Introduction to Final Accounts and Accounting Treatment

What is Final Accounts and Accounting Treatment?

Final accounts are the financial statements that a company prepares at the end of an accounting period to reflect its financial performance and position. These accounts typically include the balance sheet, profit and loss account (or income statement), and cash flow statement. The purpose of final accounts is to provide stakeholders, such as shareholders, creditors, and regulatory bodies, with a clear view of the company's financial status.
Accounting Treatment refers to the process of recording transactions and events in the company's accounting records in accordance with accounting principles. This involves:
1. Identifying Transactions – Recognizing events that affect the financial position and performance of the company.
2. Recording – Documenting these transactions in the journal as they occur.
3. Classifying – Posting these entries into the appropriate accounts in the ledger.
4. Summarizing – Aggregating the data from the accounts into the final accounts at the end of the accounting period.
5. Adjusting Entries – Making necessary adjustments for accrued and deferred items to ensure compliance with the accrual basis of accounting.
6. Closing Entries – Clearing out income and expense accounts to transfer the net results to reserves or capital accounts.

Table of Contents

1. Introduction to Final Accounts
2. Components of Final Accounts & Their Meanings
3. Accounting for Bad Debt

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1. Introduction to Final Accounts

Final accounts of non-corporate entities i.e. sole proprietary concerns and partnership firms/concerns will be explained in this article.

Final accounts are the end results of the whole accounting process. Final A/c’s or annual accounts includes the following statements:

1. Trading & Profit & Loss Account and
2. Balance Sheet.

In case of manufacturing concerns the final a/c’s may include the following statements.

1. Manufacturing A/c.,
2. Trading, Profit & Loss A/c.,
3. Balance Sheet.

The above final a/c’s are prepared with the help of trial balance and additional information/adjustments.

Trading and Profit & Loss A/c shows the result of the operation (performance) that is profits earned or loss incurred during that year. Therefore all Expenses and Incomes related to that period should come in the P&L A/c, whether it is paid/received or not is not important i.e. expense should be recognized when incurred means services/benefits are received and income should be recognized when earned i.e. when services/benefits are given. This is also referred as Mercantile system of accounting or recognition of accrual principle. Due to this we make adjustments for outstanding expenses, Outstanding Incomes, prepaid expenses, Advance Incomes, closing stock etc.

Balance sheet shows the Assets & Liabilities of the organization as on a particular date. It is not an account. It is not for any period or year. It shows the financial position of the entity as of a particular date (rather at a point of time).

Manufacturing account if prepared shows the cost of goods manufactured during that period. This cost is transferred to Trading A/c.

2. Components of Final Accounts & Their Meanings

2.1 Trading Account

• Trading account shows the profit/loss made on a gross basis that is including only the direct cost of the goods.
• In trading a/c, we credit the trading income like sale and debit the cost of goods sold (opening stock + purchases (-) closing stock).
• Alternatively Opening Stock & purchases is debited & Closing stock is credited to trading account.
• Other direct expenses related to purchase or manufacture of goods like carriage inward, wages, etc. are also debited here.
• Purchase return & Sales returns will be deducted/adjusted from the purchases & sales respectively.
• The balance is known as the gross profit or gross loss, which is transferred to profit and loss a/c.
• Non-corporate entities usually prepares trading a/c so as to know the gross margin available in its sale.
• But at corporate level usually it is not prepared. In those cases the items of trading account gets incorporated in profit & loss account.

2.2 Profit and Loss Account

• It shows the performance of the entity i.e. profit earned or loss suffered considering all indirect expenses and incomes.
• Gross profit or gross loss from trading account is transferred to P&L a/c.
• Other incomes like discount, interest, etc. are credited.
• Administrative expense, selling and distribution expense, financial expense, income tax, losses, etc. are debited to it.
• The net profit/net loss is transferred to P&L appropriation a/c (if made) otherwise to capital a/c.
• If trading a/c is not prepared then in place of gross profit/gross loss all items of trading a/c will come in P&L a/c itself.

Although not necessary, but usually full profit/loss is transferred to proprietor/partners capital account, hence profit & loss account does not appear in balance sheet.

2.3 Profit & Loss Appropriation Account

• The net profit/net loss is transferred to P&L appropriation A/c.
• Interest charged on drawings is credited to it.
• Interest allowed on capital, salary/commission to proprietor/partner and transfer to reserves are debited to it.
• The net balance then left is transferred to capital a/c.

Expenses incurred to earn income is treated as charge against profit and are debited to P&L a/c whereas items which are division of this profit earned are known as appropriation of profit and charged to P&L appropriation a/c.

