Lecture 6 End of year adjustments II Accruals

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Lecture 6 End of year adjustments II: Accruals & Prepayments, Bad Debts & Provision

Lecture 6 End of year adjustments II: Accruals & Prepayments, Bad Debts & Provision for Doubtful Debt

End of Year Adjustments The Basics of Adjusting Entries RECAP • Fiscal and calendar

End of Year Adjustments The Basics of Adjusting Entries RECAP • Fiscal and calendar years • Adjusting entries for accruals • Periodicity concept • • Applying revenue & matching principle Adjusting entries for prepayments • Entries for bad debts and provision for doubtful debts Summary of journalizing and posting • How it effects the Financial Statements • Where to put the items in the financial statements

Adjusting Entries • Adjusting entries make it possible to report correct amounts on the

Adjusting Entries • Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. • A company must make adjusting entries every time it prepares financial statements. • Revenues - recorded in the period in which they are earned • Expenses - recognized in the period in which they are incurred Adjusting entries - needed to ensure that the revenue recognition and matching principles are followed.

Accruals It is an amount owing for a service provided during a particular accounting

Accruals It is an amount owing for a service provided during a particular accounting period and still unpaid for at the end of it. The amount due will normally be paid in a subsequent accounting period.

Accrued expenses • An adjusting entry serves two purposes: i) It records the obligations;

Accrued expenses • An adjusting entry serves two purposes: i) It records the obligations; and ii) It recognizes the expenses

Accrued expenses Rent of $1200 per year is payable at the end of every

Accrued expenses Rent of $1200 per year is payable at the end of every three months. The rent was paid on time in March, however this is not always the case Amount Rent due Rent paid $300 31 March 2010 $300 30 June 2010 5 July 2010 $300 30 September 2010 8 October 2010 $300 31 December 2010 15 January 2011

Accruals Which account to use for accruals? • Don’t open a separate account for

Accruals Which account to use for accruals? • Don’t open a separate account for accruals. • Accrual entry will be made to the account that relates to that particular service. • Since the expense account now has a credit balance, it becomes a current liability.

Accrued expenses Rent of $1200 per year is payable at the end of every

Accrued expenses Rent of $1200 per year is payable at the end of every three months. The rent was paid on time in March, however this is not always the case Rent account Debit Credit 31. 03. 10 Cash $300 5. 07. 10 Cash $300 8. 10 Cash $300 31. 12. 10 Accrued c/d $300 31. 12. 10 P&L account $1, 200 01. 11 Accrued b/d $300

Effect of Accruals End-of-year entry will be as follows: Dr Profit and Loss account

Effect of Accruals End-of-year entry will be as follows: Dr Profit and Loss account $1, 200 Cr Rent account $1, 200 What happens to the accrued expense amount of $300?

Review: You owed $500 to the telephone company at 31 December 2007. During the

Review: You owed $500 to the telephone company at 31 December 2007. During the year to 31 December 2008 you paid the company $4, 000. At 31 December 2008 you owed the company $1, 000. What amount for telephone charges would you debit to the profit and loss account for 2008?

Prepayments It is a current asset representing amount paid in cash for a service

Prepayments It is a current asset representing amount paid in cash for a service that will be provided in a subsequent period. Example: If the year end of a company is 31 December and it buys a van on 1 July 2008 and pays the full year road license fee up to 30 June 2009, then half of the license fee paid will relate to 2008 and the other half to 2009. An adjustment for this effect is therefore needed at the end of 2008.

Prepayments The van is used only 6 months during 2008, so only $500 of

Prepayments The van is used only 6 months during 2008, so only $500 of license fee should be charged to P&L account (matching rule), the remaining part will carry forward as prepayment for year following year. Debit 01. 07. 08 Road license fee ledger account Credit Bank $1, 000 31. 12. 08 $1, 000 01. 09 Prepaid b/d $500 P&L account $500 Prepaid c/d $500 $1, 000

Prepayments • Don’t open a separate account for prepayments. • Prepayment entry will be

Prepayments • Don’t open a separate account for prepayments. • Prepayment entry will be made to the account in which we have first recorded the payment. • Since the expense account at the end of year has a debit balance, it becomes a current asset. End-of-year entry will be as follows: Dr Profit and Loss account $ 500 Cr Road license fee account $ 500

Prepayments For a prepayment at the year end: 1) 2) Subtract the amount from

Prepayments For a prepayment at the year end: 1) 2) Subtract the amount from the expenses in P&L. In the balance sheet show the amount of the prepayments as a current asset under the subheading “Prepayments”

Review A company had paid $3, 000 in advance for insurance at 31 December

Review A company had paid $3, 000 in advance for insurance at 31 December 2004. . During the year to 31 December 2005, it paid the insurance company $10, 000, out of which $2, 000 is for insurance cover for the following year. What amount for insurance charges should the company debit to the profit and loss account for the year to 31 December 2005?

