Year-end adjustments for a sole trader: impairment, net realisable value and a revaluation
Giulia owns Kavall Interiors, an unincorporated supplier of tiles and bathroom fittings in Birkirkara. Her draft profit for the year ended 31 December 2024 is €84,600, prepared before the following matters were considered.
Trade receivables of €61,200 include €7,400 owed by Bellusa Ltd, which entered liquidation in November 2024. A liquidator's statement received on 20 January 2025 indicates a distribution of 15 cents in the euro. Nothing has been written off.
Inventory at cost of €48,300 includes 900 boxes of discontinued floor tiles costing €21,600. They can be sold locally for €9 a box, but delivery and commission will absorb €1 a box. No adjustment has been made.
On 1 July 2024 the freehold premises were revalued from a carrying amount of €150,000 to €230,000. The building has a remaining useful life of 40 years and is depreciated on a straight-line basis. No depreciation has been charged since the revaluation, and no entry has been made to any revaluation reserve.
Giulia also withdrew tiles costing €2,300 for a bathroom in her own home; the amount is still sitting in purchases. The financial statements are authorised for issue on 31 March 2025.
1. Compute Giulia's corrected profit for the year ended 31 December 2024 and give the double entry for each adjustment.
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Workings
| Item | € |
|---|---|
| Draft profit | 84,600 |
| Bellusa: write-off (7,400 − 15% × 7,400 = 1,110 recoverable) | (6,290) |
| Inventory write-down (cost 21,600 vs NRV 900 × €8 = 7,200) | (14,400) |
| Depreciation: 150,000/40 × 6/12 = 1,875 plus 230,000/40 × 6/12 = 2,875 | (4,750) |
| Goods taken by owner | 2,300 |
| Corrected profit | 61,460 |
Double entries
- Dr Irrecoverable debts expense 6,290 / Cr Trade receivables 6,290. The 1,110 expected from the liquidator stays in receivables.
- Dr Cost of sales (inventory write-down) 14,400 / Cr Inventory 14,400. IAS 2 requires measurement at the lower of cost and net realisable value; NRV is the estimated selling price less costs to complete and sell, so €9 − €1 = €8 per box.
- Dr Depreciation expense 4,750 / Cr Accumulated depreciation 4,750. Splitting the year is necessary because the revalued amount only applies from 1 July.
- Dr Revaluation reserve 1,000 / Cr Retained earnings 1,000 - the excess depreciation on the revalued element (80,000/40 × 6/12). This is a reserve transfer and does not touch profit or total equity.
- Dr Drawings 2,300 / Cr Purchases 2,300. Goods taken by the owner are a distribution of capital, not an expense, so profit rises by 2,300 while capital falls.
A common error is to charge the whole year's depreciation on €230,000 (€5,750) or to ignore depreciation altogether because the asset was revalued. Both misstate profit and the carrying amount.
2. Giulia argues that (i) the Bellusa balance should be left alone because the liquidator's letter arrived after the year end, and (ii) the €80,000 revaluation gain should be treated as profit she can draw out. Evaluate both arguments.
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(i) The Bellusa balance
IAS 10 distinguishes adjusting from non-adjusting events. The test is whether the event gives evidence of conditions that existed at the reporting date. The liquidation began in November 2024, before 31 December, so the customer's inability to pay was already a condition at the year end. The January liquidator's statement merely quantifies it. It is therefore an adjusting event even though the letter is dated after the year end. Only if the collapse had begun in, say, February 2025 would it be non-adjusting, with disclosure instead.
The Conceptual Framework reaches the same answer: at 31 December the receivable did not meet the definition of an asset at its face amount, because Giulia did not control a right to receive €7,400. Prudence supports measuring it at the best estimate of the recoverable amount rather than waiting for certainty.
(ii) The revaluation surplus
The €80,000 is an unrealised gain. It arises because the market value of the building has risen, not because a transaction with a customer has generated a realised profit. It is credited to a revaluation reserve, which is a component of equity, not a fund belonging to Giulia in her capacity as a trader.
If she withdrew it, she would be taking capital out of the business against an asset she has not sold, eroding the capital base that the building represents. Realisation happens gradually - through the extra depreciation charged over the remaining life, released to retained earnings - or on sale of the property. Recognising it as profit would also breach the accruals principle, since no transaction has occurred. A useful test: could the gain be distributed without reducing the business's operating capacity? Here, no.
3. Giulia proposes to stop depreciating the premises because 'the building is worth more every year'. Explain, briefly, why depreciation must continue and what would change if the remaining life were revised to 25 years.
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Depreciation is not a record of falling market value; it is the systematic allocation of the depreciable amount over the useful life. The building is consumed in generating revenue, and the matching principle requires that consumption to be charged as the revenue it helps produce is recognised. IAS 16 requires depreciation of each significant part of an asset with a finite useful life regardless of fair value movements; only land with an indefinite life escapes it. Revaluing upwards changes the depreciable amount, not the obligation to depreciate. Stopping depreciation would inflate profit, overstate the carrying amount and, in a company, overstate distributable reserves.
If the remaining life were revised to 25 years at 1 January 2025, this is a change in accounting estimate, not a change in policy or a prior period error. It is applied prospectively: the carrying amount at the date of change (230,000 − 4,750 = 225,250) is spread over the 25 remaining years, giving €9,010 a year instead of €5,750, with no restatement of earlier periods. IAS 8 requires disclosure of the nature and effect of the change.