Year-end adjustments for a sole trader
Harbour View Joinery is a sole trader. Its draft profit for the year ended 31 December 20X4 is £48,600, before any of the following adjustments. Rent of £18,000 was paid on 1 January 20X4 for the twelve months to 31 March 20X5. Insurance of £9,600 was paid on 1 January 20X4 for the twelve months to 30 September 20X5. Wages of £2,400 earned by staff in December 20X4 are unpaid and unrecorded. The van, which cost £24,000 and was owned throughout the year, is depreciated at 25% per annum on a reducing-balance basis; no depreciation has been charged. Closing inventory costing £31,000 has a net realisable value of £27,500. A customer owing £1,800 has been declared bankrupt and the debt is to be written off; no entry has been made. The owner is surprised that the draft profit is higher than the increase in the bank balance and wants to know which adjustments are required.
1. Calculate the adjusted profit for the year ended 31 December 20X4 and explain the overall effect on the owner's capital.
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Start with draft profit and adjust only for items that belong to 20X4:
| Item | Working | £ |
|---|---|---|
| Draft profit | 48,600 | |
| Rent prepaid | £18,000 × 3/12 | +4,500 |
| Insurance prepaid | £9,600 × 9/12 | +7,200 |
| Wages accrued | (2,400) | |
| Van depreciation | £24,000 × 25% | (6,000) |
| Inventory write-down | £31,000 − £27,500 | (3,500) |
| Irrecoverable debt | (1,800) | |
| Adjusted profit | 46,600 |
The rent and insurance add-backs arise because part of the payments relates to 20X5. The prepaid amounts are assets, not expenses. Wages accrued are a liability. Depreciation allocates the van's cost over its useful life. Inventory is reduced to net realisable value, and the bad debt is removed from receivables. The combined effect on capital is a reduction of £2,000 (£48,600 − £46,600), matching the net reduction in assets and increase in liabilities. Profit is not a cash measure, so the owner should not expect it to equal the movement in the bank balance.
2. The owner wants to ignore the inventory write-down because the items are expected to sell for more than cost in 20X5. Discuss whether this is acceptable.
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No. Closing inventory must be measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price less the costs needed to complete and sell the items. At 31 December 20X4 the NRV is £27,500, which is below cost of £31,000, so the £3,500 write-down is required. A hope of a higher price in 20X5 does not change the condition of the inventory at the reporting date. If the write-down were omitted, profit and inventory would both be overstated by £3,500, and capital would be overstated. A later recovery in value can be recognised only up to the original cost, not above it. The owner's tax motive is not an accounting justification: tax follows the financial statements, not the other way round.