified as which type of account?
AAsset
BLiability
CEquity
DRevenue
Check answerHide answer
Correct answer: Option 2 — Liability
Q131 Mark
Which of the following is NOT an adjustment made in the financial statements?
AProvision for discount on debtors
BOutstanding income
CAccrued expenses
DCash sales
Check answerHide answer
Correct answer: Option 4 — Cash sales
Q141 Mark
What is the purpose of creating a provision for discount on debtors?
ATo estimate future cash inflows
BTo account for potential discounts given to customers
CTo reduce the total sales revenue
DTo increase the net profit
Check answerHide answer
Correct answer: Option 2 — To account for potential discounts given to customers
Q151 Mark
If a business has outstanding expenses at the end of the accounting period, how should it be recorded?
AAs an increase in assets
BAs a decrease in liabilities
CAs an increase in liabilities
DAs a decrease in equity
Check answerHide answer
Correct answer: Option 3 — As an increase in liabilities
Short Answer Questions10 questions
Q163 Marks
Why are adjusting entries necessary?
View sample solutionHide solution
Adjusting entries are needed because some transactions affect more than one accounting period. They ensure that revenues and expenses are recognised in the period to which they relate (matching principle) — outstanding expenses are added; prepaid expenses are subtracted; accrued income is added; income received in advance is subtracted. Without adjustments, profit/loss and balance sheet figures would not give a true and fair view.
Q173 Marks
Explain how to treat closing stock in trial balance.
View sample solutionHide solution
Closing stock is usually shown as an adjustment outside the trial balance — taken on credit side of trading account AND on asset side of balance sheet. If closing stock is given inside the trial balance (already adjusted), it is shown only on the balance sheet (asset side) and NOT in the trading account, because the purchases figure has already been adjusted for the closing stock.
Q183 Marks
Distinguish between bad debts and doubtful debts.
View sample solutionHide solution
Bad debts are amounts that have been confirmed to be uncollectible from debtors and are written off as a definite loss. They reduce debtors and are charged to P&L. Doubtful debts are debts that may not be collected — collection is uncertain. A provision is created for them by debiting P&L and crediting Provision for Doubtful Debts. The provision appears as a deduction from debtors on the balance sheet. Bad debts represent confirmed losses; doubtful debts represent anticipated losses.
Q193 Marks
How is depreciation treated as an adjusting entry?
View sample solutionHide solution
Depreciation is calculated on fixed assets and recorded by debiting Depreciation A/c and crediting the related asset (or Provision for Depreciation A/c). The depreciation amount is then transferred to the P&L Account as an expense. On the balance sheet, the fixed asset is shown at original cost less accumulated depreciation. This adjustment ensures that the cost of the asset used during the period is matched with the revenue earned.
Q203 Marks
What is meant by an adjustment for accrued income? Pass the entry.
View sample solutionHide solution
Accrued income is income earned during the period but not yet received in cash. Adjustment ensures it is shown in the period it relates to. Example: interest of ₹1000 on investments earned but not received by year end. Adjusting entry: Accrued Interest A/c Dr ₹1000; To Interest A/c ₹1000. In P&L: ₹1000 added to interest received. In balance sheet: ₹1000 shown as 'Accrued Income' under current assets.
Q213 Marks
What is closing stock and how is it valued in the financial statements?
View sample solutionHide solution
Closing stock refers to the unsold inventory at the end of the accounting period. It is valued at cost or market price, whichever is lower, and is recorded in the balance sheet as a current asset.
Q223 Marks
Define outstanding expenses and provide an example.
View sample solutionHide solution
Outstanding expenses are those expenses that have been incurred but not yet paid by the end of the accounting period. An example is wages payable for work done but not yet compensated.
Q233 Marks
What are prepaid expenses and how are they treated in financial statements?
View sample solutionHide solution
Prepaid expenses are payments made in advance for services or goods to be received in the future. They are recorded as current assets until the benefit is realized, at which point they are expensed.
Q243 Marks
Explain the concept of income received in advance.
View sample solutionHide solution
Income received in advance refers to payments received for services or goods that have not yet been delivered. It is recorded as a liability until the service is provided or the goods are delivered.
Q253 Marks
What is the purpose of creating a provision for doubtful debts?
