LEARNING OUTCOMES
LEARNING OUTCOMES
At the end of the topic, the student should be able to:
Review the accounting concepts, namely the accounting period and matching concepts
Explain the necessity of the adjustment entries, and Determine and record the most import types of adjustments.
5.1 INTRODUCTION
An entity usually does business on a permanent basis without any interruptions. We also know that its owners and managers need regular information on its financial results and financial position. The life of an entity is therefore divided into equal periods (financial periods), usually of 12 months, and the profit or loss is determined for that period.
Thus far it was assumed that all transactions recorded were in respect of the specific financial period. The closing off of accounts and the determination of the profit were recorded under this assumption. This does not always happen and the accounts (and eventually statements) have sometimes to be adjusted
to o e t'' the ala es i a ou ts efo e the fi al a ou ts a d fi a ial statements can be prepared.
For more accurate financial statements at the end of a financial period, additional entries, which do not originate from source documents, may therefore be necessary. These adjustment entries are necessary in order to comply with the accrual basis of accounting as well as the realisation and matching principles.
5.2 FIVE STEPS RELATING TO ADJUSTMENTS
Step 1: Identify the accounts that must be adjusted. Step 2: Determine how the accounts would be affected and what the balances
of these accounts should be.
Step 3: Calculate the amount(s) involved in the adjustment.
Step 4: Record the necessary adjustments in the general journal and post the entries to the ledger(s). Step 5: Ensure that the new balances of the accounts are now correct.
5.3 SHORT-TERM ADJUSTMENTS
This has to do with the apportionment of income and expenditure to consecutive periods within a year. This happens when income which is meant for one period but is actually earned in an earlier or later period. The same would apply to expenses, which are incurred in another period.
Prepaid expenses
A prepaid expense is an expense which has been paid during the current financial period, where all or part of the expense relates to a future financial period. For example, insurance expenses are usually payable in advance. When the financial year of a business entity ends, it is therefore possible that a portion of the insurance expense relates to the next financial period. An adjustment is therefore necessary to match only that portion of the expense which relates to the current financial period against the income for that period. Prepaid expense is shown under the current assets in the statement of financial statement.
Example
ABC LTD pays advance rent to its landowner of R10 000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010. ABC LTD will recognize an asset of R10 000 in the financial statements of year 2010 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:
Debit
Prepaid Rent
Credit
Cash
The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2011:
Debit Rent Expense (Income Statement) 10 000
Credit Prepaid Rent 10 000
Example
Jeff Stores paid R18 000 for insurance on 2 January 2009. This payment was for insurance cover for 18 months. The financial year of Jeff Stores ends on 31 December each year.
Required:
Record the adjustment in the general journal and general ledger and show the closing entries.
Solution:
General Journal DR
CR
Prepaid expenses
R6 000
Insurance R6 000 Insurance paid in advance
Profit and loss account
R12 000
Insurance R12 000 Transfer of insurance to profit and loss account
General Ledger
09 expenses Profit and loss
account
Prepaid expenses
31.12.09 Insurance
Accrued expenses
These are expenses which have been incurred by a business but which have not yet been paid by the end of the financial period. Examples are rent payable due to the landlord, outstanding insurance premiums. Accrued expenses are shown in the statement of financial position as current liabilities.
Example
The financial year of Jack Daniels, a dentist, ends on 31 March each year. His monthly rent payable is R2 000. His records for the financial year ended 31 March 2010 showed that he paid rent for ten months during the year.
Required: Record the adjustment in the general journal and general ledger and show the closing entries.
Solution:
General Journal DR
CR
Rent expense
R4 000
Accrued expenses R4 000 Adjustment of rent expense account
Profit and loss account
R24 000
Rent expense R24 000
Closing of rent expense account to profit
and loss account
General Ledger
Rent expense
31.03.10 Bank (2000 x 10)
20 000 31.03.10 Profit
24 and loss 000 account
Accrued expense
Accrued expenses
Income Received In Advance
Income received in advance is an amount not yet earned, so it must be deducted from total income to arrive at the correct income earned during the financial year. Income received in advance is shown as a current liability in the statement of financial position.
Example
AD Stores rented out part of their building for a monthly rental of R600. During the financial year ended 31 December 2009, tenant Mad Max made a total payment of R8 400.
Required:
Prepare the relevant journal and ledger entries to record the adjustments made.
Solution:
General Journal DR
CR
Rent income
1 200 Adjustment of rent income account Rent income
Income received in advance
Profit and loss account
Closing of rent income to profit and loss
account
General Ledger
Rent income
Profit and loss 7 200
account
Income received in advance
Accrued Income
This is income earned by the business in respect of services rendered but for which no payment has been received. Accrued income is shown in the balance sheet as current assets.
Example
ABC LTD receives interest of R10 000 on bank deposit for the month of December 2010 on 3rd January 2011. ABC LTD has an accounting year end of 31st December 2010. ABC LTD will recognize interest income of R10 000 in the financial statements of year 2010 even though it was received in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest income accrued:
RR
Debit Interest Income Receivable
Credit Interest on Bank Deposit (Income)
On the date of receipt of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:
Interest Income Receivable
Example
The commission earned by LT Stores for selling designer clothing was R90 000 for the year ended 31 December 2009. LT Stores received R75 000 during the year.
