One Bank Account, Two Lives: Correcting a Tailor's Profit
Kalaiselvi runs a small tailoring unit in Coimbatore. She operates one bank account for both the unit and her household. In the year ended 31 March 2024 she bought an industrial sewing machine for ₹48,000 and debited the whole amount to Purchases. She paid her son's school fees of ₹22,000 from the same account and recorded it as Office Expenses. In February she delivered uniforms worth ₹35,000 to a school on credit; she decided to record the sale only when cash is received in April. She also changed the method of charging depreciation on her existing furniture from straight line to written-down value, saying it would 'bring the profit down to a reasonable figure'. Closing stock was valued at selling price ₹60,000 although its cost was ₹42,000. Her accountant reports a net profit of ₹85,000 before any correction, and depreciation on the new machine at 10% per annum has not been charged.
1. Identify the accounting concept or convention violated by each of Kalaiselvi's five decisions, and state the direction of the effect on reported profit.
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Each decision breaks a different idea, and the effect on profit is not always the same.
- Sewing machine debited to Purchases - violates the business entity concept and the distinction between capital and revenue expenditure. A machine gives benefit for several years, so it is a fixed asset, not a purchase expense. Profit is understated by the excess expense, although depreciation must still be charged.
- School fees recorded as Office Expenses - violates the business entity concept. The proprietor and the business are separate for accounting purposes. The fees are drawings, not a business expense, so profit is understated.
- Credit sale not recorded until cash is received - violates the accrual concept and the matching concept. Revenue should be recognised when the sale is made, not when cash arrives. Profit is understated in the current year.
- Changing depreciation method to reduce profit - violates the consistency convention. A change made merely to manipulate profit is not acceptable; if a genuine change is made, it must be disclosed and applied properly.
- Closing stock at selling price - violates the prudence convention and the cost concept. Stock is valued at cost or net realisable value, whichever is lower. Profit is overstated by the unrealised holding gain.
2. Compute the corrected net profit for the year. Assume a full year's depreciation at 10% on the new machine and ignore tax.
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Start with the reported profit and correct each item in the direction it affects profit.
| Correction | ₹ |
|---|---|
| Reported net profit | 85,000 |
| Add back machine wrongly debited to Purchases | 48,000 |
| Less depreciation on machine (10% of ₹48,000) | (4,800) |
| Add back school fees wrongly treated as business expense | 22,000 |
| Add credit sales recognised under accrual | 35,000 |
| Less overvaluation of closing stock (₹60,000 − ₹42,000) | (18,000) |
| Corrected net profit | 1,67,200 |
Reasoning: the machine correction is a net addition of ₹43,200 because the asset must be capitalised but depreciation of ₹4,800 is a genuine expense. The school fees are drawings, so removing them from expenses increases profit. The credit sale belongs to this year because the goods were delivered; the cost of those goods is already inside purchases, so no further cost adjustment is needed. The stock overvaluation is removed because profit must not include unrealised gains. The depreciation-method change is not quantified in the data; it should not be used to manipulate profit and must be regularised separately.
3. Advise Kalaiselvi on two practical changes she should make in her record-keeping.
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First, she should separate her household banking from the business. A separate current account and a clear drawings account will prevent personal payments such as school fees from being mixed with business expenses. Second, she should record credit sales and purchases when the transaction happens, not when cash moves. A simple invoice book, with a column for credit sales, and a monthly reconciliation of debtors would make the accrual basis workable. She should also fix a depreciation policy and apply it consistently, and value closing stock at cost or net realisable value, whichever is lower. These changes are not merely technical: together they make profit comparable from year to year and prevent the business from paying drawings out of what looks like profit but is really capital.