ADJUSTMENTS AT THE END OF AN ACCOUNTING PERIOD

At the end of an accounting period, it is customary to close all the accounts, extract a trial balance, and then prepare the set of final accounts : the income statement and the balance sheet. However, there are a number of adjustments that may be required prior to the preparation of the final accounts. These include : (a) adjustments for owings and prepayments; ( b) adjustments for bad debts and provision for bad debts; and (c) adjustments for depreciation. (a) ADJUSTMENTS FOR OWINGS AND PREPAYMENTS

At the end of the accounting period, the revenue earned must be matched against the expenses incurred, in order to derive the profit or loss for the period. In some cases, though, the actual revenue earned may not correspond with the amount recorded in the books. Likewise, the expenses incurred may be different from the total cash paid for them. A contractual amount may either be owing ( called accrual), or paid in advance (called prepayment), at the end of the period. However, in keeping with certain accounting concept, revenue must be accounted for in the period when it was earned, and not necessarily when it was received. The same principle applies to expense items. Thus, some items of revenue and expenses may need to be adjusted when preparing the final accounts. These adjustments are classified and treated as follows: CLASSIFICATION a) Expense Owing ---------------------This is the portion of the expense item that is unpaid or owing at the end period b) Expense Prepaid ------------------------The portion of the expense item that is paid in advance TREATMENT IN THE INCOME STATEMENT TREATMENT IN THE BALANCE SHEET

The amount owing must be added to the amount already paid

The unpaid portion, called accrued expense, is treated as a current liability

The prepaid portion must be deducted from the total amount paid

The prepaid portion must be included as a current asset

CLASSIFICATION c) Revenue Owing --------------------This is the portion of a revenue item that is already earned, but not yet received d) Revenue Prepaid -----------------------This is the portion of the revenue item that is received in advance

TREATMENT IN THE INCOME STATEMENT

TREATMENT IN THE BALANCE SHEET

The outstanding portion must be added to the amount already received

The outstanding portion, called accrued revenue, must be listed as a current asset

The prepaid portion must be deducted from the total amount Received

The amount received in advance must be listed as a current liability

From the above, it can be seen that the general rule when dealing with owings ( accruals ) and prepayments is: Always Add Accruals ( Note the alliteration A A A )

Minus Prepayments

The amount for the adjustment would be shown as a footnote item to the given trial balance that will be used in preparing the final accounts. When making the adjustment, the first column of the income statement would be used to show the calculation.

LECTURE QUESTION
1. At the end of 1998, The Blue Bayou outstanding : a. Rent Expense Owing b. Wages Pre-paid c. Commission Due d. Rent Recble Prepaid 15,000 20,000 10,000 7,500 had the following balances

Required : Write up the ledger accounts to reflect these balances as at the start of 1999

2.

Record the following transactions for the year 1999 a. Rent Expense Paid b. Wages Paid c. Commission Recd d. Rent Recd 35,000 60,000 35,000 20,000

3. Given that the following amounts were outstanding a. Rent Expense Prepaid b. Wages Owing c. Commission Prepaid d. Rent Recble Owing 5,000 12,000 8,500 5,000

at the end of 1999

Required : Make the adjustments at the end of the year, clearly showing the amount for the income statement, and the amount that will be carried forward to the next year

( b) ADJUSTMENTS FOR BAD DEBTS AND PROVISION FOR BAD DEBT From the list of debtors, i.e. those who have purchased goods on credit, the firm may not be able to collect payment for the goods or services rendered. The firm may therefore decide to write off these debts as being irrecoverable. These are called bad debts. Among the reasons for the occurrence of a bad debt are : - the debtor may have died - the debtor may be out of contact - time may have elapsed for an insignificant amount - the debtor may have been declared bankrupt - there may be duress or sheer badman-ism in collecting the debt

ACCOUNTING ENTRIES FOR BAD DEBTS The main step to be followed when accounting for bad debts is : To cancel the debt as being bad Dr Bad Debt Accounts Cr. Debtors Account The Bad Debt account is treated as an expense, and is therefore listed among the expense items in section 4 of the Income statement BAD DEBTS RECOVERED

