Year-End Adjustments, Depreciation, Bad Debts and Owner Pressure
A sole trader's draft net profit for the year ended 31 December 2024 is €64,500. The following information has not been adjusted: insurance paid €4,800, of which €1,200 relates to January to March 2025; light and heat paid €3,100, with €450 accrued at 31 December; debtors before write-off €48,000, a bad debt of €1,600 is to be written off, and a provision for bad debts of 5% of remaining debtors is required, with an existing provision of €2,000; machinery at cost €120,000 with accumulated depreciation at 1 January 2024 of €42,000, depreciation is 15% reducing balance, and a new machine costing €36,000 was purchased on 1 October 2024; a 6% loan of €50,000 was taken out on 1 July 2024 and interest paid during the year was €1,000. The owner is preparing a bank loan application and wants the profit figure to be as high as possible.
1. Calculate the corrected net profit, showing each adjustment and the workings for depreciation, the bad debt provision and loan interest.
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| € | |
|---|---|
| Draft net profit | 64,500 |
| Add insurance prepaid | 1,200 |
| Less light and heat accrued | (450) |
| Less bad debt written off | (1,600) |
| Less increase in provision for bad debts | (320) |
| Less depreciation | (13,050) |
| Less loan interest accrued | (500) |
| Corrected net profit | 49,780 |
Workings
Provision: debtors after write-off = €48,000 − €1,600 = €46,400. Required provision = 5% × €46,400 = €2,320. Existing provision = €2,000, so the increase charged to profit is €320.
Depreciation: old machinery net book value = €120,000 − €42,000 = €78,000. Depreciation = 15% × €78,000 = €11,700. New machine = €36,000 × 15% × 3/12 = €1,350. Total = €13,050.
Loan interest: €50,000 × 6% × 6/12 = €1,500. Paid €1,000, so €500 is accrued.
2. Explain to the owner why the provision for bad debts and the prepaid insurance are not ignored just because no cash has moved.
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The provision for bad debts is an estimate of the amount of existing receivables that may not be collected. It is not a cash payment, but it reduces receivables to a more realistic net realisable value and matches the expected loss with the sales that created the debt. The prepaid insurance is the opposite: cash has been paid, but part of the benefit belongs to the next accounting period. The accruals concept requires the expense to be charged as the benefit is used. Treating the prepayment as income, or ignoring the provision, would overstate profit and misstate the statement of financial position.
3. The owner proposes reducing the provision from 5% to 2% to improve the profit figure for the loan application. Discuss whether this is acceptable.
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Reducing the rate to 2% would give a required provision of 2% × €46,400 = €928. Compared with the existing €2,000 provision, that would create a credit of €1,072 and increase profit to €50,852. That is not acceptable if it is done only to impress the bank. A provision is an accounting estimate and must be based on evidence such as past experience, current economic conditions and the ageing of debtors. A change is permissible only if the evidence genuinely supports a lower expected loss. Making the change solely to improve profit is biased and breaches neutrality and faithful representation. The bank would also see the reduced receivables quality and may lose confidence in the accounts.