Preparation of Financial Statements
This domain tests the final accounts of a sole proprietor - manufacturing, trading and profit & loss account and balance sheet - and above all the adjustment entries linking them. Most marks are lost by candidates who make an adjustment in one statement only.
The structure
- Manufacturing A/c - direct materials, direct wages and direct expenses; finished goods transfer to the Trading A/c at cost.
- Trading A/c - opening stock + net purchases + direct expenses − closing stock = cost of goods sold; gross profit = sales − COGS.
- Profit & Loss A/c - indirect expenses and incomes, adjustments, then net profit to Capital.
- Balance Sheet - assets and liabilities after every adjustment, marshalled by liquidity or permanence.
The double-effect rule
Every adjustment touches two places. Closing stock: credit the Trading A/c and show a current asset. Outstanding expense: add to that expense and show a liability. Prepaid expense: deduct from the expense and show an asset. Depreciation: debit P&L and deduct from the asset.
Worked example
Sales ₹5,00,000; opening stock ₹50,000; purchases ₹3,00,000; wages ₹50,000; closing stock ₹60,000; rent paid ₹40,000 with ₹10,000 outstanding. COGS = 50,000 + 3,00,000 + 50,000 − 60,000 = ₹3,40,000, so gross profit = ₹1,60,000. Rent charged = 40,000 + 10,000 = ₹50,000, giving net profit of ₹1,10,000. The balance sheet then shows closing stock ₹60,000 as an asset and outstanding rent ₹10,000 as a liability.
Traps
Bad debts, new provision and discount on debtors must be handled in that order - discount is computed on debtors after bad debts and provision. Closing stock appearing in the trial balance goes only to the balance sheet. Goods withdrawn by the proprietor or given as free samples reduce purchases and are charged to drawings or advertisement. Manager's commission "after charging such commission" uses rate ÷ (100 + rate). Abnormal stock loss goes to the P&L A/c, not the Trading A/c.