A debt that was written off as being bad in previous years may eventually become recoverable. This is called a bad debt recovered. Accounting for this involves the following steps: a) To re-instate the debtor in the firms books Dr Debtors Account Cr. Bad Debt Recovered Account b) To record any amount paid by the debtor Dr Cr. Cash or Bank Account Debtors Account 4

The Bad Debt Recovered account is treated as a new revenue and is therefore included in section 3 of the income statement

PROVISION FOR BAD DEBT Of the remaining debtors at the end of the accounting period, it may become likely that some may become bad in the future. This eventuality should be noted, in keeping with the full disclosure principle. The firm should therefore make an adjustment of its debtors as well as of its current profits to show the effects of this likelihood, in accordance with the prudence concept. The adjustment is called a provision for bad debts, or provision for doubtful debts. It is not a standard amount, but instead, it is an estimate that may fluctuate each year according to : - the prevailing state of the economic climate - knowledge of the debtors previous performance - current knowledge regarding the state of the debtors Thus the balance in the provision for bad debt account may not increase every year. Instead, the previous years amount is merely adjusted to reflect the current provision. This could either be an increase or a decrease. ACCOUNTING ENTRIES 1. To start the provision Dr Increase in PFBD Cr. Provision for Bad Debts Account 2. To increase the provision in subsequent years Dr Increase in PFBD } Cr. Provision for Bad Debt Account } With the difference over last years amount FOR THE PROVISION FOR BAD DEBTS

3. To decrease the provision in subsequent years Dr Provision for Bad Debt Account Cr. Decrease in PFBD } } With the difference over last years amount

The Increase in PFBD is an expense ( section 4) while the Decrease in PFBD is a revenue ( section 3). The PFBD is subtracted from the Debtors on the Balance Sheet. 5

PROVISION

FOR DISCOUNTS

After the bad debts have been written off, and a provision has been made for those debts that are doubtful, the firm may then make another provision. This is for any discount that may have been extended to the sure debtors. The provision for discounts is accounting for in the same manner as in the provision for bad debts, i.e., the amount is adjusted in a fluctuating manner at the end of each year, based on various factors. The accounting entries are as follows: 1. To start the provision Dr Increase in PFD Cr. Provision for Discounts Account 2. To increase the provision in subsequent years Dr Increase in PFD } Cr. Provision for Discounts Account } With the difference over last years amount

3. To decrease the provision in subsequent years Dr Provision for Discounts Account Cr. Decrease in PFD } } With the difference over last years amount

The Increase in PFD is treated as an expense, while the Decrease in PFD is a revenue. The Provision for Discount Accounts, like the PFBD, is deducted from the Total Debtors in the Balance Sheet.

LECTURE QUESTION
The Blue Bayou had the following data YEAR 1996 Trade Debtors at start of the year 25,000 Credit sales during the year 40,000 Bad Debts during the year 5,000 Provision for bad debts at year end 10 %

1997 Trade Debtors at start of the year 60,000 Credit Sales during the year 40,000 Bad debts during the year 7,000 Bad Debts recovered during the year 2,000 Amount received from debtors 25,000 Provision for bad debts at year end 15%

1998 Trade Debtors at start of the year 70,000 Credit Sales during the year 80,000 Bad Debts during the year 8,000 Bad Debts recovered during the year 5,000 Amount received from debtors 67,000 Provision for bad debts at year end 10 %

1999 Trade Debtors at start of the year 80,000 Credit Sales during the year 120,000 Bad Debts during the year 15,000 Bad Debtors recovered during the year 10,000 Amount received from debtors 65,000 Provisions for bad debt at year end 10 %

(C) ADJUSTMENTS FOR DEPRECIATION

Depreciation is the reduction in the value of a fixed as a result of various factors, such as: RATE constant wear and tear obsolescence physical deterioration technological advancements inadequacy in size or capacity OF DEPRECIATION asset over time. This may be

The rate by which an asset is depreciated, and the resultant amount charged against profit each year is subjected to several factors, including the rate of usage of the asset, as well as managements own decision. There are several approaches that may be taken to reflect this rate. Among these are : a) The Straight Line Approach An equal amount is charged each year for depreciation. This amount represents a percentage of the cost of the asset. The amount is determined by the formula : A = where A= C= S= N= C - S ---------------N

the amount to be charged as depreciation each year the cost of the asset the residual or scrap value of the asset after N years the estimated number of year that the asset will last

