Semester 2 Adjusting Entries The need for adjusting entries: Some accounts need to be updated in order to be perfectly representative of the firm’s financial affairs at the date of preparing the financial statements. The updating is usually made by a journal entry, known as an "adjusting entry". The adjusting entry is a practical response to the requirements of the matching principle. An adjusting entry could be made in any of the following cases: 1. Updating accounts in the pre-adjustment trial balance. 2. Opening a new account for the first time. 3. Updating an account in the pre-adjustment trial balance and opening a new one. Accruals Accruals are expenses that have been incurred but not yet paid or revenues that have been earned but not yet collected. The first is known as accrued expenses (accrued charges) and the second as accrued revenues. Accrued expenses A firm may receive services from other parties such as electricity, insurance, or rent, but it may not have paid the bill by the date of preparing the financial statements. In this case an adjusting entry should be made to update expenses before preparing the financial statements. An accrued expense is a current liability. The entry would make an increase in both expenses and liabilities as follows: By expense xx To accrued expense xx Other services that may lead to such a liability include: 1. Salaries and wages not paid by the date of preparing the financial statements. 2. Rent not paid 3. Interest not paid 4. Tax not paid 1 Semester 2 The adjusting entry is the same for all unpaid expenses Example: The following balances have been extracted from the trial balance of Esa co. for year ending 31/12.201X. 1. Salaries and wages 140000 2. Rent expense 45000 Information for adjustment: 1. Salaries &wages per annum 165000 2. Monthly rent 5000 Required: Prepare the necessary adjusting entries? by salaries &wages 25000 to accrued salaries &wages 25000 by rent expense 15000 to accrued rent expense 15000 Accrued revenues: Accrued revenue is a current asset. It is uncollected revenues that are usually related to secondary activities like renting of excess building space, provision of short term loans, etc. The adjusting entry records the asset and the revenue item as follows: by accrued revenue to revenue xxx xxx Example (1): The following balances have been extracted from the trial balance of Esa Co. for the year ended 2013: 2 Semester 2 1. Rent revenue 60000 2. Interest revenue 85000 Information for adjustment: The monthly rent is 6000 Interest revenue for the year 10500 Required: Prepare the necessary adjusting entries? By accrued revenue 12000 To rent revenue 12000 By accrued interest revenue 20000 To interest revenue 20000 Deferrals (Advances) This is money paid or received in advance in order to meet the receipt or delivery of future services. Money paid in advance is known as prepaid expense (deferred charge), whereas the money received in advance is known as unearned revenue (deferred revenue). Prepaid expenses A prepaid expense is a current asset account. An accounting entry is needed to reduce the asset account by an expense amount which pertains to the current accounting period and charge it to the profit and loss account. Prepaid rent and prepaid insurance are famous examples of advance payments. Example: On 1/1/2011, Esra co. purchased a three years insurance policy for 9000 paid by cheque. Required: Record the journal and the adjusting entry? The journal entry 1/1/2011: By insurance expense 9000 To bank 9000 3 Semester 2 The journal entry 31/12/2011: By prepaid insurance 6000 To insurance expense 6000 After posting the two transactions to the ledger the insurance expense account will appear as follows: Insurance expense Date Particulars 1/1 To bank Dr Date Particulars 9000 31/12 By/Prepaid insurance By/profit and loss account 9000 Cr 6000 3000 9000 Unearned revenue The adjusting entry debits (reduces) the unearned revenue by the portion which pertains to the current year and credits it to the profit and loss account. Example: On 1/1/2012 a trading firm received a 7-years 70000 advance rental payment for one of its buildings. Required: 1. Record the above transaction and prepare the adjusting entry? 