After all adjustments are made, the financial statements are prepared so that net profit and the financial position show accurate figures on the accrual basis.
Effect in the Profit and Loss Account
- Depreciation — an expense in the profit and loss account.
- Accrued expense — added to the related expense.
- Prepaid expense — deducted from the related expense.
- Accrued income — added to the related income.
- Prepaid income — deducted from the related income.
Effect in the Statement of Financial Position
- Accumulated depreciation — deducted from the asset's cost (net book value).
- Provision for doubtful debts — deducted from debtors.
- Prepayments and accrued income — current assets.
- Accrued expenses and prepaid income — current liabilities.
Key idea
Net profit = Gross profit + Income (adjusted) − Expenses (adjusted). Depreciation and bad debts reduce net profit.
Example
Gross profit is RM30,000. Expenses before adjustment are RM16,000, plus depreciation RM2,000 = adjusted expenses RM18,000. Net profit = RM30,000 − RM18,000 = RM12,000. If depreciation is ignored, net profit would be overstated by RM2,000.
Order of Preparation
Prepare the statements in order: the trading account for gross profit, followed by the profit and loss account that includes the adjusted income and expenses, and finally the statement of financial position. Make sure each adjustment is taken into account twice. For example, depreciation appears as an expense in the profit and loss account and accumulated depreciation as a deduction from the asset in the statement of financial position. Consistency between the two statements is essential so that the accounting equation balances.
Remember
Each adjustment appears twice: once in the profit and loss account (income/expense) and once in the statement of financial position (asset/liability). Ignoring depreciation or bad debts overstates net profit.