Year-End Adjustments and Profit Correction
Mapalo, a sole trader, extracted a draft net profit of $38,500 for the year ended 31 December 2025. The following had not been adjusted: closing inventory was counted at $24,000, but this included damaged goods costing $3,000 that can be sold for only $1,200; rent of $18,000 had been paid for the 18 months to 30 June 2026 and charged in full to the draft income statement; wages of $3,000 for December 2025 were unpaid and unrecorded; a bad debt of $2,500 is to be written off against receivables of $40,000; the provision for doubtful debts is to be 5% of the remaining receivables (the existing provision is $1,500 credit); and equipment costing $80,000 with accumulated depreciation of $32,000 has not been depreciated for 2025. Depreciation is 10% straight-line. Mapalo thinks the damaged goods should stay at cost because they were bought at that price, and that the unpaid wages should be ignored until paid.
1. Calculate the adjusted net profit for the year. Show each adjustment and whether it increases or decreases profit.
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| Adjustment | $ | Effect on profit |
|---|---|---|
| Draft net profit | 38,500 | - |
| Damaged inventory: cost 3,000, NRV 1,200; write down 1,800 | (1,800) | decrease |
| Prepaid rent: 18,000 × 6/18 = 6,000; remove from expense | 6,000 | increase |
| Wages accrued | (3,000) | decrease |
| Bad debt written off | (2,500) | decrease |
| Doubtful debts: receivables 40,000 − 2,500 = 37,500; 5% = 1,875; increase in provision 1,875 − 1,500 = 375 | (375) | decrease |
| Depreciation: 80,000 × 10% | (8,000) | decrease |
| Adjusted net profit | 28,825 |
Workings: 38,500 − 1,800 + 6,000 − 3,000 − 2,500 − 375 − 8,000 = 28,825.
2. Explain the accounting treatment of the damaged inventory and the prepaid rent, referring to the accrual and prudence concepts.
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Damaged inventory must be carried at the lower of cost and net realisable value. Cost is 3,000 but NRV is only 1,200, so the inventory is written down by 1,800 and the loss is charged to the income statement. This follows prudence: assets should not be shown above the amount they can recover. Keeping the goods at cost would overstate both inventory and profit.
Prepaid rent is the opposite. The business has paid for 18 months but only 12 months relate to this year. Under the accrual concept, 12,000 is an expense of 2025 and 6,000 is an asset carried forward. Charging the full 18,000 would understate profit and understate assets. The two adjustments therefore affect profit in opposite directions.
3. State the amounts to be shown in the balance sheet at 31 December 2025 for inventory, prepaid rent, receivables (net) and equipment (net).
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At 31 December 2025:
- Inventory: 24,000 − 1,800 = $22,200 current asset.
- Prepaid rent: $6,000 current asset.
- Receivables: 40,000 − 2,500 = 37,500 gross; less provision for doubtful debts 1,875 = $35,625 net current asset. The provision is 5% × 37,500 = 1,875.
- Equipment: cost 80,000 − accumulated depreciation 32,000 − current depreciation 8,000 = $40,000 non-current asset.