Chapter 5
Adjustments
• Understand what adjusting journal
entries are and why they are important
to process
• Process closing transfers at the end of
the financial period
• Prepare financial statements after
adjustments/closing entries have been
taken into account
• Understand the implications of the
accrual basis.
Recording and Reporting
Recording
Reporting
• Bookkeeper
• Accountant
• Records
• Prepares financial
transactions
statements
• Processes journal
(reports)
entries
• Information
• Posts to the ledger
prepared/presented
• Extracts trial
according to
balance
IFRS/GAAP
3
Recording process
Transactions:
source document
Prepare journal
entry
Post to the general
ledger
Extract a trial
balance
Occurs
daily
during the
financial
year
Occurs
daily/monthly
during the
financial year
Monthly
during the
financial year
Adjusting entries
• On every reporting date, the accountant ensures
that the general ledger is correct according to
IFRS
– Do assets and liabilities in the ledger still meet the
asset/liability definition and recognition criteria in the
framework?
– Is the ledger complete i.e. are all the assets and/or
liabilities that should be recognised, listed in the ledger?
– Are items in the ledger measured at correct amount?
• If the answer to any of these questions is “NO”,
the accountant must ADJUST the general ledger
by preparing adjusting/correcting journal
entries.
Adjusting entries
Ensures that the information
used to prepare financial
statements accurately
reflects the assets, liabilities,
equity, income and expenses
of the business at that point
in time
Recording process
Pre-adjustment
trial balance
Prepare adjusting
journal entries
Post to the
general ledger
Accounting Equation
A+E+D=C+I+L
a/c type
Debit
Credit
Asset
+
-
Expenses
+
Drawings
+
a/c type
Debit
Credit
Capital
-
+
-
Income
-
+
-
Liabilities
-
+
Pre-adjustment trial balance
EXTRACT Pre-adjustment trial balance
Capital
8 000
Drawings
720
Stationery on hand
200
Prepaid talk-time
440
Sales
6 711
Cost of sales
2 940
1. Pre-adjustment trial balance shows what HAS
been recorded in the books of the business
2. There is no stationery or talk-time on hand at
year end
Adjusting journal entry
DR
Stationery expense
CR
200
Stationery on hand
200
Stationery used recognised as an EXPENSE
Dr
31/1
Dr
31/1
+
Stationery on hand
Balance
200 31/1
Stationery
Asset
-
Cr
Stationery
Expense
Stationery (Expense)
200
+
Cr
200
Stationery derecognised (credited) – no longer an asset.
Assets decrease, no change in liabilities
Decrease in NAV not due to transaction with owner
Stationery expense recognised (debited)
Adjusting journal entry
DR
Talk-time expense
CR
440
Prepaid talk-time
440
Talk-time used recognised as an EXPENSE
Dr
31/1
Dr
31/1
+
Prepaid talk-time
Balance
Prepaid talktime
440 31/1
-
Cr
Talk-time
Expense
Talk-time (Expense)
440
+
Cr
440
Prepaid talk-time derecognised (credited) – no longer an
asset.
Assets decrease, no change in liabilities
Decrease in NAV not due to transaction with owner
Talk-time expense recognised (debited)
Post-adjustment Trial Balance
EXTRACT Pre-adjustment trial
balance
Account
Debit Credit
Capital
8 000
Drawings
720
Stationery on
200
hand
Prepaid talk
440
time
Sales
6 711
Cost of sales
2 940
EXTRACT POST-adjustment trial
balance
Account
Debit Credit
Capital
8 000
Drawings
720
Stationery
200
expense
Talk time
440
expense
Sales
6 711
Cost of sales
2 940
Recording/reporting process
Post-adjustment
trial balance
Prepare
closing entries
Post to the
general ledger
Post-closing trial
balance
Prepare Financial
Statements
Closing entries
SEE PG 87
At the end of the financial year, the business needs to
calculate the profit or loss. Once all adjusting journal
entries are processed, the income and expenses need
to be closed of to zero
Profit or Loss= Income - Expenses
What are closing entries?
Closing entries are transactions that allow all
income/expense, losses/gains to be closed off to a
zero balance to the profit and loss account – and
transferred to an equity account.
Closing entries
SEE PG 87
When do we process closing entries?
Annual accounts - Income and expense, gains and
losses are closed off to relevant EQUITY accounts
i.e. Retained Earnings during the year-end
process.