Trading account, P&L a/c and P&L app. a/c are period statements, showing the result (performance) of that period, usually an accounting year.

In case of corporate organization like companies balance after all appropriations including dividend, remains in P&L/P&L appropriation a/c and hence appears in balance sheet.

2.4 Manufacturing Account

• A manufacturing concern may prepare Manufacturing a/c to ascertain cost of goods manufactured.
• Raw material consumed (Op. stock + Purchases – Closing stock), carriage inward, wages, power, depreciation of factory building, machinery, etc. and other manufacturing (factory) expense are debited to it.
• Opening ThIP stock is debited and closing ThIP stock credited.
• Balance is the cost of goods manufactured and is then transferred to trading account.
• When manufacturing a/c is not prepared, these items will come in trading a/c. Sometimes depreciation a/c may be directly taken to P&L a/c instead of trading a/c.
• Manufacturing a/c is also a period statement.

A manufacturer is one who purchases raw material and process it into finished goods with the help of labour and machines at his factory and sells the finished goods. Whereas a trader purchases goods and sells it as it is.

2.5 Balance Sheet

• Balance sheet shows the financial position of the entity as at a particular point of time.
• It shows what and how much entity owns (i.e. its assets) and how much it owes to others (i.e. its liabilities), the balance (i.e. asset – liability) is the owners equity.
• It is not an account, hence does not have debit and credit side.
• On one side assets like fixed assets (building, machinery, furniture, etc.), current assets (like stock, debtors, cash bank balance, advances, prepared a/c) and investments if any are shown.
• On the other side in addition to owners capital and reserves, the outside liabilities like loans taken, creditors, expenses payable etc. are shown.
• The two sides total must be same.
• On the asset side of balance sheet we start with most permanent to least permanent i.e. fixed assets, investments and then current assets. It is known as permanency preference. In case of manufacturer/trader this sequence is followed.
• When asset side starts with most liquid asset to least liquid like cash bank balance and ends with fixed assets is known as liquidity preference generally followed by institutions like banks.
• Liability side is mostly same in all cases we have first owner capital and reserves, then loans and thereafter current liabilities and provisions.

Balance sheet is a point of time statement, when stated as at 31.3.2021 it means as at close of that date i.e. after considering all transactions of that day.

Even though balance sheet does not have debit and credit side, student should remember that asset side represent debit and capital and liability side represent credit. It will help in correctly preparing final accounts.

In General Mercantile/accrual system is followed, as it is the proper and complete system to measure the performance of entity. In your syllabus every where this is considered. Under this system, incomes are recognized when these are earned irrespective of whether amount is received or not. Similarly expenses are recognized when these are incurred or accrued irrespective of whether amount is paid or not. As a result we have to make adjustment for expenses outstanding (payable), prepaid, income outstanding (receivable) and advance-received etc.

2.6 Trial Balance

• Trial balance is a statement containing the balances of all accounts as at the end of certain period usually classified into debit and credit.
• The total of debit and credit side must tally because whole accounting is done by double entry principle, otherwise it indicates arithmetical inaccuracies.
• It has balance of expenses, incomes, assets and liabilities.
• With the help of trial balance and adjustments the final accounts are prepared.
• All expenses and incomes will go into Manufacturing, Trading, P&L and P&L app. a/c depending upon its nature and all assets and liabilities will go into balance sheet.

2.7 Adjustment/Other information/Additional information

• When the trial balance is prepared, there may still be some accounts which are not yet final and may need some adjustments, some corrections etc.
• Such information is given together with trial balance and commonly referred as adjustment/additional information/other information etc.
• It is basically a transaction which needs to be entered in the account books or some errors which needs to be rectified, hence we give double entry effect i.e. Debit & Credit both for such adjustments.
• Some times indirect information is contained, in the trial balance, which when interpreted results into an adjustment (known as adjustment derived).

Place where information is given is irrelevant. Hence adjustment though commonly given below the trial balance, can be given in the trial balance or above the trial balance.

2.7.1 Common adjustments and their entry

2.7.2 Adjustment of closing stock before preparing Trial Balance

• Any or all of the adjustments mentioned above can be recorded in the books of account and then trial balance can be prepared.
• Similarly stocks can also be adjusted before preparing trial balance as follows:
• Transfer Opening stock account to Purchases account i.e. Debit purchase a/c and Credit Opening stock a/c.
• Record closing stock in the books i.e. Debit Closing stock account and Credit Purchases account.
• Now in the Trial balance opening stock will not appear instead closing stock will appear which will be shown as asset in the balance sheet.
• The balance in Purchases account is the cost of goods sold also known as adjusted purchases which will be debited to trading account.