Required:
Prepare the relevant journal and ledger entries to record the necessary adjustment.
Solution: General Journal
Accrued income
15 000 Commission income
15 000 Adjustment of commission income account
Commission income
90 000 Profit and loss account
90 000 Closing of commission income to profit and loss
account
General Ledger
Commission income
31.12.0 Profit and loss
.12. b/d
Accrued income
Credit Losses
Any business which grants credit to its customers runs the risk of having some of those customers not paying their debts. If such debts remain unpaid for some time, they must be written off as irrecoverable and taken off from the list of trade debtors. The debts written off as irrecoverable are listed as an expense in the income statement.
Example:
On 1 January 2009, BP Distributors had the following trade debtors: Simon – R300 Peter – R200
On 30 September 2009, it was decided to write the debts off as bad since they have been owed for more than 2 years. The financial year ends on 31 December 2009.
Required:
Show the relevant Journal and Ledger entries for the above transactions.
Solution:
Credit losses
R500
Debtors Control: Simon
R300
Debtors Control: Peter
R200
W ite off de to s a ou ts as
irrecoverable Profit and loss account
R500
Credit losses
R500
Closing off credit losses to profit and
loss account
Credit losses
30.09.09 Debtors Control 300 31.12.09 Profit and 500 (Simon)
loss account Debtors
Profit and loss account
31.12.09 Credit losses
5.4. LONG-TERM ADJUSTMENT
If an enterprise spends an amount from which it will benefit over the long term, it is spread equally over the whole term over which it will be used. Normally non-current assets (fixed assets) are acquired and used over a long term, equipment serves as an example.
Depreciation
When a business buys an asset, which is intended to be used in the business for more than one financial year, that asset is described as a non-current asset When a business buys an asset, which is intended to be used in the business for more than one financial year, that asset is described as a non-current asset
5.5. METHODS OF DEPRECIATION
A business can use several methods of depreciation to determine the amount of depreciation to be written off a specific asset. Some of the commonly used methods are the straight-line method (fixed instalment), the diminishing (reducing) balance method and the revaluation method.
The Straight-Line Method
In this method, depreciation is calculated on the cost of the asset using a pre- determined depreciation value. The depreciation value could be given as a certain percentage, e.g. 12% per annum. If a fixed asset was bought for R5 000 and its depreciation rate was given as 10% per annum, the annual depreciation will be: (R5 000 x 10%) = R500.
Where the economic (useful) life of the asset can be estimated with certainty that can be used to determine the depreciation rate. Assume that an asset was bought for R10 000 and it was expected to have an economic life of 10 years, the annual depreciation will be (R10 000/10) = R1 000.
If the asset is expected to have some value after its economic life, this value is known as residual value. To calculate depreciation, the residual value must be deducted from the cost of the asset before the depreciation rate if applied.
Example:
Bonzy Stores bought equipment for R20 000 on 1 January 2000. It was estimated that this asset would have a residual value of R4 000 after its economic life of 10 years. Calculate the annual depreciation.
Solution:
Annual depreciation: cost price – residual value/economic life (R20 000 – R4 000)/10 = R1 600
Diminishing Balance Method
Based on this method, the annual depreciation is calculated on the carrying amount of the asset. The carrying amount is obtained by deducting the accumulated depreciation (total depreciation to date) on the asset from the original cost of the asset. Depreciation rate is then applied to the book value to calculate the depreciation.
Example:
Frazer Metals bought a machine for R60 000 on 1 March 1996. It was decided to depreciate the asset by 10% per annum on the diminishing balance method. The financial year of the business ends on 31 December. Calculate the annual depreciation for the financial years ended 31 December 1996, 1997 and 1998.
Solution:
1996 – Annual depreciation: (Cost – Accumulated Depreciation (Acc. Dep)) x depreciation rate x no. of months
(R60 000 – 0) x 10% x 10/12 = R5 000
1997 – Annual depreciation: (Cost – Acc. Dep) x depreciation rate
(R60 000 – R5 000) x 10% = R5 500
1998 – Annual depreciation: (Cost – Acc. Dep.) x depreciation rate
(R60 000 – R10 500) x 10% = R4 950
The Revaluation Method
This method of depreciation compares the carrying amount of the asset at the beginning of the year with the estimated value of the asset at the end of the year. The difference between the 2 values represents the annual depreciation on the asset for the year.
Example:
Blue-Bird Traders valued its equipment at R10 000 on 1 January 1999. On 31 December 1999, the equipment was valued at R8 200. Calculate the annual depreciation on equipment for the year ended 31 December 1999.
Solution:
Annual depreciation – 31 December 1999
Carrying amount at 1 January 1999 R10 000
Estimated value 31 December 1999
R 8 200
Annual depreciation
R 1 800
5.6. ACCOUNTING ENTRIES FOR DEPRECIATION
After the depreciation amount has been determined the accounting entries have to be made.