Close off income and expenses
DR
Sales income (P/L)
CR
6 711
Profit or Loss (E)
6 711
Close off sales income to Profit/Loss account
DR
Profit or Loss (E)
CR
2 940
Cost of sales expense (P/L)
2 940
Close off cost of sales expense to Profit/Loss account
Dr 31/1
Cost of sales
Dr 31/1
2 940 31/1
Sales
Sales income (Equity)
Profit/Loss
account
Dr 31/1
Profit/Loss account (Equity)
Balance
6 711 31/1
Balance
Cost of sales expense (Equity)
2 940 31/1
Profit/Loss
account
Cr +
6 711
Cr +
6 711
Cr +
2 940
16
Close off income and expenses
DR
Profit/Loss (E)
CR
200
Stationery expense (P/L)
200
Close off stationery expense to profit and loss account
DR
Profit/Loss (E)
CR
440
Talk-time expense (P/L)
440
Close off talk-time expense to profit and loss account
Dr - Profit/loss (Equity)
Cost of
Sales
Sales
Cr +
6 711
Dr - Stationery expense
Balance
2 940
Stationery
expense
200
Talk-time
expense
440
200 Profit/
loss
Dr – Talk time expense
Balance
440 Profit/
loss
Cr +
200
Cr +
440
Close off Profit/Loss
DR
Retained earnings (E)
CR
720
Drawings (E)
720
Close off drawings to retained earnings account
DR
Profit/loss (E)
CR
3 131
Retained earnings (E)
3 131
Close off profit to retained earnings account
Dr - Profit/loss (Equity)
Cost of
Sales
Stationery
expense
Sales
Cr +
6 711
Dr – Retained earnings Cr +
Drawings
2 940
720 Profit/
loss
Dr - Drawings
3 131
Cr +
200
Balance
Talk-time
expense
440
Retained
earnings
3 131
720 Retained
earnings
720
Post-closing Trial Balance
Extract from POST-adjustment
trial balance
Account
Debit Credit
Capital
8 000
Drawings
720
Stationery
200
expense
Talk time
440
expense
Sales
6 711
Cost of sales
2 940
Extract from post-CLOSING
trial balance
Account
Debit Credit
Capital
8 000
Retained
Profit
2 411
[3 131 – 720]
Points to note
• Adjusting entries processed to get correct
balances to prepare the financial
statements.
• Closing entries processed after adjusting
entries
• Closing entries processed to net income
and expense account balances off to zero.
• Asset and liability accounts not affected by
closing entries
Recording
Business purchases R3 000 stationery
Bookkeeper
Dr Stationery
exp
Cr Bank/TP
OR
Dr Stationery
Asset
Cr Bank/TP
Which is correct?
Recording
Either !!!! – when information is
recorded initially
When is it important that A, E and L are
accurate?
When the Financial statements are
prepared
Financial statements are generally
prepared at the end of the financial
period!
Reporting
Regardless of how the transaction was
initially recorded, the following must be
disclosed:
Financial
statements
Stationery
used
Expense
SOCI
Stationery
on hand
Asset
SOFP
Reporting
The financial statements need to
be prepared at 31 December:
• Assume stationery of R1 000 is
on hand
• How should the records be
adjusted so that the reports are
accurate?
Adjusting journal entries
If the bookkeeper initially
recorded:
If the bookkeeper initially
recorded:
Dr Stationery EXPENSE R3 000
Cr Bank/TP
R3 000
Dr Stationery ASSET
Cr Bank/TP
Then the adjusting entry is:
Dr Stationery asset
R1 000
Cr Stationery expense R1 000
Then the adjusting entry is:
Dr Stationery expense R2 000
Cr Stationery asset
R2 000
We need to show that some of
the stationery
originally purchased and treated
as an expense is still
ON HAND and is an ASSET
We need to show that some of
the stationery originally
purchased and treated as an
asset has been USED
and is an EXPENSE
R3 000
R3 000
So, what sort of Adjusting journal
entries need to be made?
Adjustments…..
Accrued Expense: The benefit has been used but not paid for therefore
a liability recognised;
Prepaid expense: The expense has been paid for in advance and the
expense has not yet been recognised;
Income Accrued: The income has been earned but not received;
Income received in advance: Income received but the service has not
been provided for
An example
Extract of AA Stores
Pre-Adjustment trial balance as at 31 August x9
Debit
Credit
Plant and equipment
410 000
Trade receivables
55 000
Sales income
1 000 000
Rent income
16 500
Cost of sales expense
425 000
Rent expense
56 000
Water & electricity
8700
expense
An example
• AA Stores estimates it used water and electricity worth
R9 000 during the year. The bookkeeper records all
payments of electricity as an expense.
