Financial statements
The financial statements which have been covered so far have shown that total sales
minus total expenses for the period will result in the net profit (or a net loss) for the
period. Up to this level it is assumed that the expenses and income are incurred
(recognised) exactly in the financial period under review. E.g. if statement of profit or
loss is drafted up, all the expenses shown in the trial balance are exactly for that
period only, there will be no accruals or prepayments. These types of financial
statements are much easy to prepare.
Adjustments
When financial statements are prepared incorporating adjustments they become
much comprehensive as calculations will have to be done to get the amounts which
have to be posted to each set of financial statement. This will involve the following
adjustments:
1. Accruals;
2. Prepayments;
3. Depreciation, and
4. Provision for bad debts.
Accruals
Accruals mean expense or income incurred but has not yet been paid. This can be
applicable to income and expenses, let us see how it will be applied.
Accrued expenses
This will be defined as: amount of expenses that have been used by the
organisation but have not yet been paid until the end of the financial period.
(Example) Water &Electricity: Let us assume the total amount for water and
electricity for the whole year is N$ 10 000, total amount paid for is only N$ 8000. In
this case it means that there is a difference; as the amount paid for that expenses is
only N$ 8000. The result will mean that:
Total amount paid
Total amount incurred
Difference = Accrued expenses
N$8 000
N$10 000
N$2 000
In other word the business paid less than what they were supposed to have paid for
water & electricity.
The effect of accrual on the financial statements
The effect will be that the accrued amount of N$2 000 will be added to the amount of
water and electricity in the statement of profit or loss and the same amount will be
recoded as a liability in the statement of financial position, this is because the
amount have not yet been paid.
Statements of profit or loss and other comprehensive income for the year
ended........
Less: operating expenses
Water & electricity (8000 + 2000)
N$ 10 000
Statements of financial position as at................
Current liabilities
Accrued expenses
N$ 2000
The double entry for accrued expense
The reason why the accrued amount is added to the amount already paid in the
statement of profit or loss is not a formula, but is an entry that is done by DR one
account and CR another account. The entry will be as follow:
DR. Water & Electricity expenses
CR. Accrued expenses account
Accrued income
This will be defined as: Income that the business is entitled to but have not yet
received the money until end of the financial year.
(Example) Interest received: Let’s assume that the total amount which the business
supposed to get for interest received on an investment for the whole year is N$3
500. What was received for that period is only N$2 000. In this case this means that
there is a difference as the amount received for the income is only N$2 000. The
result will mean:
Total amount received
Total amount incurred
Difference = Accrued income
N$2 000
N$3 500
N$1 500
In other word, this is basically saying that the organisation received less than what it
was supposed to have received.
The effect on the financial statements
The effect will be that, the accrued amount of N$1 500 will be added to the amount
of interest received in the statement of profit or loss and classified as an asset in the
statement of financial position.
Statements of profit or loss for the year ended........
Add: other income
Interest received (2000 + 1500)
N$3 500
Statements of financial position as at................
Currents assets
Accrued income
N$ 1500
The double entry for accrued income
The reason why the accrued amount is added to the amount already paid in the
statement of profit or loss is not a formula, but is an entry that is done by DR one
account and CR another account. The entry is as follow:
DR. Accrued income
CR. Interest received account
Prepayments
Prepayment means is expenses or income that is paid in advance. This can be
applicable to both income and expenses, let us see how it will be applied.
Prepaid expenses
This will be defined as: amount of an expense that have been paid in advance by
the organisation, but has not yet been incurred during the financial period under
review.
(Example) Rent expenses: Let us assume the total amount for rent for the whole
year is N$6 500. The total amount paid for that is N$7 000. In this case it means that
there is a difference as the amount paid for the expense is N$7 000. The result will
mean:
Total amount paid
Total amount incurred
Difference = Prepaid expenses
N$7 000
N$6 500
N$500
In other word this is basically saying that the organisation paid more than what it was
supposed to have paid.
Effect on the financial statements
The effect will be that the prepaid amount of N$500 will be deducted from the
amount of rent paid in the statement of profit or loss and classified as an asset in the
statement of financial position as follows:
Statements of profit or loss for the year ended........
Less: operating expenses
Rent expenses (7000 - 500)
N$ 6500
Statements of financial position as at................
Current Assets
Prepaid expenses
N$ 500
The double entry for prepaid expense
The reason why the prepaid amount is deducted to the amount already paid in the
statement of profit or loss is not a formula, but is an entry that is done by DR one
account and CR another account. The entry will be as follow:
DR. Prepaid expenses
CR. Rent expenses account
Prepaid income
This is defined as: an amount of income that has been received in advance by the
organisation, but has not yet been incurred until year end.