View sample solutionHide solution
A provision for doubtful debts is created to account for the estimated amount of accounts receivable that may not be collected. This helps in presenting a more accurate financial position by anticipating potential losses.
Long Answer Questions6 questions
Q266 Marks
From the following information, prepare the P&L Account and Balance Sheet of M/s Anjali Stores as on 31 March 2024 (assume relevant balances; show only the adjustments): Trial balance items include Salaries ₹20000; Rent ₹5000; Insurance ₹2400 (one year ending 30 Sep 2024); Debtors ₹50000; Bad debts ₹1000; Provide for doubtful debts @5% of debtors. Outstanding salary ₹3000.
View sample solutionHide solution
Adjustments treatment: (i) Salaries 20000 + outstanding 3000 = 23000 charged to P&L. Outstanding salary 3000 shown as current liability. (ii) Insurance ₹2400 paid for 12 months ending 30 Sep 2024 — only 6 months (Apr-Sep 2023 already in trial; or Apr 2023-Mar 2024 portion = 6 months Oct-Mar = 1200) actually relates to current year. Wait: better interpretation — paid for year ending 30 Sep 2024 means 1 Oct 2023 to 30 Sep 2024; 6 months (Oct-Mar) belong to current year FY 2023-24 = ₹1200; 6 months (Apr-Sep 2024) is prepaid = ₹1200 shown as current asset. P&L charge: ₹1200. (iii) Bad debts 1000 — debited to P&L. (iv) Provision for doubtful debts @5% on debtors after bad debts: (50000 − 1000) × 5% = ₹2450. New provision ₹2450 — full charge to P&L (assuming no opening provision). Total bad debts + provision charged to P&L = 1000 + 2450 = ₹3450. Balance sheet: Debtors 50000 − Bad debts 1000 − Provision 2450 = ₹46550 net debtors.
Q276 Marks
From the following information of M/s Manoj Traders, prepare the Profit & Loss Account and Balance Sheet for the year ended 31 March 2024 (after the Trading Account has shown a Gross Profit of ₹80000): Capital ₹150000, Drawings ₹10000, Land ₹100000, Furniture ₹30000, Debtors ₹40000, Creditors ₹20000, Cash ₹15000, Salaries ₹15000, Rent ₹6000. Adjustments: charge depreciation on furniture @10% p.a.; outstanding salary ₹1000; create 5% provision for doubtful debts.
View sample solutionHide solution
Adjustments first: depreciation on furniture = 30000×10% = 3000; outstanding salary = 1000; provision for doubtful debts = 40000×5% = 2000. P&L A/c: Dr — To Salaries 15000+1000 = 16000; Rent 6000; Depreciation 3000; Provision for doubtful debts 2000; Net Profit transferred 53000. Cr — By Gross Profit b/d 80000. Balance Sheet as on 31 March 2024: Liabilities — Capital 150000 + Net Profit 53000 − Drawings 10000 = 193000; Outstanding salary 1000; Creditors 20000. Total = ₹214000. Assets — Land 100000; Furniture 30000−3000 = 27000; Debtors 40000−2000 = 38000; Cash 15000; (Insurance prepaid if any). Total = ₹180000... Recheck totals (real-world numbers may need a bit more data) — illustration shows the methodology.
Q286 Marks
Explain the treatment of: (i) prepaid expenses, (ii) outstanding expenses, (iii) accrued income, (iv) income received in advance, (v) bad debts written off after preparing trial balance.
View sample solutionHide solution
(i) Prepaid expenses — paid in current period but relate to next period. P&L: deduct from related expense. Balance sheet: show as current asset. Entry: Prepaid Expense A/c Dr; To Expense A/c. (ii) Outstanding expenses — incurred in current period but not yet paid. P&L: add to related expense. Balance sheet: show as current liability. Entry: Expense A/c Dr; To Outstanding Expense A/c. (iii) Accrued income — earned in current period but not yet received. P&L: add to related income. Balance sheet: show as current asset. (iv) Income received in advance — received but pertains to next period. P&L: deduct from related income. Balance sheet: show as current liability. (v) Bad debts written off after trial balance — debit P&L (bad debts); credit debtors. Provision for doubtful debts is then computed on debtors net of these new bad debts.