Correspondingly the rate ( %) can be determined as follows: R = A --------- x C 100 -------1

where R is the rate expressed as a whole number ( % )

b) The Reducing Balance Method The amount to be charged each year declines with the depreciated value of the asset. This amount is a percentage rate of the written down, or current book value, of the asset. The rate must therefore be determined before the amount can be known. This is derived from the following formula: n r = 1 S --------- C

where r is the rate expressed as a decimal

e.g. Let - the cost of an equipment be $25,000 - the estimated life span of the asset be 4 years - the estimated scrap value be $4,000 then the amount as per the straight line approach would be : 25,000 - 4,000 ------------------------ = $5,250 4 Correspondingly, the rate per annum would be: 5,250 100 ----------- x ------- = 25,000 1 21 %

Likewise the rate per annum as per the reducing balance method is : 4 r = 1 4,000 --------- 25,000

0.3675

or 37 %

OTHER METHODS OF CALCULATING DEPRECIATION While the straight line and the reducing balance are the two main methods of calculating depreciation, there are other methods that may be used. Among these are :

a. Sum of the Year Digits (SOYD) : Summing the years 1,2,3,& 4, = 10. We then reverse the order of the years as a fraction of the sum. Thus in year 1 we find 4/10 of the total depreciable amount (25,000-4,000). For year 2, we find 3/10, etc. b. Units of Production : the total units of output is estimated over the years that the asset will be in used. Each years output is then expressed as a fraction of the total output, and this fraction multiplied by the total depreciable amount. ACCOUNTING ENTRIES FOR DEPRECIATION The amount for depreciation each year is charged as an expense in the profit and loss account. Correspondingly, the total amount charged over the years is reflected in the Provision for Depreciation Account.

The accounting entry each year is as follows To account for the annual depreciation Dr Depreciation Cr Provision for Depreciation of . . . ( separate account used for each asset)

The depreciation account is closed off as an expense to the Income Statement ( section 4 ), while the balance in the Provision for Depreciation Account is deduction from the corresponding asset, in the Balance Sheet at the end of each year. Where the asset is in use for only a part of the year, the amount for depreciation for the year may be pro-rated according to the number of months of use of the asset. Another approach is to charge a full years depreciation in the year of acquisition of the asset, irrespective of the month, and none in the year when the asset is disposed of. DISPOSAL OF A FIXED ASSET After some years of use, a fixed asset may be sold. This is not recorded in the Sales Account, but involves the use of the Disposal of Fixed Asset Account. The accounting entries are as follows: a) Transfer the asset at cost price to the Disposal Account Dr Disposal Account Cr Asset Account b) Transfer the total amount charged for depreciation on the asset Dr Provision for Depreciation Cr Disposal Account 10

c) Record the amount received from the sale of the asset Dr Bank / Cash Account Cr Disposal Account d) The balance in the Disposal Account is transferred to the Income statement as a new revenue or a gain on disposal ( section 3 ) or as an expense or a loss on disposal ( section 4 ).

LECTURE QUESTION
The Blue Bayou had the following record for its non-current assets

a. Mar 1996

Purchased Building for 40,000 Depreciation 10 % p.a. straight line pro rated Purchased Motor Van for 60,000 Depreciation 10 % reducing balance pro rated Purchased Equipment for 90,000 Depreciation SOYD. Equipment will be kept for 6 years with an estimated scrap value of 6,000 Purchased Machinery for 100,000 Depreciation Units of Prod method over 5 years Estimated Outputs 1999 :60,000; 2000 :40,000; 2001 :30,000; 2002 :20,000; 2003 :10,000 Sold Motor Van for $35,000

b. Aug 1996

c. Jan 1998

d. Jan 1999

e. Aug 1999 Required : i. ii. iii.

Show the respective asset account Calculate and record the amount for the respective depreciation charges Show the disposal accopunt

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TUTORIAL QUESTIONS

1. Identify and explain the accounting concept involved in the adjustments for accruals and prepayments.

2. Discuss some of the reasons for the occurrence of a bad debt in a business organization

3. What are some of the factors that give rise to the issue of depreciation?

4.

