Meera Traders: Converting a Cash-Book Profit into an Accrual Profit
Meera Traders is a proprietorship completing its first year. The accountant struck a draft profit of ₹4,20,000 from the cash book, posting credit sales and credit purchases only when settled - a practice the auditor has criticised. Before sign-off, six items remained unadjusted: closing stock of ₹85,000; rent for March of ₹12,000 due but unpaid; insurance of ₹9,000 paid in March covering the next six months; fixtures costing ₹6,00,000 bought in the first month, on which no depreciation has been charged although the firm's policy is 10 per cent a year on cost; debtors of ₹2,40,000, of which ₹15,000 is believed irrecoverable, with a 5 per cent provision on the remainder required by the firm's practice; and goods costing ₹18,000 taken by the owner for a family function, which were passed through purchases. The owner has already given the bank a copy of the ₹4,20,000 figure in support of an overdraft renewal.
1. Prepare a reconciliation from the draft profit of ₹4,20,000 to the corrected profit, showing each adjustment, its amount, and the accounting principle that justifies it. State any limitation on the resulting figure.
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| Item | Adjustment (₹) | Principle |
|---|---|---|
| Draft profit | 4,20,000 | - |
| Closing stock not recorded | +85,000 | Matching - cost of goods sold must exclude unsold goods |
| Rent for March unpaid | −12,000 | Accrual - expense incurred, not yet paid |
| Insurance paid in advance | +9,000 | Accrual/matching - benefit belongs to next period |
| Depreciation: ₹6,00,000 × 10% | −60,000 | Matching + going concern - cost spread over the years benefiting |
| Bad debts written off | −15,000 | Prudence - foreseeable loss recognised now |
| Provision: 5% × (2,40,000 − 15,000) = ₹11,250 | −11,250 | Prudence - expected loss on remaining debtors |
| Goods withdrawn by owner | +18,000 | Business entity - drawings are not an expense |
| Corrected profit | 4,33,750 |
Arithmetic check: 4,20,000 + 85,000 − 12,000 + 9,000 − 60,000 − 15,000 − 11,250 + 18,000 = ₹4,33,750.
Limitation to state explicitly. Because credit sales and credit purchases were posted only on settlement, the draft itself understates sales, purchases and debtors. The six items correct year-end adjustments only; a full accrual restatement also needs the unpaid debtor and creditor balances, which are not given here. ₹4,33,750 is therefore the best correction of the listed items, not a complete accrual profit, and should be presented to the bank with that caveat.
2. Explain why the ₹18,000 of goods taken by the owner is added back to profit rather than treated as an expense, and show how it affects the balance sheet. How would the treatment differ if the goods had gone to a customer?
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Why it is added back. The goods were charged to purchases, which reduced profit. But the owner did not consume them in the business - he took them for personal use. Under the business entity concept, the proprietor is separate from the business, so goods taken for personal use are drawings, an appropriation of capital, not a business expense. Leaving the ₹18,000 in purchases would understate profit and understate drawings at the same time; adding it back restores profit and records the amount as a reduction of capital.
Balance sheet effect:
- Profit rises by ₹18,000, so capital rises by ₹18,000.
- Drawings rise by ₹18,000, so capital falls by ₹18,000.
- Net effect on capital: nil, which is correct - the owner has simply taken out what he already owned.
- Stock is unaffected because the goods left the business before the year end.
If it had gone to a customer:
- Sold for cash: it is a sale, so revenue and profit increase by the selling price less cost; the add-back would not arise.
- Given on credit: it becomes a debtor until paid, and only the profit element is recognised.
- Given free as a sample or gift: it is a selling or promotional expense at cost, not drawings, and profit stays reduced.
The judgement turns on who received the goods and on what terms, not on the fact that stock left the premises.
3. The bank officer asks for a 'clean' figure, and the owner suggests charging depreciation and the provision in the next financial year instead. Evaluate that suggestion.
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The suggestion must be refused. Three principles apply directly.
- Accounting period. Each year's profit is measured separately. Pushing a cost into the next year does not eliminate it; it simply overstates this year's profit and understates next year's - the total over the asset's life is unchanged.
- Matching. The fixtures were used to earn this year's revenue, so a share of their cost must be charged against this year's revenue. The depreciation is ₹60,000 a year precisely because the benefit is consumed year by year.
- Prudence. The ₹15,000 is already believed irrecoverable and a further 5 per cent of the remaining debtors is doubtful. A foreseeable loss must be recognised in the year the doubt arises, not deferred until the account is formally written off.
The deferral would also misstate the balance sheet: fixtures would be carried at more than their recoverable amount, and debtors at more than is expected to be collected - the very figures the bank relies on for security.
What to present instead. Submit ₹4,33,750 with the reconciliation, explaining that the fall from the draft is mostly the correction of a cash-basis presentation, not a deterioration in trading. Support the overdraft with the corrected trend, the quality of debtors, and the stock figure. Giving the lender a figure the accountant knows to be overstated would make the submission misleading, which no instruction from the owner can cure.