Bad & doubtful debts • Realization rule requires to include amount of credit sales

Bad & doubtful debts • Realization rule requires to include amount of credit sales in Revenue account even if the cash is not received at that date. • Some of debtors might default on payments when they become due. • By eliminating bad debt and creating a provision for other uncertainties, “accounting profit” is adjusted and becomes more reliable.

Bad & doubtful debts • Bad debt – highly unlikely it will be paid/recovered;

Bad & doubtful debts • Bad debt – highly unlikely it will be paid/recovered; long-time owing and proven to be bad. • Doubtful debts – are the debt that are likely to be bad but have not yet been proven to be so.

Bad & doubtful debts On 5 January, we sold $200 and $50 of pens

Bad & doubtful debts On 5 January, we sold $200 and $50 of pens to Chumi and Chiki respectively. However, at the year end, Chumi only managed to pay $120 and Chiki business already went bankrupt.

Bad & doubtful debts Writing off a bad debt completely removes the debt from

Bad & doubtful debts Writing off a bad debt completely removes the debt from the accounting books And the double entry will be: Dr Bad debts (it is an expense account) Cr Debtors (reduce the debtor figure by the amount of the bad debt) The balance of Bad Debts account is then transferred to Profit and Loss account at the end of accounting period.

Provision for d. debts Why do we need provision? How do you decide how

Provision for d. debts Why do we need provision? How do you decide how much to provide? The estimated figure can be made: i) By looking at each debt, and deciding to what extent it will be bad; ii) By estimating, on the basis of experience, what percentages(%) of the total amount due from the remaining debtors will ultimately prove to be bad debts. Ageing Schedule for Doubtful Debts Period debt owing Amount ($) Estimated % doubtful Provision for doubtful debts ($) Less than 1 mth 5, 000 1 50 1 – 2 months 3, 000 3 90 2 – 3 months 800 4 32 3 months – 1 year 200 5 10 Over 1 year 160 20 32 9, 160 214

Provision for d. debts On 31 December 20 x 9 (year in which provision

Provision for d. debts On 31 December 20 x 9 (year in which provision is first made), debtors amounted to $10, 000 and provision for bad and doubtful debts is 2% or $200. The accounting entries would be as follows: Dr Profit and Loss account $200 Cr Provision for bad and doubtful debts $200

Provision for d. debts Increasing the provision: suppose that at the end of the

Provision for d. debts Increasing the provision: suppose that at the end of the following year, 31 December 2010, debtors had risen to $12, 000 but the provision is still kept at 2%, or $240. Since a provision of $200 had been brought forward from 2002, in 2010 a provision for the additional $40 only should be made. The accounting entries on 31 December 2010 would be as follows: Dr Profit and Loss account $40 Cr Provision for bad and doubtful debts $40

Provision for d. debts Reducing the provision: suppose that at the end of the

Provision for d. debts Reducing the provision: suppose that at the end of the following year, 31 December 2011, debtors fell to $10, 500 but the provision remained at 2%, or $210. Since a provision of $240 had been brought forward from 2010, the provision in 2011 needs to be reduced by $30. The accounting entries on 31 December 2011 would be as follows: Dr Provision for bad and doubtful debts $30 Cr Profit and Loss account $30

Provision for d. debts • New account which is contra-account to the debtors account,

Provision for d. debts • New account which is contra-account to the debtors account, thus the rules of debit and credit for this account should be the opposite to the debtors account. • If there is an increase in the provision, a credit entry should be made; a decrease in the provision will require a debit entry. • Once original (first) entries have been made, subsequent entries in the provision for bad and doubtful debts account will only be made for the additional or the reduced amounts of the provision.

References: 1. Wood, F & Sangster, A (2001) Business Accounting 1, chapters 5, 6,

References: 1. Wood, F & Sangster, A (2001) Business Accounting 1, chapters 5, 6, 25, 26, 28 2. Dyson, J. R (2004) Accounting for Non-Accounting Students, chapter 5. 3. ACCA (2006) Approved text for the professional qualification, Study Text 2006/07, Paper 1. INT, Kaplan publishing: Foulks Lynch, chapter 5. 4. Glautier, M & Underdown B (2001) Accounting Theory and Practice, 7 th edition, chapters 9 & 10