Accrued expense
Benefit used but not paid
W&E expense
in TB @
31/8/x9 =
R8 700
1/9/x8
What was paid:
R8 700
What was used:
R9 000
The business paid R300 TOO LITTLE
Expenses
Liability
We owe for a service
we have USED –
recognise a liability
Adjusting journal entry
DR
Water and electricity exp
CR
300
Accrued expenses
300
Unpaid W&E recognised as a LIABILITY
Dr
-
Accrued expenses (L) +
Cr
31/8/9 Water and
electricity exp
Dr
31/8/9
+
Water and electricity exp
Balance
Accrued
expenses
8 700
300
300
-
Cr
An example
• AA Stores rents a property and is charged R4 000 rental
per month. The bookkeeper records all cash payments
for rent as expenses.
Prepaid expense
Paid but benefit not used
Rent
expense in
TB @ 31/8/x9
= R56 000
1/9/x8
What was paid:
R56 000
What was used:
R48 000 [R4 000 x 12]
The business paid R8 000 TOO MUCH
Expenses
Asset
They owe us a service –
recognise an asset
Adjusting journal entry
DR
Prepaid rent (A)
CR
8 000
Rent expense
8 000
Unused rent recognised as an ASSET
Dr
-
31/8/9 Balance
Dr
31/8/9
+
Rent expense
Rent expense
+
Cr
56 000 31/8/9 Prepaid rent
Prepaid rent (A)
8 000
8 000
-
Cr
An example
• AA Stores owns a building in Parow industrial. The rent
income is R1 500/month. The tenant has occupied the
building for the full financial year.
Accrued income
Earned but not received
Rent income
in TB @
31/8/x9 =
R16 500
1/9/x8
What was received:
R16 500
What was earned:
R18 000 [R1 500 x 12]
The business received R1 500 TOO LITTLE
Income
Asset
They owe us for a
service – recognise an
asset
Adjusting journal entry
DR
Accrued income (A)
CR
1 500
Rent income
1 500
Income not yet received (but earned) recognised as an ASSET
Dr
Dr
31/8/9
-
+
Rent income
Rent income
Cr
31/8/9 Balance
16 500
Accrued
income
1 500
Accrued income (A)
1 500
+
-
Cr
An example
• On 1 August X9, a customer ordered and paid for
running shoes amounting to R3 500. The shoes will only
be delivered during September. The bookkeeper
included this amount in sales income.
Income received in advance
Received but not earned
1/9/x8
Sales in TB @
31/8/x9 = =
R1 000 000
What was received:
R1 000 000
What was earned:
R996 500 [R1 000 000 –
R3 500]
The business received R3 500 TOO MUCH
Income
Liability
We still owe goods –
recognise a liability
Adjusting journal entry
DR
Sales
CR
3 500
Income received in
advance
3 500
Unearned income recognised as a LIABILITY
Dr
-
Income received in advance (L) +
31/8/9 Sales
Dr
31/8/9
Income received
in advance
Sales
3 500
3 500
+
Balance
Cr
Cr
1 000
000
Post adjustment Trial balance
Extract of AA Stores
Pre-Adjustment trial balance
Extract of AA Stores
POST-Adjustment trial balance
Sales income
1 000 000
Sales income
996 500
Rent income
16 500
Rent income
18 000
Rent
expense
Water &
electricity
exp
56 000
Rent expense
48 000
8 700
Water &
electricity exp
9 000
Inc received in
advance
3 500
Accrued inc
1 500
Prepaid exp
8 000
Accrued exp
300
Cash and accrual: expenses
Effect on profit
calculation
Cash paid this
Recognise
year, benefit from
expense this year expense used this
profit decreases
year
Cash paid this
No effect on this
year, benefit from
years profit
expense used
calculation
next year
Benefit from
Recognise
expense used this
expense this year year, cash paid
profit decreases
next year
Effect on
statement of
financial position
No new asset or
liability recognised
Recognise a
prepaid expense
(asset)
Recognise an
accrued expense
(liability)
Cash and accrual: Income
Effect on profit
calculation
Effect on the
statement of
financial position
Cash received this Recognise income
No new asset or
year, service
this year - profit
liability recognised
provided this year
increases
Cash received this
No effect on this Recognise income
year, service
year’s profit
received in
provided next
calculation
advance (liability)
year
Service provided Recognise income
Recognise an
this year, cash
this year - profit
accrued income
received next year
increases
(asset)
In preparing the financial statements,
the business will question whether the
amounts in the pre-adjustment trial
balance for Property, Plant and
Equipment (PPE), Trade receivables
and Inventory are the amounts that
should be shown on the Statement of
financial position.
