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
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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:
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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
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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
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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
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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.
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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
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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
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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.
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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:
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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.
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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
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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
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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
________________________
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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.
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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.
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