Murugan's Garment Shop: Adjustments That Cut Profit
Murugan is a sole proprietor dealing in readymade garments in Salem. His trial balance for the year ended 31 March 2024 shows: opening stock ₹40,000; purchases ₹2,60,000; sales ₹4,20,000; wages ₹35,000; carriage inward ₹5,000; salaries ₹48,000; rent ₹24,000; insurance ₹12,000; bad debts ₹6,000; sundry debtors ₹80,000; furniture ₹60,000; provision for doubtful debts (opening) ₹4,000. Additional information: (a) closing stock was ₹55,000; (b) wages of ₹4,000 for March are unpaid; (c) rent of ₹24,000 was paid for 15 months up to 30 June 2024; (d) goods costing ₹5,000 were taken by Murugan for personal use but no entry was passed; (e) depreciation on furniture is 10% per annum; (f) a provision for doubtful debts is to be maintained at 5% of debtors. Murugan expects a net profit of about ₹1,00,000 and is upset that the figure will be much lower.
1. Compute the gross profit and net profit for the year, showing the necessary adjustments.
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Trading Account
| Particulars | ₹ |
|---|---|
| Sales | 4,20,000 |
| Opening stock | 40,000 |
| Purchases (2,60,000 − 5,000 goods taken) | 2,55,000 |
| Wages (35,000 + 4,000 outstanding) | 39,000 |
| Carriage inward | 5,000 |
| Less: Closing stock | (55,000) |
| Cost of goods sold | 2,84,000 |
| Gross profit | 1,36,000 |
Profit and Loss Account
| Particulars | ₹ |
|---|---|
| Salaries | 48,000 |
| Rent (24,000 × 12/15) | 19,200 |
| Insurance | 12,000 |
| Bad debts | 6,000 |
| Add: New provision (5% of 74,000) | 3,700 |
| Less: Opening provision | (4,000) |
| Depreciation on furniture (10% of 60,000) | 6,000 |
| Total expenses | 90,900 |
| Net profit | 45,100 |
The new provision is calculated on debtors after bad debts: ₹80,000 − ₹6,000 = ₹74,000; 5% is ₹3,700. Since the opening provision was ₹4,000, the provision has fallen by ₹300, which is a credit to the P&L.
2. Explain the treatment of the goods taken by Murugan and the prepaid rent. Why do drawings not reduce profit?
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Goods taken for personal use are not a business expense. They are drawings in kind. Murugan must credit Purchases with ₹5,000 and debit Drawings with ₹5,000. Crediting purchases reduces the cost of goods sold, so gross profit rises by ₹5,000; but the ₹5,000 is not income - it is a reduction of the owner's capital. If the entry were not passed, purchases and cost of goods sold would be overstated and profit understated. Rent of ₹24,000 covers 15 months, but only 12 months belong to this year. Rent per month is ₹1,600, so this year's expense is ₹19,200 and ₹4,800 is prepaid. The prepaid amount is an asset, not an expense, and must be shown in the balance sheet. Drawings do not reduce profit because profit measures the result of business operations, while drawings are a distribution of the owner's claim; they reduce capital, not profit.
3. Murugan asks whether he can avoid the provision for doubtful debts because 'the debtors are good'. Advise him.
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He should not avoid it merely to protect the profit figure. The prudence convention requires that expected losses be recognised even though they are not certain. A provision is an estimate of debts that may not be collected; it is not an admission that every debtor is bad. The correct approach is to review the ageing of debtors: old balances, disputed balances and customers in financial difficulty may need a higher provision, while genuinely good debts can be retained at the normal rate. If Murugan has evidence that a specific debtor is doubtful, he should provide for that debt. The provision reduces profit now but protects capital from being withdrawn on the basis of profits that may never be collected. If he changes the rate, he must disclose the reason and apply it consistently.