ACCOUNTING Financial and Organisational Decision Making

ACCOUNTINGFinancial and Organisational Decision Making Chapter 7 End of period adjustments Slides written and designed by Tony Van Eekelen

Learning Objectives • In this chapter you will be introduced to : • the need for adjusting entries at the end of the accounting period under the accrual method of accounting • the steps in the accounting cycle required after all transactions are posted to the ledger so as to prepare final accounting reports • the terms ‘prepayments’ and ‘accrual’

Learning Objectives • The purpose of reversing entries and the circumstances under which they are required • the method of accounting for bad and doubtful debts • the nature of depreciation and factors that affect the annual depreciation expense

Learning Objectives • the calculation of depreciation using the straight line, reducing balance, production-units and sum-of-the-digits methods • how to record the sale of a non-current asset • how to prepare financial statements after classifying and summarising a series of transactions

Adjusting entries • Due to the accounting period concept, adjusting entries are needed so that only the relevant portion of revenue and expenses relating to the period are recorded.

The accrual accounting system • Revenue and expenses need not involve cash in the current period • Expenses may have been incurred but not yet paid. • E.g. wages - workers have done the work but have yet to be paid. • Expenses may have been paid but not yet consumed • e.g. You have paid the rent for the next month but have yet to consume it

The accrual accounting system • Similarly, revenues may been earned but the cash has not yet arrived. • E.g. a credit sale • In some cases, the cash may have been received but the revenue has yet to be earned. • E.g. subscription to a magazine. The publisher earns the income when it provides the magazine

Cash accounting system • Profit is measured as the difference between cash received and the cash paid within the period Profit Cash received Cash paid

Recording adjustments Journals Ledger entries Trial Balance Adjustments Adjusted Trial balance Closing entries Financial statements

Adjustment 1 - Expenses that have been paid but not incurred • Paid but not incurred is known as prepayments • This prepaid component of the expense at balance day becomes an asset as there will be some future economic benefit to the firm.

Adjustment 1 - Example • A business pays rent for the next 12 months on 1 April X7 for $1200. • At the 30 June X7, have consumed 3 months ($300) and prepaid 9 months ($900). • Need to adjust the rent expense account to reflect that only $300 has been consumed and that $900 is for next period.

Adjustment 1 - Adjusting entries Date Accounts Dr Cr. 1/4/X7 Rent expense 1200 cash 1200 (original entry) 30/6/X7 Prepaid Rent 900 Rent expense 900 (adjusting entry) 30/6/X7 Profit and Loss Summary 300 Rent expense 300 (closing entry)

Adjustment 1 - Reversing entry • To ensure that the prepayment is brought forward as an expense, a reversing entry is performed. Date Accounts Dr Cr. 1/7/X7 Rent expense 900 Prepaid rent 900 (reversing entry)

Adjustment 2 - Expenses that have been incurred but not paid • Incurred but not paid is known as accrued expenses. • This accrued component of the expense at balance day needs to be added to the expense account and as it is a future sacrifice, it must be added to a liability account known as accrued expenses.

Adjustment 2 - Example • A business has paid wages of $12,000 but it owes $1,000 for work performed. • Need to adjust the wages expense account to include the $1,000 incurred and increase the liability by $1,000.

Adjustment 2 - Adjusting entries Date Accounts Dr Cr. During Wages expense $12,000 year cash $12,000 (original entry) 30/6/X7 Wages Expense $1,000 Accrued wages $1,000 (adjusting entry) 30/6/X7 Profit and Loss Summary $13,000 Wages expense $13,000 (closing entry)

Adjustment 2 - Reversing entry • To ensure that the accrual is not double counted in the following year as an expense, a reversing entry is performed. Date Accounts Dr Cr. 1/7/X7 Accrued Wages $1,000 Wages Expense $1,000 (reversing entry)

Adjustment 3 - Revenue that has been received but not earned • Revenue received but not earned is known as a liability. • This unearned component of the revenue at balance day becomes a liability as there will be some future sacrifice to the firm.

Adjustment 3 - Example • A business receives $2000 on 1 April X7 for services to be rendered. • At the 30 June X7, 40% of the services have been performed. • Need to adjust the services revenue account to reflect that only $800 has been earned and that $1,200 will be earned in the next period.

Adjustment 3 - Adjusting entries Date Accounts Dr Cr. 1/4/X7 Cash 2,000 Services Revenue 2,000 (original entry) 30/6/X7 Services Revenue 1,200 Unearned Revenue 1,200 (adjusting entry) 30/6/X7 Services revenue 800 Profit and Loss Summary800 (closing entry)

Adjustment 4 - Revenue that has been earned but not received • The services or the goods have been provided and the revenue has been earned but payment is still to be received.