Q296 Marks
Explain Gross profit ratio and Net profit ratio with examples.
View sample solutionHide solution
(1) Gross Profit Ratio = (Gross Profit / Net Sales) × 100. Indicates the efficiency of trading or production activities. Higher ratio is better. Example: GP ₹50000 on sales of ₹250000 → GP ratio = 20%. A declining ratio over years signals rising costs or falling selling prices. (2) Net Profit Ratio = (Net Profit / Net Sales) × 100. Indicates the overall profitability after all expenses. Example: NP ₹25000 on sales of ₹250000 → NP ratio = 10%. The gap between GP and NP ratios reveals indirect expenses and non-operating losses. Both ratios are key indicators in analysing financial performance and comparing across years/firms.
Q306 Marks
Distinguish between provision for doubtful debts and bad debts written off, and show their treatment in P&L Account and Balance Sheet.
View sample solutionHide solution
Bad debts written off — confirmed loss when a debtor refuses or is unable to pay. Recorded as Bad Debts A/c Dr; To Debtors A/c. Charged to P&L. Provision for doubtful debts — anticipated loss; some debtors may default. Created based on past experience as a percentage of debtors. Recorded as P&L A/c Dr; To Provision for Doubtful Debts A/c. P&L treatment: combined entry — Bad Debts (already written off) + New provision − Old provision = Net charge to P&L. Balance Sheet treatment: Debtors total − Bad debts (if not yet adjusted) − Provision for doubtful debts = Net realisable debtors. The provision is a contra-asset (deduction from debtors), not a separate liability.
Q316 Marks
Differentiate between adjustment entries and rectification entries in tabular form.
Assertion–Reason Questions8 questions
Q321 Mark
Assertion (A): Adjusting entries are required to comply with the matching principle.
Reason (R): Adjustments ensure that revenues and expenses of the period are correctly recognised regardless of the cash flow.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q331 Mark
Assertion (A): Outstanding expenses are shown as current liabilities.
Reason (R): Outstanding expenses represent obligations to pay in the near future.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q341 Mark
Assertion (A): A prepaid expense is shown as a current asset on the balance sheet.
Reason (R): The portion that relates to the next accounting period is treated as an asset.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q351 Mark
Assertion (A): Provision for doubtful debts is computed on debtors after deducting bad debts.
Reason (R): The provision is an estimate of further bad debts on the remaining good debtors.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q361 Mark
Assertion (A): Manager's commission is calculated on net profit before charging commission.
Reason (R): Commission as a percentage of pre-commission profit is straightforward to compute and avoids circular calculations.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q371 Mark
Assertion (A): Closing stock is included in the financial statements to ensure that the cost of goods sold is accurately calculated.
Reason (R): Closing stock is treated as an asset in the balance sheet and affects the profit calculation.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Q381 Mark
Assertion (A): Outstanding expenses are recorded as assets in the financial statements.
Reason (R): Outstanding expenses represent amounts that are owed but not yet paid, thus they are liabilities.
Show explanationHide explanation
Correct answer: Option 4 —
A is false, but R is true.
Q391 Mark
Assertion (A): Accrued income is recognized in the financial statements even if cash has not yet been received.
Reason (R): Accrued income follows the accrual basis of accounting, which recognizes income when earned.
Show explanationHide explanation
Correct answer: Option 1 —
Both A and R are true, and R is the correct explanation of A.
Statement-Based Questions8 questions
Q401 Mark
Statement 1: Adjustments are necessary at year-end to apply matching principle.
Statement 2: All revenues and expenses must be matched within the same accounting period.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q411 Mark
Statement 1: Closing stock appearing in the trial balance is shown only on the balance sheet.
Statement 2: If closing stock is in trial balance the purchases have already been adjusted.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q421 Mark
Statement 1: Accrued income is added to the related income in P&L Account.
Statement 2: It is shown as a current asset on the balance sheet.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q431 Mark
Statement 1: Bad debts written off are charged to P&L as a confirmed loss.
Statement 2: Provision for doubtful debts represents anticipated future losses on debtors.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q441 Mark
Statement 1: Income received in advance is deducted from the related income in P&L.
Statement 2: It is shown as a current liability since it relates to a future period.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q451 Mark
Statement 1: Outstanding expenses are recorded as liabilities in the balance sheet.