Tony Young operates a travel service enterprise. His accounting records at the end of 2001 included the following data : ITEMS a. b. c. d. START OF THE YEAR Office expenses : Prepaid 5,000 Wages & Salaries Owed 10,000 Comm Recble Owed 3,000 Rent Recble Prepaid 7,000 DURING THE YEAR Paid 15,000 Paid 50,000 Received 25,000 Received 12,000 END OF THE YEAR Owed 2,500 Prepaid 5,000 Prepaid 2,000 Owed 1,000

Write up the ledger accounts, clearly indicating the amount that should be posted to the income statement at the end of the year. 5. The following items were obtained from the books end of 1998 ITEMS START OF THE YEAR of the Chariots Place as the

DURING THE YEAR Paid 10,000 Paid 15,000 Received 30,000 Received 25,000

END OF THE YEAR Prepaid Owed Owed Prepaid 3,000 4,000 7,000 8,000

a. Telephone Exp Owed 2,500 b. Utilities Prepaid 3,000 c. Interest Earned Prepaid 5,000 d. Comm. Rcble Owed 4,000

Write up the ledger accounts, clearly indicating the amount that should be posted to the income statement at the end of the year.

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6.

The following is the debtors record in the books of YEAR

The Zanadu

DEBTORS AT BAD DEBTS PROV. FOR BAD YEAR END DURING THE YEAR DEBTS AT YEAR END -------------------------------------------------------------------------------------------------------------1995 25,000 3,000 10% 1996 30,000 5,500 5% 1996 40,000 4,000 5% Required : Show (a) the ledger accounts for bad debts, and provision for bad debts (b) the extracts from the income statement and the balance sheet

7. The following data was obtained from the books of Jimmy Neutron 1996 1997 1998 1999 ----------------------------------------------------------------------------------------------------DEBTORS AT START 30,000 ? ? ? CREDIT SALES BAD DEBTS W/O BAD DEBTS RECOVERED MONEY RECD PFBD Required : show 40,000 5,000 0 35,000 5% 50,000 7,500 2,500 40,000 10 % 60,000 8,000 4,000 50,000 5% 80,000 8,500 5,500 60,000 10 %

the accounts for debtors, bad debts, bad debts recovered, and the PFBD

8. Roscorlo purchased a heavy duty lawn mower for $325,000. It will be kept for five years, afterwards it will be scrapped for $25,000. The mower will be used to cut ( sq m ) Yr.1 - 35,000; Yr. 2 30,000; Yr. 3 20,000; Yr. 4 10,000; and Yr 5 - 5,000. Calculate the annual depreciation charge using (a) straight line (b) reducing balance (c) sum of the years digit, and ( d) units of production methods

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9.

The Ragged Rascal is a farm machine that costs 250,000. It is estimated that it will last for 5 years, with an estimated scrap value of 40,000. during its useful life it will plough the following acreage of farm land YEAR ACREAGE 1980 95,000 1981 70,000 1982 65,000 1983 40,000 1984 10,000 At the end of 1984 the machine is sold for 55,000 Required : i. calculate the annual depreciation charge using ( a ) straight line, (b) Reducing balance ( c) SOYD, and ( d) Units of production methods ii. Write up the disposal account at the end of 1984

10. The Ledon Furnishing Company purchased a canvas cutter for $560,000. This will be kept for 6 years, after which it will have a scrap value of 80,000. The amount of canvas that it is expected to cut during its useful life is Yr. --1 2 3 4 5 6 Amount ( Metre ) of canvas ---------------------------------3,500 2,300 1,700 1,100 800 400

Required : i. calculate the annual depreciation charge using ( a ) straight line, (b) Reducing balance ( c) SOYD, and ( d) Units of production methods ii. Based on the SOYD method, write up the disposal account at the end of year 3 given that the equipment is sold then for 300,000

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11. From the following list of balances in the books of Little John, as at August 31, 1992, prepare the set of final accounts: Capital Loan Land & Building 150,385 Fixtures & Fittings 32,000 Prov. for depn on Fix & Fit Machinery & Equipment 25,000 Prov for depn on Mach. & Equip Debtors 12,500 Prov. for Bad Debts Carriage Inwards 1,250 Return Inwards 2,700 Return Outwards Carriage Outwards 1,085 Creditors Sales Purchases 82,345 Commission Received Motor Vehicle 30,400 Prov for Depn on Motor Veh Rent Received Wages & salaries 22,400 Telephone charges 2,500 Bad Debts 4,000 Stock at Sept 1. 1991 15,000 Bank Cash 2,275 ----------383,840 ======= 125,000 75,000 6,000 10,000 2,200 2,300 13,200 125,000 5,500 3,040 4,200

