Adjustments to final accounts Flashcards
When preparing financial statements, the following should be taken into account:
I. Accruals and prepayments
II. Depreciation of Non Current Assets
III. Bad debts and Provision for bad debts
IV. Drawings of goods by owner for personal use
Accruals and Prepayments
-According to the Accruals concept, expenses and income should be accounted for when they are incurred or earned and not when money is paid or received.
1. Accruals
Example 1: Rent payable for the year ended 31 Dec 2009 amounts to Rs12,000. However, the business paid only Rs10,000 during the year.
(a) Income Statement (extract) for the year ended 31 Dec 2009
(b) Balance Sheet (extract) as at 31 Dec 2009
-Note: The annual rent incurred is Rs12,000 while the amount actually paid is only Rs10,000. The remaining Rs2,000 represents a CURRENT LIABILITY for the
business.
Prepayments
Example 2: Insurance payable for the year ended 31 Dec 2009 amounted to Rs24,000. However, the business paid Rs30,000 during the year.
(a) Income Statement (extract) for the year ended 31 Dec 2009
(b) Balance Sheet (extract) as at 31 Dec 2009
Note: The annual insurance incurred is Rs24,000 while the amount actually paid is higher at Rs30,000. The surplus Rs6,000 represents a CURRENT ASSET for the
business.
Depreciation of Non Current Assets
So far Non Current Assets (NCA) such as buildings, motor vehicles, have been treated as if their values remained unchanged at the end of every accounting
period. However, in practice, a fall in the value of NCA is expected due to the following factors:
Wear and tear
Obsolescence (out of date)
Depletion
Passage of time
-This fall in the value of NCA is known as depreciation.
-Depreciation for a particular period may be considered as that part of the cost of a NCA which has been used to earn revenue for that period. Thus, depreciation is an expense and must be charged against profits in the Income Statement.
Calculation of depreciation
It can be calculated using one of the following methods:
(a) Straight line method
(b) Reducing balance or diminishing method
(c) Revaluation method
Straight line method
- The annual depreciation is calculated as a fixed percentage of the COST of an asset. The annual depreciation charge will be the same over the lifetime of the asset.
- Alternatively, if the depreciation rate is not given, the following may be used:
Annual Depreciation = Cost – Scrap/residual value
(divide)Lifetime
-Example (i) A machine is bought for Rs3,000 in year 1. Depreciation is charged at the rate of 20% per annum straight line. Calculate annual depreciation at end of
year 1.
-Example (ii) Machine X which costs Rs10,000 is expected to last 10 years. At the end of year 10, it is expected to be sold for a scrap value of Rs100. Find the
annual depreciation.
Example (iii) A motor vehicle was bought on 1 Jan 2000 for a cost of Rs10,000. Its lifetime is 5 years and depreciation is at the rate of 20% per annum straight line.
Reducing balance or diminishing balance method
-Annual depreciation is a fixed percentage of the NET BOOK VALUE (NBV) of the asset. Annual depreciation will keep on reducing in subsequent years.
-Example (i) A machine is bought for Rs3,000 in year 1. Depreciation is charged at the rate of 20% per annum reducing balance method. Calculate annual depreciation at end of year 2.
-Example (ii) A motor vehicle was bought on 1 Jan 2000 for a cost of Rs10,000. Its lifetime is 5 years and depreciation is at the rate of 10% per annum reducing
balance method. Complete the following table.
Revaluation method:
-Using this method, assets are valued at the end of each accounting period. The annual depreciation is obtained as follows:
Value at beginning of year – Value at end of year
-Example (i) Original cost of van on 1 Jan 2000 was Rs20,000, and present value at 31 Dec 2000 was $ 17,000. Find annual depreciation.
Bad debts and allowance for doubtful debts/ Provision for bad debts
In a business, it is possible that not all debtors/accounts receivable/trade receivable can be collected. Some of the debts may never be collected because the debtors are either dead, bankrupt, cannot be traced or are unable to pay.
Bad debts
- The amount of debts that are definitely known to be irrecoverable (i.e the business is sure about the debtor and the amount), must be written off as bad debts.
- Bad debts represent a loss to the business and should be charged as an expense in the Income Statement. It also reduces the amount of debtors for the business.
Provision for bad debts/ Allowance for doubtful debts
-In addition to debts that are definitely irrecoverable, it is very likely that a certain amount of debtors may not pay. But exactly how much debts and from whom payment will not be received is not known with certainty till the year end.
-Hence bad debts can be written off anytime during the year but a provision is made only at the year end.
-The amount of the provision will depend on the company’s policy. It may be a general percentage e.g 5%. Thus, if the total debtors are Rs10,000, then the
provision will be (5%x 10000)= Rs500.
-The provision is also charged as expense in the Income Statement and should be deducted from debtors in the Balance Sheet.
Case 1: Provision for bad debts created for the first time (i.e no existing provision at start)
-Example: On 1 Jan 2000, debtors amounted to Rs10,000. On 31 Dec 2000, a provision of 5% is to be created. Show income statement and balance sheet
extracts for year ended 31 Dec 2000.
(a) Income Statement (extract) for the year ended 31 Dec 2000
(b) Balance Sheet (extract) as at 31 Dec 2000
-Case 2: There is an increase in provision for bad debts
-Example: On 1 Jan 2001, debtors were Rs15,000. The business decides to maintain the provision at 5% on 31 Dec 2001. Show income statement and balance sheet extracts for year ended 31 Dec 2001.
(a) Income Statement (extract) for the year ended 31 Dec 2001
(b) Balance Sheet (extract) as at 31 Dec 2001
-Case 3: There is a decrease in provision for bad debts
Example: On 1 Jan 2002, debtors were Rs11,000. The business decides to maintain the provision at 5% on 31 Dec 2002. Show income statement and balance sheet extracts for year ended 31 Dec 2002.
(a) Income Statement (extract) for the year ended 31 Dec 2002
(b) Balance Sheet (extract) as at 31 Dec 2002
Note
Note: In the income statement, when there is an existing provision at the start of the year, the difference between existing and new provision is shown. On the other hand, in the balance sheet, it is the new provision which is deducted from debtors. An increase in provision represents an additional loss, and therefore it appears as an expense. A decrease in provision represents a gain, which is treated as an income and added to gross profit.
Drawings of goods by owner for personal use
Whenever the owner takes out goods from the business for his/her personal use, this has the following effect:
- Reduces the amount of goods available for sale
- Increases drawings amount.