Let’s look at PPE
• Why would a business purchase PPE?
To generate benefit for the business by using the
asset e.g Machinery; Vehicles
• Does the business expect PPE to be
used forever?
No, the asset is expected to be used for a
specified time or units after which it is disposed of
• The TIME used OR amount of UNITS it
can produce (i.e. Km driven by a vehicle)
referred to as the estimated useful life
Depreciation
As the business is using the asset, how
must it recognise the cost of using up the
asset?
‘Depreciation is a systematic allocation
of the depreciable amount of an asset
over its estimated useful life’
• Residual value - estimated amount
(less disposal costs) at which asset
sold for at end of its estimated useful
life.
• It is only used to calculate
depreciation
Depreciable amount – amount of the
cost of the asset allocated as an
expense over the life of the asset.
Cost – Residual value
= Depreciable amount
Depreciation
• How do we calculate depreciation?
• For each asset we need the following
information:
‘Period’ of
1.
2.
3.
4.
benefits
• Time
• Number of
actions
Cost
Residual value
Estimated useful life
• Time –
Method of
SLM/DB
depreciation
• Number of
actions
Depreciation
• Cost: R410 000
• Residual Value: R 50 000
• Estimated useful life: 3 years
(R410
Straight line
method
000 – R50 000)
3
= R120 000
Straight-line assumes that the benefits are
used evenly
Adjusting journal entry
DR
Depreciation expense
CR
120 000
Accumulated depreciation:
vehicle
120 000
Allocate one year’s depreciation
Dr
-
Accumulated depreciation: vehicle
Yrend
Dr +
Yr-end
Depreciation
expense
Depreciation expense
Accumulated
depreciation:
vehicle
120 000
+
Cr
120 000
-
Cr
Accumulated depreciation
• Do NOT credit asset account
• Credit an account called accumulated
depreciation
• WHY - IAS 16: keep record of asset’s
original cost or revalued amount in
general ledger.
• Purpose of accumulated depreciation
account - reduce the carrying value of
the asset i.e. vehicle, when reported on
the statement on financial position.
Depreciation
R410 000 – R50 000/3 = R120 000 annual depreciation
Dr
-
Accumulated depreciation: vehicle
Yr-end
1
Yr-end
2
CA = 410 - 120
290 000
Purchased
Yr-end 1
+
Cr
Depreciation
expense
Depreciation
expense
120 000
Yr-end Depreciation
3
expense
120 000
CA = 410 - 240
170 000
Yr-end 2
120 000
CA = 410 - 360
50 000
Yr-end 3
Carrying amount (CA) = Cost – Accumulated
depreciation
Let’s look at Trade receivable
• Businesses sell goods on credit
• They expect to receive payment in the
future, however, sometimes they do
not receive part or all of the amount
owed to them...
Bad debts
• Carrying value of trade receivables
reported on the statement of financial
position cannot be greater than the
expected future economic benefits (i.e.
the payments expected to be received
from debtors).
• On every reporting date, the trade
receivables asset should be impaired
by the amount the business expects
will not be paid by the debtors in the
future
Bad debts
• A debtor had gone insolvent. He owed
R700
• The business is aware of the specific
debtor who is unable to pay
– The trade receivables account is
decreased (i.e. credited).
– The business recognizes an expense –
bad debts
Adjusting journal entry
DR
Bad debts expense
CR
700
Trade Receivables
700
Write off the debt of a specific debtor
Dr
+
Trade Receivables
Cr
Yrend
Dr Yr-end
Bad debts
expense
Bad debts expense
Cr
Trade
Receivables
700
700
+
Allowance for doubtful debts
Debtors purchase
goods on credit
Year 1
Unlikely that
ALL of these
debtors will
pay
Year in which they pay
(or are meant to pay)
Year 2
Experience shows that it is more likely than
not that a certain percentage of trade
receivables owing at year-end will not be
collected. The inflow of FEBs are not
probable - This amount is recognised as an
expense
Allowance for doubtful debts
• Based on past experience accountant
reliably estimated business will NOT
collect 2% of outstanding debtors at
year end.