12,400 -------------383,840 =========

End note: 1. Stock at August 31, 1992 was 35,000. 2. Wages owing by 7,600 3. Telephone charges prepaid by 1,000 4. Commission due 2,500 5. The provision for bad debt is to be adjusted to 10% of debtors 6. Provide for depreciation as follows : Fixture and fittings at 10% straight line, machinery and equipment at 15% reducing balance, and motor vehicle at 10% straight line.

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12. The following balances were extracted from the books of Dennis Browns CASSANDRA at the end of December 31, 1992. : Sales Capital Stock at January 1, 1992 Purchases Return Inwards Wages Return Outwards Rent Payable Rates Motor Vehicle Provision for Depn - Motor Vehicle Drawings Loan Building Provision for Depn - Building Equipment Provision for Depn - Equipment Debtors Fixtures & Fittings Provision for Depn Fix. & Fit Provision for bad debts Commission Received Carriage Outwards Carriage Inwards Rent Received Creditors Bank Cash 250,000 150,000 35,250 90,500 2,200 40,500 2,500 8,000 5,500 55,000 5,500 8,000 75,000 120,000 12,000 50,000 5,000 22,400 50,000 5,000 1,500 6,000 2,000 2,050 8,000 15,240 42,840 1,500 ----------535,740 ======= ---------535,740 =======

Year end notes : a) Stock at December 31, 1992 25,300 b) Depreciate Building at 5 % on the straight line, equipment at 10% on reducing balance, the motor vehicles at 15% on the reducing balance, fixtures & Fittings 10% straight line c) Wages prepaid 8,000 d) Rates owing 1,500 e) Commission Received is owing by 2,000 f) Rent Received is prepaid by 1,500 g) The Provision for bad debts is to be revised to 5 % of debtors Required : Prepare the set of final accounts for the year.

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13. The following trial balance was obtained from the books of Harold Melvin as at December 31, 1989 : Building Provision for depreciation (Bldg) Equipment Provision for depreciation (Equip) Capital Loan Sales Insurance Wages Bad debts Purchases Stock at Jan 1, 1989 Commission Receivable Bank Cash Discount allowed Discount receivable Drawings Debtors Creditors Provision for bad debts Carriage outwards 80,000 16,000 42,000 7,980 60,000 25,000 120,000 5,000 12,000 700 65,000 22,000 18,000 24,720 8,500 3,000 5,500 22,000 35,000 17,200 4,000 3,200 --------298,400 ====== ---------298,400 =======

End of year footnotes included : a. b. c. d. Insurance is owing by $1,000 Wages is prepaid by $3,000 The provision for bad debts must be adjusted to 20% of debtors. Depreciate building at 10 % using the reducing balance method, and equipment 10% based on the straight line method. e. Stock at year end is valued at $25,000 f. Commission Receivable is prepaid by $2,000 Required : Prepare the trading and profit and loss account for the year ending December 31, 1989, as well as the balance sheet as at that date.

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The following trial balance was obtained from the books of The Macabare as at December 31, 2002 : Building Provision for depreciation (Bldg) Equipment Provision for depreciation (Equip) Capital Loan Sales Insurance Wages Bad debts Purchases Stock at Jan 1, 2002 Commission Receivable Bank Cash Discount allowed Discount receivable Drawings Debtors Creditors Provision for bad debts Carriage outwards 80,000 16,000 42,000 7,980 60,000 25,000 135,000 5,000 12,000 700 65,000 22,000 18,000 24,720 8,500 3,000 5,500 22,000 50,000 17,200 4,000 3,200 --------313,400 ====== ---------313,400 =======

End of year footnotes included : g. h. i. j. Insurance is prepaid by $1,000 Wages is owing by $3,000 The provision for bad debts must be adjusted to 10% of debtors. Depreciate building at 5 % using the straight line method, and equipment 10% based on the reducing balance method. k. Stock at year end is valued at $45,000 l. Commission Receivable is owing by $4,000 Required : Prepare the trading and profit and loss account for the year ending December 31, 2002, as well as the balance sheet as at that date.

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