Sharma Furniture Works: Four Entries That Change the Loan File
Sharma Furniture Works is a sole proprietorship in Bareilly with a year ending 31 March. The owner, Deepak, has reported a net profit of ₹2,40,000 and is applying for a ₹15 lakh term loan. Before submission his accountant finds four doubtful entries. On 1 April the firm bought a wood-cutting machine for ₹1,50,000 and paid ₹12,000 as freight, insurance in transit and installation; the entire ₹1,62,000 was debited to the Wages Account. Repairs to the showroom roof, costing ₹25,000, were debited to the Building Account. An old edge-bander, whose written-down value on 1 April was ₹22,000, was sold in December for ₹18,000 and the whole proceeds were credited to the Sales Account. No depreciation has been charged on the new machine. Deepak's practice is to charge depreciation at 15% per annum on the written-down value of machinery, but he now wants to switch to the straight-line method because it would produce a higher profit in the file he is about to give the bank.
1. Classify each doubtful entry as capital or revenue, state the correction, and compute the corrected profit.
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Test applied: an item is capital if it creates a benefit lasting beyond the year or brings an asset to working condition; it is revenue if it merely maintains existing earning capacity.
| Item | How it was treated | Correct treatment | Effect on profit (₹) |
|---|---|---|---|
| Machine ₹1,50,000 + ₹12,000 freight/installation/transit insurance debited to Wages | Revenue expense | Capitalise ₹1,62,000 as machinery; freight, transit insurance and installation are part of cost because they are necessary to bring the asset to working condition. Charge depreciation 15% × 1,62,000 = ₹24,300 | Add back 1,62,000; deduct 24,300 = +1,37,700 |
| Showroom roof repairs ₹25,000 debited to Building | Capital | Revenue repair: it restores, but does not increase, the earning capacity of the building. Debit to Profit and Loss | −25,000 |
| Sale of edge-bander ₹18,000 credited to Sales | Revenue receipt | Capital receipt, not sales. Remove ₹18,000 from sales; record loss on sale = WDV 22,000 − 18,000 = ₹4,000 | −18,000 − 4,000 = −22,000 |
Net adjustment = 1,37,700 − 25,000 − 22,000 = +₹90,700.
Corrected profit = 2,40,000 + 90,700 = ₹3,30,700.
Note the direction of the errors: two of them understated profit and two overstated it, so the owner has no automatic reason to celebrate. The ₹1,62,000 cash outflow is unchanged in every case; what changes is the year to which it is charged.
2. Show how the corrections change the balance sheet, and explain why the bank should not rely on profit alone.
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Machinery. The new machine enters the books at cost ₹1,62,000 less depreciation ₹24,300 = ₹1,37,700. The old edge-bander disappears with its WDV of ₹22,000. Assuming these are the only machines, machinery in the balance sheet changes from nil to ₹1,37,700.
Building. Reduced by ₹25,000, because the roof repair was not an addition.
Capital. Increases by the corrected profit of ₹90,700 (assuming no drawings were affected).
Balance sheet totals still agree, because every correction has a double entry: removing ₹1,62,000 from Wages debits machinery and later depreciation; removing ₹25,000 from Building debits repairs; removing ₹18,000 from Sales debits the machinery account and a loss account.
Why the bank must look further than profit:
- Profit is an accounting figure, not cash. Depreciation of ₹24,300 reduced profit without taking a rupee out of the bank. A banker assessing repayment capacity looks at cash accruals, not reported profit.
- The corrections reveal weak book-keeping. A firm that misposts a ₹1,62,000 asset purchase into wages has no reliable stock or debtor records, and the bank will price that risk in.
- A method change designed to impress a lender is a red flag. If Deepak changes the depreciation method in the same year he applies, the bank will ask for the quantified effect and may treat the projection as unreliable.
The honest route is to submit the corrected statements with a note explaining each adjustment; an unexplained ₹90,700 improvement destroys credibility.
3. Advise Deepak on whether he should switch to the straight-line method before applying for the loan.
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Advice: do not switch this year, and if he must switch, do not do it silently.
Reasons:
- Consistency. A sole trader is not bound by the Companies Act, but the consistency convention and Accounting Standard 10 require the same depreciation method year after year so that results are comparable. A change is permitted only if it gives a more true and fair view, and the fact that the change would flatter a loan application is not a reason of that kind.
- The gain is temporary, not real. Under straight-line the charge is 15% of original cost every year, so early profits are higher but later profits are lower than under WDV. Over the asset's life the total depreciation is identical. Deepak would be borrowing against a profit figure that reverses itself.
- It may backfire. The bank will compute the Debt Service Coverage Ratio and ask for a Chartered Accountant's certificate. An unexplained method change invites scrutiny of the very figures Deepak wants accepted.
If he still decides to change:
- Apply the new method from the current year onwards and disclose it in a note to the accounts.
- Quantify and disclose the effect: on the corrected figures, straight-line would charge 15% of ₹1,62,000 = ₹24,300, which happens to equal the WDV charge in year one because the asset is new. The difference appears only from year two, when WDV gives 15% of ₹1,37,700 = ₹20,655 against ₹24,300 under straight-line. So the switch would actually lower profit in later years and gains him almost nothing now.
- State the reason as a change in the expected pattern of use of the asset, never as a wish to show higher profit.
The stronger file is the corrected one: profit ₹3,30,700, machinery ₹1,37,700, with every adjustment explained.