Effect of Omitted Adjustments on Profit and Equity

Adjustments at the Balance Date and Preparation of Sole Proprietorship Financial Statements

Skill: Analyse

Stimulus

Question

(a) For EACH omitted adjustment, analyse its effect on the reported net profit, state whether net profit is overstated or understated, and give the reason.

(b) Calculate the net effect on the reported net profit.

(c) Explain why the owner's equity is affected by the same amount as the net effect on net profit.

Thinking steps

1. Identify the type of each adjustment: depreciation, bad debts and provision for doubtful debts are EXPENSES; prepaid insurance instead reduces the current year's expense.
2. Recall the basic relationship: if an expense is understated, total expenses are too low, so net profit is OVERSTATED; if an expense is overstated, net profit is UNDERSTATED.
3. Analyse items 1–3: depreciation, bad debts and provision for doubtful debts not recorded means expenses are understated, so each overstates net profit by its amount.
4. Analyse item 4: prepaid insurance not removed means the whole payment was charged as expense, so the expense is overstated and net profit is understated by RM400.
5. Combine the effects: (4,500 + 700 + 900) overstated less 400 understated = net profit overstated by RM5,700.
6. Link to equity: net profit is transferred to capital, so the profit error flows straight into owner's equity by the same amount: equity is overstated by RM5,700.

Model answer

(a) Analysis of each adjustment:

1. Motor vehicle depreciation RM4,500 not recorded → depreciation expense understated → net profit OVERSTATED by RM4,500.

2. Bad debts RM700 not written off → bad debts expense understated → net profit OVERSTATED by RM700.

3. Provision for doubtful debts RM900 not created → provision expense understated → net profit OVERSTATED by RM900.

4. Prepaid insurance RM400 not adjusted → insurance expense overstated → net profit UNDERSTATED by RM400.

(b) Net effect = (4,500 + 700 + 900) − 400 = RM5,700 OVERSTATED. The true net profit should be RM5,700 lower than reported.

(c) At period end, net profit is transferred to the Capital Account (added to owner's equity). Because net profit is overstated by RM5,700, the capital carried to the Statement of Financial Position is also overstated by RM5,700. This matches the net overstatement of assets of RM5,700 (vehicle NBV +4,500, debtors +700, net debtors +900, less omitted prepaid insurance −400), so the accounting equation stays balanced.