Adjustment 4 - Example • At the 30 June X7, a business provided services on credit for $6,000 as yet unrecorded. Date Accounts Dr Cr. 30/6/X7 Revenue Receivable $6,000 Service Revenue $6,000 (adjusting entry)

Adjustment 5 - Accounting for supplies • During the year supplies such as stationery are used by the business, and should be treated as an expense. • However, any leftover supplies at balance day should be treated as an asset. • Thus an adjusting entry is needed to show this asset.

Adjustment 5 - Example • A business purchases supplies during the year for $1,600. • At the 30 June X7, a stock take revealed that there was $320 of supplies on hand. • Need to adjust the supplies expense account to reflect that only $1,280 has been consumed and that $320 is for next period.

Adjustment 5 - Adjusting entries Date Accounts Dr Cr. During Supplies expense 1600 year cash 1600 (original entry) 30/6/X7 Supplies on hand 320 Supplies expense 320 (adjusting entry) 30/6/X7 Profit and Loss Summary 1,280 Supplies expense 1,280 (closing entry)

Adjustment 6 - Bad and doubtful debts • Due to the recognition of revenue as it is earned, and not received, it is possible that the cash will not be received. • This will cause statements to be overstated. • Need to recognise bad debt: • matching concept • avoid overstating profits

Adjustment 6 - Example • Doubtful Debts • To achieve the matching concept, the business will allow for 5% of its accounts receivable as doubtful. Currently, accounts receivable is $2,000. • Need to allow for $100 as doubtful in an expense account and to reduce the accounts receivable by the same amount. However, as they are doubtful, do not credit the accounts receivable account. Introduce a contra account known as Allowance for doubtful debts.

Adjustment 6 - Adjusting entries Date Accounts Dr Cr. 30/6/X7 Bad & Doubtful Debts 100 Allowance for doubtful debts 100 (adjusting entry) 30/6/X7 Profit and Loss Summary 100 Bad & Doubtful Debts100 (closing entry)

Adjustment 6 The Allowance for doubtful debts account is deducted from accounts receivable to show the amount expected to be realised. Balance sheet extract Accounts receivable 2,000 Less allowance for doubtful debts 100 1,900 Note: there is no reversing entry

Adjustment 6 • When the doubtful debt does become bad then the entry is Accounts Dr Cr. Allowance for doubtful debts 100 Accounts receivable 100 (Writing off bad debts)

Adjustment 7 - Depreciation • “Depreciation is the process of allocation of the cost of an asset over its estimated useful life” [IAS 4- para4] • Is based upon the matching and continuity assumptions, and is the allocation of the cost over it life in accordance with benefits derived.

Depreciation methods Straight Line: • Assumes that the asset will derive equal benefits each year. • Amount written off as depreciation is the same each year. Annual depreciation = cost -residual value estimated life

Depreciation methods Reducing-Balance: • Assumes that the asset will derive greater benefits in earlier years of its life. • Amount written off as depreciation reduces each year Annual depreciation = % of (cost -accumulated depreciation)

Depreciation methods Reducing-Balance: • The % is calculated by using the following formula: • where n = number of years

Depreciation methods Production of units: • Assumes that the use of the asset can be measure and is the best indicator. • Amount written off as depreciation is based upon the amount used as a proportion of the estimated total use. Annual depreciation = unit depreciation x number of units used

Depreciation methods Production of units: • The unit depreciation is calculated as follows:

Depreciation methods Other methods: • Other methods do exist such as the sum-of-the-digits approach. • This method allocates using the following formula: • where n = life of asset

Recording depreciation • To record depreciation we must have an expense account, ie depreciation and the credit entry will be a contra account known as accumulated depreciation. • The accumulated depreciation account is shown in the balance sheet under the asset that is being depreciated, to show the written down value (“book-value”).

Example of depreciation • A business decides to allow for $1,000 depreciation on motor vehicles. Date Accounts Dr Cr. 30/6/X7 Depreciation Exp. 1000 Accumulated depreciation 1000 (adjusting entry) 30/6/X7 Profit and Loss Summary 1000 Depreciation Expense1000 (closing entry)

d l o s Sale of asset • In the event of a non-current asset being sold, the asset and its depreciation must be removed from the ledger. • The procedure for this is to close the asset account to a sale of asset account and also close the accumulated depreciation to this account. • Any proceeds from sale need to be included into the account. • The balancing figure is closed to the profit and loss summary account

Sale of asset Sale of asset Asset - cost Accumulated Depreciation Cash - proceeds from sale Profit/loss summary (loss) Profit/loss summary (profit) Balancing items

Misconceptions about depreciation • Not all assets are depreciated. • Land , accounts receivable • Depreciation is not based upon wear and tear or obsolescence • The book value is not the expected market value. • Depreciation does not provide funds directly, but indirectly via taxation savings.

Record Transactions Prepare trial balance Interim reports Final reports Make adjusting entries in ledger Adjust trial balance or use worksheet Make closing entries in ledger Profit and loss statement Balance sheet Worksheets Figure 7.2

ACCOUNTING Financial and Organisational Decision Making