1/1 The transaction: By cash 70000 To rental revenue 70000 31/12 The adjusting entry By rental revenue 60000 To unearned rental revenue 60000 4 Semester 2 After posting the above transactions to the ledger, the rental revenue account appears as follows: Rental revenue Date 31/12 Particulars Dr To unearned rental 60000 revenue By profit and loss 10000 total 70000 Date Particulars 1/1 By cash Cr 70000 total 70000 5 Semester 2 Nature of fixed assets Tangible fixed assets such as machinery, motor vehicles, fixtures and even buildings (i.e. long-term assets you can touch) do not last forever. There also intangible fixed assets (i.e. Goodwill) Depreciation of Fixed assets: Depreciation is defined as the allocation of the cost of fixed assets over their estimated life span so that each accounting period is charged with a portion of the cost of the fixed assets. That portion is an expense item which is known as depreciation expense. The depreciation expense reduces the fixed asset cost in the balance sheet by a contra account known as provision for depreciation or allowance for depreciation and sometimes accumulated depreciation. This contra account accumulates the annual depreciation charge by the following adjusting entry: By depreciation expense xx To provision for depreciation xx The difference between the cost of fixed asset and the provision for depreciation is called the book value. Before starting to explain the methods of depreciation, it is helpful at this stage to define some common terms that are used in describing the depreciation methods. Cost of fixed asset: The cost of a fixed asset is defined as all payments necessary to transfer the ownership interest to the buyer and make the asset ready for use. For imported machinery this might include the following: 1. The billing cost up to the point of delivery 2. Import tax 3. Clearance expense 4. Loading and off-loading expenses 5. Freight charges 6. Installation Useful life: This is the estimated life span of the fixed asset measured in terms of years, units of production or working hours. 6 Semester 2 Salvage: This is the estimated market value of the fixed asset at the end of its useful life. It is also known as the residual value. Depreciable cost: Depreciable cost is difference between the cost of a fixed asset and its salvage. Methods of depreciation: Straight-line method: This method assumes that the passage of time is the only factor causing depreciation. Therefore the useful life of the fixed asset is measured in terms of years. The depreciable cost is allocated evenly between the estimated years of useful life using the following equation: Annual depreciation = cost- salvage Useful life Example : On first January 2014 a manufacturing firm purchased some machinery for 7000. The useful life and the salvage were estimated to be 5 years and 1000 respectively. Required: 1. Make the necessary journal entry for the machinery on 31/12/2014 2. Prepare the depreciation schedule for the machinery. Annual depreciation cost – salvage Useful life = 7000-1000 = 1200 5 years Adjusting entry: By depreciation expense 1200 To provision for depreciation 1200 7 Semester 2 By the end of financial year, depreciation amount for the year to be debited to profit and loss account as expenses and credited to its concerned assets account ( deducted from assets cost in the balance sheet). Depreciation schedule: End of year 2014 2015 2016 2017 2018 cost Depreciation expense 7000 7000 7000 7000 7000 Provision for depreciation 1200 1200 1200 1200 1200 1200 2400 3600 4800 6000 Book value 5800 4600 3400 2200 1000 Reducing balance method In this method, a fixed percentage for depreciation is deducted from the cost in the first year. In the second or later years the same percentage is taken of the reduced balance (i.e. cost less depreciation already charged). This method is also known as the diminishing balance method or the diminishing debit balance method. If a machine is bought for £10,000 and depreciation is to be charged at 20 percent, the calculations for the first three years would be as follows: £ Cost 10,000 First year: depreciation (20%) ( 2,000) 8,000 Second year: depreciation (20% of £8,000) ( 1,600) 6,400 Third year: depreciation (20% of £6,400) Cost not yet apportioned, end of Year 3 ( 1,280) 5,120 8 Semester 2 Examples 1 A business has just bought a machine for £8,000. It will be kept in use for four years, when it will be disposed of for an estimated amount of £500. The accountant has asked you to prepare a comparison of the amounts charged as depreciation using both methods. (For the reducing balance method, a percentage figure of 50 per cent will be used) 2 A Gill, purchased a notebook PC for £2,600. It has an estimated life of four years and a scrap value of £200. She is not certain whether she should use the straight line or the reducing balance basis for the purpose of calculating depreciation on the computer. You are required to calculate the depreciation (to the nearest £) using both methods, showing clearly the balance remaining in the computer account at the end of each of the four years under each method. (Assume that 45 per cent per annum is to be used for the reducing balance method.) 