Giving reasons for the effect of the following transactions on the profitability, suggest rectifying entries for each of the transaction where necessary. [5×2] a. The total of purchase book has been…

Model Answer: Effect of Transactions on Profitability and Rectifying Entries

a. The total of purchase book has been overcast by Rs. 20,000.

Effect on Profitability:

• The Purchase Book records all credit purchases of goods for resale.
• If the total is overcast by Rs. 20,000, it means the actual purchases are less than recorded (since the total was inflated).
• Impact on Profit:
  • Higher purchases recorded → Lower Closing Stock (assuming COGS is calculated as Opening Stock + Purchases – Closing Stock).
  • Higher COGS → Lower Gross Profit → Lower Net Profit.
  • Alternatively, if purchases are understated in reality but overstated in books, COGS is overstated, reducing profit artificially.

Rectifying Entry: Since the Purchase Book total was overcast, the actual purchases are Rs. 20,000 less than recorded. To correct:

Dr. Purchase A/c                     Rs. 20,000
    Cr. Creditors A/c                 Rs. 20,000

Reasoning:

• The overcasting means the Creditors A/c was overstated (since purchases were recorded higher).
• Reducing Purchases and Creditors by Rs. 20,000 corrects the books.

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b. Freight incurred on machinery of Rs. 200,000 has been posted to Freight Account as Rs. 20,000.

Effect on Profitability:

• Freight on machinery is a capital expenditure (asset acquisition cost).
• If posted as Rs. 20,000 instead of Rs. 200,000, the actual cost of machinery is understated by Rs. 180,000.
• Impact on Profit:
  • Understated machinery cost → Higher Depreciation Expense (if depreciation is calculated on the understated value).
  • But more critically:
    • Freight A/c (expense) was understated by Rs. 180,000 (since only Rs. 20,000 was posted).
    • Lower Expense → Higher Net Profit (artificially inflated).

Rectifying Entry: The freight on machinery (Rs. 200,000) was incorrectly posted as Rs. 20,000 to Freight A/c.

• Rs. 180,000 was omitted from both Freight A/c and Machinery A/c.

Dr. Machinery A/c                   Rs. 180,000
    Cr. Freight A/c                  Rs. 180,000

Reasoning:

• Machinery A/c should include the full freight cost (capitalized).
• Freight A/c (expense) was understated, so we increase it to reflect the correct expense.

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c. A credit purchase from Rita amounting to Rs. 60,000 has been posted to Gita’s account.

Effect on Profitability:

• Posting to the wrong creditor’s account does not affect profitability directly (since both are creditors).
• However, misclassification of transactions can lead to:
  • Incorrect aging of receivables/payables (if Rita and Gita have different payment terms).
  • Difficulty in reconciling supplier statements (Rita may demand payment, but the amount is recorded under Gita).
• No direct impact on profit, but liquidity and working capital management are affected.

Rectifying Entry: The Rs. 60,000 purchase from Rita was wrongly posted to Gita’s account.

Dr. Gita’s A/c                       Rs. 60,000
    Cr. Rita’s A/c                    Rs. 60,000

Reasoning:

• This is a transfer entry to correct the misposting between two creditors.
• No impact on P&L, but corrects the trial balance.

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d. Sales return of Rs. 50,000 from Mathura was posted to Return Outward Book.

Effect on Profitability:

• Sales Return Inward (from customers) should be recorded in the Returns Inward Book (contra sales).
• If posted to Returns Outward Book (used for returns to suppliers), it means:
  • Sales Revenue was not reduced (since returns inward were not recorded).
  • Returns Outward was incorrectly increased (which is an expense, not revenue adjustment).
• Impact on Profit:
  • Sales Revenue is overstated by Rs. 50,000 → Higher Gross Profit (artificially inflated).
  • Returns Outward (expense) was wrongly increased (but this does not offset the revenue error).

Rectifying Entry: The Rs. 50,000 Sales Return Inward was wrongly posted to Returns Outward.

Dr. Returns Outward A/c              Rs. 50,000
    Cr. Sales A/c                     Rs. 50,000
Dr. Mathura’s A/c                    Rs. 50,000
    Cr. Returns Inward A/c            Rs. 50,000

Reasoning:

1. Reverse the wrong entry (Returns Outward was debited instead of credited).
2. Record the correct entry (Sales Return Inward reduces Sales Revenue and increases the customer’s account).

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e. A purchase of machinery of Rs. 20,000 has been debited to Purchase Account.

Effect on Profitability:

• Machinery Purchase is a capital expenditure (asset), not an expense.
• If debited to Purchase A/c (which records goods for resale), it means:
  • COGS is overstated by Rs. 20,000 (since machinery was included in purchases).
  • Machinery Asset is understated by Rs. 20,000 (not recorded in the fixed asset register).
• Impact on Profit:
  • Higher COGS → Lower Gross Profit → Lower Net Profit.
  • Depreciation will also be lower (since machinery is understated).

Rectifying Entry: The Rs. 20,000 machinery purchase was wrongly debited to Purchase A/c.

Dr. Machinery A/c                   Rs. 20,000
    Cr. Purchase A/c                  Rs. 20,000

Reasoning:

• Machinery is a fixed asset, not an expense.
• Purchase A/c should only include goods for resale, not capital assets.

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Summary of Rectifying Entries