The Furniture Workshop's Year-End Arguments
Kabelo runs a small furniture workshop in Molepolole. His draft income statement for the year ended 31 March 2025 shows a net profit of P85,000, but his accountant queries five items. On 20 March 2025 Kabelo received a P12,000 deposit from a customer for a dining suite to be delivered in May 2025, and he has recorded it as sales revenue. A customer owing P3,500 was declared bankrupt in February 2025; Kabelo has not written the debt off because 'he might pay one day'. Kabelo paid P9,600 in July 2024 for insurance covering the twelve months from 1 July 2024 and charged the whole amount to the year. Closing inventory is valued at its selling price of P48,000 rather than its cost of P30,000. Finally, because he hopes to sell the business next year, Kabelo has revalued the workshop building at market value in the accounts.
1. For each of the five items, name the accounting principle or concept that is being misapplied and state the correct accounting treatment.
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1. The P12,000 deposit - misapplies the realisation (revenue recognition) concept. Revenue is earned when goods are delivered to the customer, not when cash is received. Nothing has been delivered, so the P12,000 is a liability (income received in advance / customer deposit). Correct entry: Dr Bank 12,000, Cr Deposit received in advance 12,000. Reported profit is too high by P12,000.
2. The P3,500 bad debt - ignores prudence. A debt is written off when there is evidence it will not be collected; bankruptcy is such evidence. Correct entry: Dr Bad debts 3,500, Cr Trade receivable 3,500. If the money is later recovered it is credited as bad debts recovered in the year of receipt. Profit is too high by P3,500.
3. The P9,600 insurance - misapplies the accruals (matching) concept. Only the nine months 1 July 2024 to 31 March 2025 belong to this year: 9,600 × 9/12 = P7,200. The remaining 3/12 = P2,400 is a prepayment, a current asset. Profit is too low by P2,400.
4. Closing inventory at selling price - misapplies prudence, supported by the consistency convention. Inventory is valued at the lower of cost and net realisable value, so cost P30,000 must be used. Profit is too high by the unrealised P18,000.
5. The revalued building - ignores the historical cost convention and going concern. The business is trading on; assets are shown at cost less accumulated depreciation. A revaluation surplus is not profit and does not pass through the income statement, so this item has no effect on profit as calculated.
2. Calculate the corrected net profit for the year ended 31 March 2025, starting from the draft profit of P85,000. Show the effect of each item.
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| Item | Effect on profit (P) | Running profit (P) |
|---|---|---|
| Draft net profit | - | 85,000 |
| 1. Deposit treated as sales | (12,000) | 73,000 |
| 2. Bad debt not written off | (3,500) | 69,500 |
| 3. Insurance prepayment 3/12 × 9,600 | +2,400 | 71,900 |
| 4. Inventory at selling price, not cost (48,000 − 30,000) | (18,000) | 53,900 |
| 5. Building revaluation | nil | 53,900 |
Corrected net profit = P53,900.
Reasoning checks: the deposit and the bad debt are both amounts Kabelo has counted as income (or failed to count as expense) without any entitlement to them; the prepayment reduces an expense that was over-charged; the inventory adjustment removes a gain that has not yet been earned because the goods are still on hand. The draft profit of P85,000 overstated the true result by P31,100 (85,000 − 53,900).
3. Kabelo says: 'If I am selling the business next year I should definitely stop using historical cost.' Explain the going concern assumption and decide whether his intention changes the basis of preparation.
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The going concern assumption states that the financial statements are prepared on the basis that the entity will continue in operational existence for the foreseeable future, with no intention or necessity to liquidate or curtail materially the scale of its operations.
Applying it here:
- Kabelo intends to sell the business as a going concern - a buyer takes over a trading workshop, its stock, its customers and its staff. The entity is not being wound up, so the assumption still holds and accounts continue to be prepared on a historical cost basis, with depreciation charged on cost.
- Historical cost is only abandoned (in favour of break-up values) where the business is actually closing down and assets will be sold off piecemeal. That is not the position.
- If Kabelo wants to show a buyer what the business is worth, a revaluation is possible in principle, but it requires a consistent policy, an independent valuation, and separate disclosure of the revaluation surplus in a revaluation reserve. It is not slipped into the income statement as profit, and it does not replace the ordinary accounts.
- Accounting records must still comply with the accruals, prudence and consistency conventions regardless of a planned sale.
Conclusion: the intention to sell does not justify departing from historical cost. Kabelo should correct the five errors, and if he wants market values he should prepare a separate valuation statement for the buyer.