3 A machine costs £8,000. It will be kept for five years, and then sold for an estimated figure of £2,400. Show the calculations of the figures for depreciation (to nearest £) for each of the five years using (a) the straight line method, (b) the reducing balance method, for this method using a depreciation rate of 20 per cent. 4 A car costs £9,600. It will be kept for three years, and then sold for £2,600. Calculate the depreciation for each year using (a) the reducing balance method, using a depreciation rate of 50 per cent, (b) the straight line method. 5 A photocopier costs £23,000. It will be kept for four years, and then traded-in for £4,000. Show the calculations of the figures for depreciation for each year using (a) the straight line method, (b) the reducing balance method, for this method using a depreciation rate of 35 per cent. 6 A printer costs £800. It will be kept for five years and then scrapped. Show your calculations of the amount of depreciation each year if (a) the reducing balance method at a rate of 60 per cent was used, (b) the straight line method was used. 9 Semester 2 Bad debts Bad debts account is an expense account used when a debt is believed to be irrecoverable and is written off. When a debt is found to be ‘bad’, the asset as shown by the debt in the debtor’s account is worthless. It must be eliminated from the account. Whatever the reason, once a debt has been declared ‘bad’, the journal entry is the same. You debit the bad debt account with the amount of the bad debt and credit the debtor’s account in the Sales Ledger to complete the double entry. Bad debts A/C xx Ali (debtor) A/C xx At the end of the period, the total of the bad debts account is transferred to the profit and loss account. Provisions for doubtful debts In order to arrive at a figure for doubtful debts, a business must first consider that some debtors will never pay any of the amount they owe, while others will pay a part of the amount owing only, leaving the remainder permanently unpaid. The accounting entries needed for the provision for doubtful debts are: 1 Debit the profit and loss account with the amount of the provision (i.e. deduct it from gross profit as an expense). 2 Credit the Provision for Doubtful Debts Account. At 31 December 20X3, the debtors figure after deducting bad debts was £10,000. It is estimated that 2 per cent (2%) of debts (i.e. £200) will eventually prove to be bad debts, and it is decided to make a provision for these. The accounts will appear as follows: Dr Profit and Loss Account 200 Cr Provision for Doubtful Debts 200 In the balance sheet, the balance on the provision for doubtful debts will be deducted from the total of debtors: 10 Semester 2 Balance Sheet (extract) as at 31 December 20X3 £ £ Current assets Debtors Less Provision for doubtful debts 10,000 ( 200) 9,800 Increasing the provision: 1 Debit Profit and Loss Account with the increase in the provision (i.e. deduct it from gross profit as an expense). 2 Credit the Provision for Doubtful Debts Account. Reducing the provision: 1 Debit Provision for Doubtful Debts Account. 2 Credit Profit and Loss Account (i.e. add it as a gain to gross profit). Bad debts recovered Sometimes, a debt written off in previous years is recovered. When this happens, you: 1 Reinstate the debt by making the following entries: Debtor’s account xx Bad debts recovered account xx 2 When payment is received from the debtor in settlement of all or part of the debt: Cash/bank xx Debtor’s account xx At the end of the financial year, the credit balance in the bad debts recovered account is transferred to either the bad debts account or direct to the credit side of the profit and loss account. The effect is the same, since the bad debts account will, in itself, be