Statement 2: Prepaid expenses are shown as assets in the balance sheet.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Q461 Mark
Statement 1: Provision for doubtful debts reduces the total debtors in the balance sheet.
Statement 2: Depreciation is not considered while preparing financial statements for a sole proprietorship.
Show answerHide answer
Correct answer: Option 3 —
Only Statement 2 is true.
Q471 Mark
Statement 1: Closing stock is included in both the trading account and the balance sheet.
Statement 2: Income received in advance is treated as a liability until earned.
Show answerHide answer
Correct answer: Option 1 —
Both statements are true.
Case Study / Passage Questions3 questions
Q483 Marks
On 31 March 2024 M/s Verma Stores has these items: Salaries paid ₹50000; Outstanding salaries ₹3000; Rent paid ₹12000 (includes ₹2000 for April 2024); Insurance prepaid ₹500; Interest received ₹1000 (out of which ₹200 relates to next year).
Outstanding expenses are:
AAdd to expense
BSubtract from expense
CNo effect
DTreat as income
Income received in advance is:
AAdd to income
BSubtract from income
CAdd to expense
DSubtract from expense
Pass the adjustment entries and explain the rationale.
Show answersHide answers
1. Option 1 — Add to expense
2. Option 2 — Subtract from income
3. Adjustments treatment: (1) Outstanding salaries 3000 — added to salaries in P&L (total 53000); shown as current liability on balance sheet. (2) Rent paid 12000 includes prepaid 2000 — expense in P&L is only 10000; ₹2000 shown as prepaid asset on balance sheet. (3) Insurance prepaid 500 — already appears as a separate item (asset on balance sheet); only the expired portion is in P&L. (4) Interest received 1000 includes 200 advance — only 800 shown as income in P&L; 200 shown as 'Income received in advance' under current liabilities. These adjustments apply the matching principle so expenses and revenues fall in the correct period.
Q493 Marks
On 31 March 2024 M/s Anita Ltd has debtors ₹100000 (after writing off bad debts ₹3000 during the year). Old provision for doubtful debts as on 1 April 2023 was ₹4000. The new provision required is 5% of closing debtors.
If old provision is less than new provision the difference is:
ADecrease
BIncrease
CNo change
DCancel
Net charge to P&L for bad debts and provision is:
A₹2000 charge
B₹2000 credit
C₹4000 charge
D₹5000 charge
Compute net charge to P&L and balance sheet treatment.
Show answersHide answers
1. Option 2 — Increase
2. Option 3 — ₹4000 charge
3. New provision required = 100000 × 5% = ₹5000. Old provision = ₹4000. Adjustment to provision = 5000 − 4000 = ₹1000 (additional charge). P&L charge: Bad debts already written off 3000 + Increase in provision 1000 = ₹4000 charged to P&L. Wait, the actual computation differs because it depends on whether opening balance was used during the year. Standard formula: Net charge = Bad debts + Closing provision − Opening provision = 3000 + 5000 − 4000 = ₹4000. Balance sheet: Debtors 100000 − Provision 5000 = Net debtors ₹95000. The combined treatment ensures matching of estimated bad debts with the period's revenue.
Q503 Marks
M/s Sangam & Co. has agreed to pay its manager a commission of 10% on net profit before charging the commission. Net profit (before commission) for the year ended 31 March 2024 is ₹110000.
Manager's commission is calculated on:
AOn gross profit
BOn net profit before commission
COn net profit after commission
DOn sales
The manager's commission for the year is:
A₹10000
B₹11000
C₹12222
D₹15000
Compute manager's commission for both pre- and post-commission bases.
Show answersHide answers
1. Option 2 — On net profit before commission
2. Option 2 — ₹11000
3. Manager's commission @10% on profit before commission = 110000 × 10% = ₹11000. Net profit AFTER commission = 110000 − 11000 = ₹99000. Adjustment entry: P&L A/c Dr ₹11000; To Manager's Commission A/c ₹11000. Balance sheet: Manager's commission outstanding ₹11000 (current liability, if not yet paid). Alternative: if commission is given on profit AFTER commission (less common), formula is rate/(100+rate) × profit-before-commission = 10/110 × 110000 = ₹10000. Question explicitly states 'before commission' so the simpler 10% × 110000 applies.
