Kiran Persaud: Adjusting a Draft Profit Figure
Kiran Persaud owns a variety store. His accountant prepared a draft statement showing a net profit of $58,300 for the year ended 31 December, before the following matters were dealt with. Closing stock at 31 December was counted at $12,400 and has not yet been entered in the accounts. Rent paid during the year was $12,000, of which $3,000 relates to next year. Wages of $2,400 for the last week of December are unpaid. Insurance of $4,800 was paid for the 16 months ending 30 April next year. A debt of $1,500 is to be written off; debtors then total $40,500 and the existing provision for doubtful debts is $1,800, to be adjusted to 5% of debtors. The delivery van cost $60,000 and has accumulated depreciation of $18,000; it is depreciated at 20% per annum on the reducing balance. Equipment costing $25,000 is depreciated at 10% per annum on cost. Finally, goods costing $1,200 were taken by Kiran for his family and no entry was made; the closing stock was counted after the goods had been removed.
1. Prepare a schedule adjusting the draft net profit, showing the amount and direction of each adjustment, and state the adjusted net profit.
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| Adjustment | $ | Effect |
|---|---|---|
| Draft net profit | 58,300 | |
| Closing stock not yet entered | 12,400 | add |
| Rent prepaid (next year) | 3,000 | add |
| Insurance prepaid: 4,800 ÷ 16 = 300 × 4 months | 1,200 | add |
| Goods taken by owner (purchases overstated) | 1,200 | add |
| Wages owing | (2,400) | less |
| Bad debt written off | (1,500) | less |
| Increase in provision: 5% × 40,500 = 2,025 − 1,800 | (225) | less |
| Depreciation van: 20% × (60,000 − 18,000) | (8,400) | less |
| Depreciation equipment: 10% × 25,000 | (2,500) | less |
| Adjusted net profit | 61,075 |
Each add-back removes an expense charged to the wrong period or an amount that is not an expense at all; each deduction recognises an expense of this year that the draft omitted. The provision is calculated on debtors after the bad debt is removed, because that debt will never be collected.
2. Explain how the goods taken by Kiran should be recorded, and why the adjustment increases profit rather than being treated as an expense.
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The correct entry is Dr Drawings $1,200; Cr Purchases $1,200. Kiran has withdrawn part of his capital in the form of stock, so the amount is an appropriation of capital, not a cost of trading.
Because no entry was made, the $1,200 sits inside purchases and therefore inside cost of sales. Since the closing stock was counted after the goods had gone, it does not include them either, so nothing offsets the overstatement. Cost of sales is too high by $1,200 and profit too low by the same amount; adding it back restores the correct figure.
The distinction matters: charging the goods as an expense would understate profit and overstate drawings, and the owner would pay tax on a profit lower than he actually earned while his capital account drifted out of line with reality. Drawings reduce capital directly; they never pass through the income statement.
3. State the effect on the statement of financial position if the prepaid insurance and the unpaid wages were both ignored.
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Ignoring the prepaid insurance of $1,200 means an asset is left out: current assets are understated by $1,200 and capital is understated by $1,200, because the expense was overcharged.
Ignoring the unpaid wages of $2,400 means a liability is left out: current liabilities are understated by $2,400 and capital is overstated by $2,400, because profit includes an expense that has not been matched with a payable.
Taken together, capital is understated by a net $1,200 ($2,400 − $1,200) and the statement still balances, but the working capital position is distorted by $3,600 in total - an important point if Kiran is seeking overdraft facilities. Accruals and prepayments are not optional refinements; they determine whether the statement of financial position reflects what the business owns and owes at the year end.