Kabo's Year-End Adjustments
Kabo's draft profit for the year ended 31 December is P84,000. His draft figures include: rent paid P24,000 (covering 12 months to 31 March of the following year); insurance paid P9,000 (for 9 months to 30 September of the following year); a bad debt written off P1,200 already recorded; a debtor owing P2,000 who has been declared bankrupt with no prospect of recovery; and a provision for doubtful debts which he has never created, though trade receivables after the write-offs are P40,000 and he wishes to provide 5%. He also took goods costing P1,500 for personal use, recorded as a sale at P1,500.
1. Calculate the adjusted profit, showing each adjustment and its direction.
Read the worked answer
| Item | Effect on profit (P) |
|---|---|
| Draft profit | 84,000 |
| Rent prepaid: 3 months (Jan–Mar) of P24,000 = 24,000 × 3/12 = P6,000 | +6,000 |
| Insurance prepaid: 3 months (Oct–Dec) of P9,000 = 9,000 × 3/12 = P2,250 | +2,250 |
| Bad debt written off (already recorded) | 0 |
| Additional bad debt - bankrupt debtor | (2,000) |
| Provision for doubtful debts: 5% × P40,000 = P2,000 | (2,000) |
| Goods taken for own use: sale wrongly recorded, stock reduced | see below |
| Adjusted profit | 86,250 |
Drawing adjustment: the goods were recorded as a sale of P1,500 but were not a sale - reverse the sale (reduce profit by P1,500) and treat the amount as drawings (reduce capital, not profit). This gives adjusted profit of 84,750.
Reasoning: prepayments are deducted from expenses because they relate to the next period (accruals/matching). The provision is a charge against profit because prudence requires receivables to be shown at recoverable amount.
2. Explain why the provision for doubtful debts is charged to the income statement even though no debtor has yet defaulted, and state the effect on the statement of financial position.
Read the worked answer
Why charge it: the accruals/matching concept requires the cost of expected losses from credit sales to be recognised in the same period as the sales that created the receivables. Prudence requires assets not to be overstated: if experience shows 5% of receivables are unlikely to be collected, carrying them at full face value overstates assets and profit. The provision is an estimate, not a write-off - no specific debt has been identified, so the debtor's account is untouched.
Statement of financial position effect:
- Trade receivables P40,000 less provision P2,000 = P38,000 net.
- The provision is shown as a deduction from receivables (or in the notes), not as a liability.
- Profit for the year falls by P2,000.
Next year: only the movement in the provision is charged or credited. If receivables rise and the provision must be P2,500, only P500 is charged. If receivables fall and the provision reduces, the reduction is credited to the income statement - a point students frequently miss.
Examiner tip: distinguish clearly between a bad debt (specific, written off) and a provision (general estimate).