transferred to the profit and loss account at the end of the financial year. 11 Semester 2 Inventory system Perpetual inventory system is usually used by firms trading in a highly expensive inventory with a relatively limited number of units. Under the perpetual inventory system no purchase account is maintained. The cost of purchase, freight-in, and purchase returned are all charged to merchandise inventory account. A distinctive feature of the perpetual inventory system is the recording of two entries at date of sale. One entry debits the cost of sale and credit merchandise inventory and the other entry debit cash/account receivable and credit sale. This feature enables the firm to be acquainted, at any point of time, with cost of sale and the cost of ending inventory. Example : Alpha company uses the perpetual inventory system to record the purchase of goods. During may 2014, the company made the following transactions: 10/5 Purchased 50 items at $1000 per item 20/5 Sold 20 items at $1200 per item Required: Prepare the journal entries 10/5 By merchandise inventory 50000 To bank 50000 Goods being purchased 20/5 By cost of goods sold 20000 To merchandise inventory 20000 By bank 24000 To sale 24000 12 Semester 2 Accounting entries under perpetual system Under the perpetual system all transactions related to purchase are charged directly to merchandise inventory account. Accounts such are purchase, freight-in, and sale returned are debited to merchandise inventory while purchase returned and cost of sale are credited to merchandise inventory. The following example explains the journal entries under perpetual inventory system: Example: During January 201x, a trading firm made the following transactions: 1/ 1 Purchased 40 units at $10000 per unit 2/1 Paid $10000 as freight-in 6/1 Returned 5 units to the supplier 9/1 Sold 15 units on account at $15000 per unit 15/1 The customer returned 3 units Required: Prepare the journal entries under the perpetual inventory system Perpetual system: By merchandise inventory 400000 To account payable 400000 ________________________ By Merchandise inventory 10000 To bank 10000 ________________________ By account payable 50000 To Merchandise inventory 50000 ________________________ By account receivable 225000 To sale 225000 13 Semester 2 By cost of goods sold 225000 To merchandise inventory 225000 ________________________ By sale returned 45000 Account receivable 45000 By merchandise inventory 45000 Cost of goods sold 45000 ________________________ 14 Semester 2 Exercise 1 The following trial balance was extracted from the books of Bahwan on 31 December 2007. From it, and the note below it, prepare his trading and profit and loss account for the year ending 31 December 2007, and a balance sheet as at that date. Particulars Dr. $ Cr. $ Sales 18,614 Purchases 11,570 Stock 1 January 2007 3,776 Carriage outwards 326 Carriage inwards 234 Returns inwards 440 Returns outwards 355 Salaries and wages 2,447 Motor expenses 664 Rent 576 Sundry expenses 1,202 Motor vehicles 3,400 Fixtures and fittings 600 Debtors 4,577 Creditors 3,045 Cash at bank 3,876 Cash in hand 120 Drawings 2,050 Capital 13,844 35,858 35,858 Additional information: 1. Closing stock amounted to £4,000. 2. Depreciation is to be charged at rates of 10% on cost for Fixtures and Fittings and 25% on cost for Motor Vehicles. 3. Bad debts of £800 are to be written-off. 15 Semester 2 Exercise 2 The following trial balance was extracted from the books of Sara at the close of business on 31 December 2009. Particulars Dr. £ Cr. £ Purchases 92,800 Sales 157,165 Cash at bank 4,100 Cash in hand 324 Capital 11,400 Drawings 17,100 Office furniture 2,900 Rent 3,400 Wages and salaries 31,400 Discount allowed 820 Discount received 160 Debtors 12,316 Creditors 5,245 Stock 1 January 2009 4,120 Provision for doubtful debts 1 January 2009 405 Delivery van 3,750 Van running costs 615 Bad debts written off 730 174,375 174,375 Additional information: 1. Stock 31/12/2009 £2,400. 2. Wages and salaries accrued at 31/12/2009 £340. 3. Rent prepaid at 31/12/2009 £230. 4. Van running costs owing at 31/12/2009 £72. 5. Increase the provision for doubtful debts by £91. 6. Provide for depreciation as follows: Office furniture £380; Delivery van £1,250. Required: Draw up the trading and profit and loss account for the year ending 31/12/2009 together with a balance sheet as on the same date. 16