Trade receivable balance = R15 000
The inflow of these FEB’s is not probable
2% of R15 000 = R300
Allowance for doubtful debts
• Recognise the R300 as an expense
• Which account will we CR???
• The business does not know which
debtors will not pay – so we cannot CR
trade receivables
• CR Allowance for doubtful debts (-A)
Adjusting journal entry
DR
Bad debts expense
CR
300
Allowance for doubtful
debts
300
Create an allowance for the 2% reliably estimated not to pay
Dr
-
Allowance for doubtful debts
Yrend
Dr +
Yr-end
Bad debts expense
Allowance for
doubtful debts
300
+
Bad debts
expense
Cr
300
-
Cr
Statement of financial position
At what amount will Trade receivables
appear on the SOFP???
Current Assets
Trade Receivable
R14 700
R15 000– R300
OR
R15 000 x 98% the probable FEB’s
Allowance for doubtful debts
• The Trade receivable account is
credited when the specific customer is
known
• The Allowance for doubtful debts
account is credited when it is expected
that some customers will not pay, but
the specific customers have not been
identified.
Year 2
Year 1
Year 2
2% of trade receivable
balance irrecoverable.
Trade receivable R15 000
R15 000 x 2% = R300
Allowance for doubtful debts
2% of trade receivable
balance irrecoverable.
Trade receivable R18 000
R18 000 x 2% = R360
Already a balance of R300
Allowance for doubtful debts
Balance
Bad debts 300
300
Bad debts 60
Bad debts
All for DD 300
P/L
Bad debts
300
All for DD
60 P/L
60
Financial statements
Year 1
SOFP
Current assets
Trade receivable
SPLOCI
Bad debts expense
Year 2
14 700
300
R15 000 – 300
OR
R15 000 x 98% - the
probable FEB’s
SOFP
Current assets
Trade receivable 17 640
SPLOCI
Bad debts expense
60
R18 000 – 360
OR
R18 000 x 98% - the
probable FEB’s
Reversing adjusting entries
• When and how does an adjusting entry
processed in one financial period affect
the following financial period
• When new asset/liability accounts
created i.e. prepaid expense
• The benefit inherent in this account is
used up in the following period
• The obligation inherent in the new
liabilities i.e. accrued expense is settled
in the following period
Reversals of adjustments
• When we made adjustments relating to
incomes and expenses (prepaid
expenses, accrued expenses, income
received in advance and accrued
income), we created new asset and
liability accounts
• These accounts can be reversed at the
start of the next financial period
Reversals: Prepaid expense
Year 1
Process adjustments
New Asset and Liability
accounts created
Close off income and
expense accounts
Year 2
This asset account is still in
the books at the start of year
2. By the end of the year the
benefit will be consumed i.e.
expensed
Prepaid electricity (A)
Prepaid electricity (A)
31/12
Electricity
expense 200
31/12 Electricity 1/1 Electricity
expense 200 expense 200
Electricity expense
1/1 Prepaid
electricity 200
Reversal
entry
Reversals: Accrued expense
Year 1
Used R500 Electricity
expense – still not
paid for
Year 2
When R500 paid in year 2
DR electricity account. This
is cancelled by the CR
(reversal)
Accrued electricity (L)
31/12 Electricity
expense
500
Accrued electricity (L)
1/1
Electricity
expense 500
31/12 Electricity
expense 500
Electricity expense
Reversal
entry
1/1 Accrued
electricity 500
Reversals: Accrued income
Year 1
Earned R25 for
interest –not yet
received
Accrued interest income (A)
31/12
Interest
income 25
Year 2
When R25 received in year
2 CR interest income. This
is cancelled by the DR
(reversal)
Accrued interest income (A)
31/12
Interest
income 25
1/1
Interest
income 25
Interest income
1/1 Accrued
interest income 25
Reversal
entry
Reversals: Income received in
advance Year 2
Year 1
Received R120 – not
yet earned
The business will earn R120
by supplying the goods – no
further cash will be received
Income received in advance (L)
31/12 Sales
120
Income received in advance (L)
1/1 Sales
120
31/12 Sales
120
Sales
Reversal
entry
1/1 Inc Rec in
advance 120