(Example) Commission received: Let us assume that the total amount for
commission for the whole year is N$1 200. The total amount received up-to-date is
N$1 400. In this case it means that there is a difference as the amount received for
that income is only N$ 1400. The result will mean:
Total amount received
Total amount incurred
Difference = Prepaid income
N$1 400
N$1 200
N$200
In other word, this is basically saying that the organisation received more than what it
was supposed to have received.
The effects on the financial statements
The effects will be: the prepaid amount of N$200 will be deducted from the amount
of commission received in the statement of comprehensive income and will be
classified as a liability in the statement of financial position as follow:
Statements of profit or loss for the year ended........
Add: Other income
Commission received (1400 - 200)
N$ 1200
Statements of financial position as at................
Current liabilities
Prepaid income
N$ 200
The double entry for prepaid income
The reason why the prepaid amount is deducted to the amount already paid in the
statement of comprehensive income is not a formula, but is an entry that is done by
DR one account and CR another account. The entry will be as follow:
DR. Commission received
CR. Prepaid income
Depreciation
Depreciation is part of year end adjustment, is defined as follows: Decrease in value
of assets due to wear and tear, decay and decline in price.
Depreciation affects non -current assets to the extent that some non- current assets
own by business need to be depreciated. E.G Motor van, equipment, computers and
so on. Depreciation is regarded as an expense in the accounting records of an
organisation.
Method of calculating depreciation
There are two common methods that can be used to calculate depreciation, they are:
Straight line method and Reducing balance method (Diminishing balance method).
Straight line method
Sometimes also called the fixed instalment method, the number of years used is
estimated. The cost, less the estimated disposal value, is then divided by the number
of years to give the depreciation charge each year. This means that depreciation
charged will be constant each year.
Formula
Cost – Residual value
Number of years
= Depreciation
or
Cost price X Rate% = Depreciation
Reducing balance method
By this method a fixed percentage of depreciation is deducted from the cost price in
the first year. In the second or later years the same percentage is taken of the
reduced balance (cost less total depreciation already charged). Depreciation
charged each year decrease from one year to another.
Formula
Cost – Accumulated depreciation = NBV X Rate%
The double entry
Whether the straight line method or reducing balance method is used the double
entry for recording depreciation is the same, this will be shown as follow:
DR. Depreciation
CR. Accumulated depreciation
Provision for bad debts/ doubtful debts
Provision for bad debts is an estimate that is made for the value of debtors who are
unlikely not be able to pay. This is not the same as bad debts because a bad debt is
the actual amount that is known that is not going to be paid. Provision for bad debts
is calculated every year to determine the amount of debtors that are probably not
going to pay using a fixed percentage on the outstanding debtors. This will then be
compared between last year provision and this year provision and then the
difference will either be increase or decrease in provision for bad debts. An increase
in provision for bad debts is an expense while a decrease in provision for bad debts
is an income. Prudence concept apply to provision for bad debts.
The Double entry
The double entry for provision for bad debts will be as follows:
Increase in provision for bad debts
DR. Bad debts
CR. Provision for bad debts
Decrease in provision for bad debts
DR. Provision for bad debts
CR. Bad debts
Effect on financial statements
An increase in provision for bad debts is recorded in operating expenses and the
amount calculated will be shown in the statement of financial position being
deducted from accounts receivable.
Example: Increase in provision
Debtors balance as at year end
N$10 000
Provision for bad debts for previous year
N$800
Policy: Provision for bad debts is calculated on the outstanding debtor’s amount at
10%.
Answer: 10% X 10 000 = N$1 000 provision for this year.
Provision for last year minus provision for this year. N$1 000 –N$800= N$200
increase in provision
Statement of profit or loss for the year ended................
Less: Operating expenses
Increase in provision for bad debts
N$ 200
Statement of financial position as at .......................
Current assets
Accounts receivable
N$ 10 000
Less: Provision for bad debts
(N 1 000)
N$9 000
Example: Decrease in provision
Debtors balance as at year end
N$8 000
Provision for bad debts for previous year
N$900
Policy: Provision for bad debts is calculated on the outstanding debtor’s amount at
10%.
Answer: 10% X 8 000 = N$800 provision for this year
Provision for last year minus provision for this year. N$900 –N$800 = N$100
decrease in provision
Statement of profit or loss for the year ended................
Add: Other income
Decrease in provision for bad debts
N$ 100
Statement of financial position as at .......................
Current assets
Accounts receivable
N$8 000
Less: Provision for bad debts
(N$800)
N$7 200
The accounting concept
The underlying accounting concept which apply to year-end adjustment is Accruals
basis (matching rule). Which state that revenue and costs should be recognised in
the period in which they are incurred regardless of whether cash or cash equivalent
is received or paid.
Source: Wood, F and Sangster, A. 2005. Business Accounting (10th e.d). China:
Pearson Education Limited.
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