Table-Based Questions3 questions
Q513 Marks
Common adjustments and their treatment in P&L and Balance Sheet:
Adjustment
Treatment in P&L
Treatment in Balance Sheet
Outstanding expense
Add to expense
Current liability
Prepaid expense
Subtract from expense
Current asset
Accrued income
Add to income
Current asset
Income received in advance
Subtract from income
Current liability
Bad debts (after TB)
Charge to P&L
Deduct from debtors
Provision for doubtful debts
Charge to P&L
Deduct from debtors
Depreciation
Charge to P&L
Deduct from asset
Which appears as a current asset on the balance sheet?
AOutstanding salary
BPrepaid rent
CAccrued interest
DIncome received in advance
Income received in advance is treated in the P&L by:
AAdd to income
BSubtract from income
CNo effect
DAdd to expense
Explain why each adjustment has two effects.
Show answersHide answers
1. Option 2 — Prepaid rent
2. Option 2 — Subtract from income
3. Adjustments apply the accrual basis of accounting and the matching principle. Each adjustment has TWO effects: one in the P&L (recognise the right amount of expense or income for the period) and one in the Balance Sheet (recognise the asset or liability the adjustment creates). Memorise the table by recognising the pattern: outstanding/accrued = liability or asset for what's pending; prepaid/in-advance = asset or liability for what's been overdone. Two-fold treatment ensures both income statement and balance sheet are correct.
Q523 Marks
Provision treatment in P&L and Balance Sheet:
Provision
P&L treatment
Balance Sheet treatment
Provision for doubtful debts
Net change to P&L
Deduction from debtors
Provision for tax
Charge to P&L (after tax)
Current liability
Provision for depreciation
Charge to P&L
Deduct from fixed asset
Provision for discount on debtors
Charge to P&L
Deduction from debtors
Provision for doubtful debts is shown on balance sheet as:
AAsset side
BLiability side
CDeduction from debtors
DP&L only
Provision for tax is computed:
ACharged before tax
BCharged after tax
CBoth
DNeither
Why are some provisions deducted from assets and others shown as liabilities?
Show answersHide answers
1. Option 3 — Deduction from debtors
2. Option 2 — Charged after tax
3. Provisions are charges against profit (not appropriations) so they appear in the P&L. Their balance sheet treatment depends on what they relate to: if they relate to a specific asset (doubtful debts depreciation discount) they appear as a deduction from that asset (contra-asset). If they relate to a future obligation (tax) they appear as a current liability. The combined effect: profit is reduced by the provision charge and the related asset or liability appears at its net or owed amount. This dual treatment satisfies the matching principle and faithful representation.
Q536 Marks
Compute net profit after applying the following adjustments to gross profit ₹80000.
Item
Amount
Gross profit
₹80000
Salaries paid
₹15000
Outstanding salary
₹1000
Rent paid
₹6000
Bad debts written off
₹1000
Debtors (closing)
₹40000
Provision for doubtful debts @5%
? ₹2000
Depreciation on furniture
₹3000
Picture-Based Questions1 question
Q543 Marks
Study the adjustments matrix and answer:
Outstanding salary affects:
AP&L only
BBalance Sheet only
CBoth P&L and Balance Sheet
DNeither
Income received in advance is shown on the balance sheet as a:
AAsset
BLiability
CCapital
DRevenue
Explain why every adjustment has a dual effect.
Show answersHide answers
1. Option 3 — Both P&L and Balance Sheet
2. Option 2 — Liability
3. Year-end adjustments apply the matching principle: revenues and expenses must fall in the period to which they relate, regardless of cash flow. Each adjustment has a DUAL effect: one in the P&L (recognise the right amount of expense or income for the period) and one in the Balance Sheet (recognise the asset or liability the adjustment creates). The pattern: (1) Outstanding/Accrued items create a CURRENT LIABILITY (owe to outsider) or CURRENT ASSET (owed by outsider) and adjust the related expense/income. (2) Prepaid/In-advance items create the opposite — paid in advance becomes an asset; received in advance becomes a liability. (3) Bad debts, provisions, and depreciation reduce both the asset and the profit. Skipping adjustments overstates or understates the period's profit and the year-end financial position.
