Correcting Draft Profit Before Financial Statements
Draft profit of Rohan Traders for the year ended 31 March 2025 is ₹1,86,000 before the following. Closing stock ₹22,000 was omitted. Goods costing ₹15,000 were taken by Rohan for personal use and recorded only as purchases. Wages ₹9,000 paid for installing new machinery were debited to wages. Rent ₹4,000 for March is outstanding. Bad debts ₹6,000 are to be written off; debtors after write-off are ₹1,14,000 and a provision for doubtful debts at 5% is required; there is no existing provision. The accountant says the draft profit is final because all cash payments are recorded. Rohan wants to know the corrected profit and whether omission of closing stock affects only profit or also the balance sheet. He also asks whether installation wages can be treated as revenue expenditure to reduce tax.
1. Compute corrected net profit. Show each adjustment and whether it increases or decreases profit.
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Start with draft profit ₹1,86,000 and correct on an accrual basis:
| Adjustment | Effect on profit ₹ | Reason |
|---|---|---|
| Add omitted closing stock | +22,000 | Reduces cost of goods sold; also creates a current asset |
| Add goods taken by proprietor | +15,000 | Purchases were overstated; the debit belongs to Drawings, not expense |
| Add installation wages | +9,000 | Capital expenditure; debit Machinery, not Wages |
| Less outstanding rent | (4,000) | Accrued expense of the year |
| Less bad debts | (6,000) | Loss already incurred; debtors must be reduced |
| Less provision for doubtful debts | (5,700) | 5% of ₹1,14,000 after bad debts |
Corrected profit = 1,86,000 + 22,000 + 15,000 + 9,000 − 4,000 − 6,000 − 5,700 = ₹2,16,300.
2. Explain why omission of closing stock affects both profit and the balance sheet, and why installation wages are not a revenue expense.
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Closing stock is credited in the trading account, reducing cost of goods sold, and is also shown as a current asset. If it is omitted, purchases or cost of goods sold remain too high, so gross profit and net profit are understated; simultaneously, current assets and capital are understated. The omission therefore affects two statements, not only profit.
Installation wages bring the new machinery to a working condition. They are part of the cost of the asset and should be debited to Machinery, then depreciated over its useful life. Treating them as wages would understate the asset and overstate expense in the current year. Deliberately treating capital expenditure as revenue expenditure to reduce tax would misstate the financial statements and is not acceptable accounting.
3. Evaluate the accountant’s statement that draft profit is final because all cash payments are recorded.
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The statement confuses cash recording with accrual accounting. Profit must reflect expenses incurred and income earned for the period, not merely cash paid. Outstanding rent, bad debts, the doubtful-debt provision and the omitted closing stock are all required adjustments even though no cash movement occurs for some of them. The matching and prudence concepts require these adjustments. The accountant’s statement would also ignore the capital-revenue distinction for installation wages and the drawings adjustment.