2.7.3 Add-less vs. debit-credit while giving treatment to adjustments

• Although there is nothing wrong in either.
• But as a student our objective should be to improve our knowledge of accounting.
• Debit credit is the language of accounting and not add-less, hence it is advisable to use your debit-credit (i.e. accounting) knowledge everywhere.
• Formulate a double entry for every transaction/adjustment and then give its effect to same accounts if appearing in trial balance and the final figure then will appear in final account.
• There is no point in memorising a long list of adjustment with there add less effects. Entry should be formed using basic accounting knowledge.

In any case in a real situation every adjustment is required to be accounted in the books of account then only profit and loss a/c and balance sheet will be as per the books of account (or in agreement with books of account) as is certified by an auditor.

2.8 Transfer entries/closing entries/closing of books of account

• After all adjustment are duly accounted.
• The individual expenses accounts are closed by debiting into trading or P&L a/c etc. as the case may be.
• Similarly all incomes a/c are closed by crediting it to Trading & P&L a/c.
• Such entries are known as closing entries.
• Balance of trading account (gross profit) is transferred to P&L a/c.
• Balance of P&L a/c (net profit) is transferred to capital a/c.
• Thus we are left with only the balances of assets and liabilities (including capital) which are shown in the balance sheet and carried forward to next years books of account by writing the balance on the other side of the account and thus account is shown as closed i.e. total on both debit and credit side gets equalized.
• When the books of account have been audited and final accounts have been prepared, then the closing entries as above are passed.
• All assets and liabilities accounts are balanced, shown in the balance sheet and carried forward to next years account book.
• It is a accepted norm, not to make any changes once the account books are audited and closed.

1. All debit balances will be either expenses or assets & all credit balances will be either incomes or Liabilities.
2. All expenses and incomes accounts are transferred to trading and profit and loss a/c and are thus closed.
3. All assets & liabilities as shown in the Balance sheet are carried forward to next years books as opening balance.

3. Accounting for Bad Debt

3.1 Meaning of Bad debt loss and its accounting

• When goods are sold on credit it creates a debt (debtor) to be collected in future.
• Debtors will include a number of parties from whom money has to be collected.
• If amount can’t be collected from any party it is said to be a bad debt (a loss).
• If we are sure that amount can’t be collected and wants to close that party’s account i.e., wants to write off the Bad debt then entry will be:

(1) Bad debt a/c Dr. …..

To Concerned party A/c (Debtors a/c) …..

• But if we don’t want to close the party account and still want to account the Bad debt loss i.e., want to provide for the Bad debts or create provision for Bad debts, then entry will be:

(2) Bad debts a/c Dr. …..

To Provision/Reserve for Bad & doubtful debt a/c …..

3.2 When are bad debts accounted?

• Entry for writing off the Bad debts (Entry No.1 in above question) may be passed any time during the year.
• But entry for creating provision for Bad debts (Entry No.2) is passed at the end of year only.
• The total debtors at the end of the year is ascertained and how much of it is doubtful of recovery is estimated.
• This will give the amount of total provision required or to be maintained.
• If already we don’t have any provision in the books then entry as per (2) above will be passed for full amount.
• But if we have opening balance of provision then entry will be passed only for the difference amount known as additional provision (i.e. New Provision (i.e. total provision required) (-) Opening balance of Provision).
• Alternatively opening provision is reversed and entry for closing provision (New provision) is passed by full amount.

3.3 If existing provision for bad and doubtful debt is more

• If the opening balance of provision is more than the provision required at the end of the year, then the excess provision will have to be written back as follows:

(3) Provision for Bad & Doubtful debt a/c Dr. …..

To Bad debts a/c …..

• This may be mentioned in adjustment as ‘provision to be decreased/reduced by……..

3.4 Treatment in final accounts

• The total of Bad debt is debited in profit & loss a/c. Total bad debt loss is:

1. 1. bad debt written off + additional provision or
   2. bad debt written off + new provision (-) old provision.

• The closing balance of provision (Final Provision/new provision) will be shown as deduction from Debtors in Balance Sheet.

3.5 Interpretation

Interpretation of adjustment given in the question as to whether it is Total Provision or Additional Provision can be made as follows:

• Entry as per (2) above should always be passed for additional provision.
• Whenever total provision is given, from this opening provision should be deducted to get the amount of additional provision.
• Alternatively old provision should be reversed (entry No. 3) and then create full new provision (entry No. 2).