Chapter 8 END OF YEAR ADJUSTMENTS

1. Chapter 8END OF YEAR ADJUSTMENTS

2. Closing off Account The balances of ALL expenses and income accounts are closed off to the Income Statement (Trading and Profit and Loss Account) at the end of the accounting period.

3. Closing off Accounts

4. Closing off Account Journal Entry

5. Closing off Accounts Sales A/c

6. Closing off Account Journal Entry

7. Adjustments • Adjustments are any transactions or events which were not recorded at the time of preparation of the Trial Balance; • Apart from omitted transactions, many other adjustments occur as a result of applying the matching/accrual and realisation concepts; • Adjustments must be done before preparing the Final accounts (Manufacturing, Income Statement and Balance Sheet) are prepared; • Adjustments appear as notes after the Trial Balance totals.

8. Adjustment: Income The Realisation concept states that amount for income to be used to prepare the Income Statement is the amount which should be collected from the sale goods or the provision of services during the accounting period under review even if cash has not been collected.

9. Adjustment: Income Cash collected during the accounting period X Add owing at close x Collected in advance at start x Less Owing at start (x) Collected in advance at close (x) Income for the period X Income collected in advance = current liability Income owing = current asset

10. Adjustment: Income Income in advance = current liability Income owing = current asset NB. Assets and liabilities are also used in the Balance Sheet

11. Adjustment: Expense The matching/accrual concept states that all the expenses incurred (supposed to be paid) in an accounting period to produce income should be recorded in the trading and profit and loss account even if not paid.

12. Adjustment: Expense • The accounting period for which the Income Statement A/c is to be prepared must be identified. Pay attention to the date, the month and the year; • If any amount is relevant to the accounting period then add to cash paid during the same accounting period; • If any amount is not relevant to the accounting period then subtract from cash paid during the same accounting period.; • A prepayment takes place if the amount of an expensepaid during the accounting period is greater than the amount to be paid; • An accrual takes place when the amount of an expense actually paid during the accounting period is less than the amount to be paid.

13. Adjustment: Expense Cash paid during the accounting period X Add owing at close x Paid in advance at start x Less Owing at start (x) Paid in advance at close (x) Expense for the period X Prepaid expense = current asset Expense owing = current liability

14. Adjustment: Expense Prepaid expense = current asset Expense owing = current liability NB. Assets and liabilities are also used in the Balance Sheet

15. Adjustment: Depreciation • Fixed or non current assets are resources which allow a controlling firm to gain economic benefits over a period of more than one year in the future; • Depreciation is the portion of the cost of a fixed asset expended or used up during each accounting period for which the fixed asset is used or held;

16. Adjustment: Depreciation • Land used for development and not for mining is the only fixed asset that is not depreciated. • Depreciation is therefore a non-cash expense. • The reasons for depreciation are: use; wear and tear; obsolescence (new model making the old model out of date); and time.

17. Adjustment: Depreciation Estimating annual depreciation charge or expense The straight line method either Cost of the fixed asset less estimated scrap/residual value Estimated useful life of the fixed asset Or Cost of the fixed asset x annual rate of the depreciation

18. Adjustment: Depreciation Estimating annual depreciation charge or expense Reducing balance method Net book value of the fixed asset x annual rate of the depreciation Cost of fixed asset less total previous depreciation expense (aggregate/accumulated/provision for depreciation)

19. Adjustment: Depreciation Methods compared

20. Adjustment: Depreciation Methods compared • In the earlier years the annual expense under the reducing balance is greater than the straight-line method; • While in later years the annual expense under the reducing balance is less than the straight-line method. • Using the straight-line method gives a fixed annual depreciation expense. It is only if the cost of fixed assets changes that the annual expense will change.

21. Adjustment: Depreciation Double Entry The balance of the provision for depreciation account is used in the Balance Sheet as a contra asset. The account records the sum of annual depreciation charge from the date of purchase of the fixed asset. The balance of the depreciation expense account is used in the Income Statement as an expense

22. Adjustment: Depreciation Balance sheet extract

23. Adjustment: Bad Debts A bad debt occurs anytime a business is unable to collect any amount from a debtor (someone to whom goods were sold on credit). A debtor may not be able to pay because of death, bankruptcy or if (s)he has flees the country.

24. Adjustment: Bad Debts When a debt becomes uncollectable it is written off as follows: The written off customer balance is transferred to the Bad debt A/c. This reduced the value of debtors. The bad debt a/c balance is a loss or an expense and is used the Income Statement. Note the above double entry must be carried out only if a note detailing bad debts appears after the Trial Balance totals. If bad debts only appear in the Trial Balance, it must only be used in the Income Statement.

25. Adjustment: Provision for Bad Debts • A provision for bad debts or doubtful debts represents an estimation of the value of debtors who may not pay or may default. This is another example of a non cash expense; • The aim of an initial provision for bad or doubtful is to set aside an amount from profits to cover the value of debtors who may default; • The value of debtors who may be default is normally expressed as a percent

26. Adjustment: Provision for Bad Debts The example below shows the debtors balances of a firm for three consecutive years. A provision for bad debts is to be establish at 5%.

27. Adjustment: Provision for Bad Debts The value of the ending provision for bad debts is entered in the Balance Sheet for each year as a contra asset and subtracted from debtors Balance Sheet extract

28. Adjustment: Provision for Bad Debts Only the increase or decrease in the provision for bad debt balance is entered in the Income Statement: An increase as an expense i.e. $1 250 and $ 500 for the accounting period 2002 and 2001 respectively A decrease as income i.e. $550 for 2003 The opening balance of a provision for bad debts will be found in the Trial Balance, while the closing balance will be given in a note after the Trial Balance totals

29. Adjustment: Provision for Bad Debts Provision for bad debt a/c