TOPIC 4
Balance day Adjustment
INTRODUCTION

What we have learnt so far;







Basic accounting conventions and concepts
The accounting equation
Accounting cycle
Recording transactions in the books of original entry
Balancing off ledger account
Transferring ledger balances to the trial balance
What we want to learn
Posting adjusting entries
LEARNING OUTCOMES
 By
the end of this Topic you should;
Differentiate between accrual and cash
accounting
 Explain why accrual accounting is superior to
cash accounting
 Describe accruals and adjust identify adjusting
entries
 Describe prepayments and adjust identify
adjusting entries

RECAP OF SOME ACCOUNTING CONCEPTS



Matching concept
The accrual concept of recognition of
expenses and incomes is referred to as the
matching principle.
The matching principle requires revenues
to be recognised at the same accounting
period for which the cost of generation
(expenses) are recorded
RECAP OF SOME ACCOUNTING CONCEPTS

Time period concept
The continuous life time of the entity can be
dividend into distinct periods, usually 12 months.
Time period assumption allows evaluation of
performance of a business.
To evaluate performance over a period of time,
expenses and incomes for that specific period
should be compared to determine whether a
profit or loss has been made.
ACCRUALS VS CASH ACCOUNTING
 Cash
accounting is an accounting base where
revenues and expenses are recorded as and
when cash is received and paid respectively
 Cash basis has been criticized for its failure
to provide a reliable measure of the
organisation
 Cash basis fails to recognize business
activities undertaken on credit and assumes
noncash charges.
 Preference is given to accrual basis of
accounting
ACCRUAL BASIS OF ACCOUNTING
 Accrual
basis of accounting has gained a
worldwide acceptance since;
Follows the matching concept
 Recognizes expenses when incurred and
revenues when earned
 Considers noncash charges incurred in a
business such as depreciation expense
 Provides a more realistic measure of business
activities

BALANCE DAY ADJUSTMENTS
 Passing
adjustments at year end helps to
ensure that matching concept is not violated
 Year end adjustments should be plausible
 Caution should be taken against engaging in
Creative accounting
Creative accounting occurs when adjustments
that are not valid are passed. This is tantamount
to fraudulent financial reporting.
Reminder: Accountants should be ethical
BALANCE DAY ADJUSTMENTS
 Using
accrual basis of accounting there are
two main types of adjustments that will be
required as at the reporting date;
1.
2.
Accruals and prepayments
Non cash charges
NON CASH CHARGES

The reporting entity incurs some expenses which
are not paid on cash basis.
Examples




Depreciation charge
Amortization charge
Increae in bad and doubtful debts
Obsolescence of inventories
These adjustments will be the subject of
our next topic, Topic 5
ACCRUALS AND PREPAYMENTS
Accruals relates to expenses where invoices will
not have been received at year end. It also
includes unbilled revenues where such is earned
at reporting date
 Prepayments relate to advance payments and
receipts. Where payments for expenses have been
made in advance, we need to recognize an asset
and where there are receipts before provision of a
service, recognize a liability.

ACCRUALS


Accrued Revenues — income earned but
not received at reporting date and has not
been billed. For instance, rental income
earned towards end of the year
Recording accrued revenue
Dr
Accrued revenue
Cr Revenue
XX
XX
ACCRUALS
Accrued Expenses — Incurred expenses for
which invoices are yet to be received from
suppliers. An estimate should be made for
such expenses and the accounts adjusted
accordingly.
 Example;

Water bills for periods to year end
 Gas bills
 Electricity
 Post paid telephone bills

ACCRUALS

Illustration
Assume that a business has a loan of $4,000 that is
payable (both interest and principal) in lump sum
after 10 years. The loan attracts an annual interest at
10 percent.
At year end the unpaid interest should be recognized
as a liability computed as follows;
Principal ($4,000) * Rate (10%) * Time (1 year) = $400

Recording
Dr Interest expense account $400
Cr Accruals
$400
PREPAYMENTS
 Arise
 Are
when payments are made in advance
of two types;
 Prepaid expenses
 Prepaid revenues / unearned incomes
PREPAID EXPENSES

Relate to expenses paid before service is enjoyed.
Illustration
Bakari Mohammed Radiators Limited is an
enterprise in wholesale trade of motor vehicle
accessories and its accounting period ends on 31
December. On 30th June 2010, the company
bought an annual insurance policy for its vehicle
at a cost of $1,000 and paid the same on 1 July in
cash.
At year end a prepaid expense of $500 ($1,000 *
6/12) will be recognized
PREPAID EXPENSES
To record a prepaid expense, we debit an asset
account, prepayments, and credit the respective
expense account
 Using our illustration;

Dr Prepaid insurance
Cr Expenses
$500
$500
Generally prepaid expenses are expected to be utilised in the
following financial period and as such as normally
classified as a current asset in the balance sheet.
PREPAID REVENUES
 Prepayments
could also arise when cash is
received before a service is offered
 Common with professional fees
 Revenue is earned when the effort is
expended
 If not earned, it should be deferred to the
period when earning effort is made
 Deferred income is treated as a current
liability
DEFERRED INCOME
Using cash basis of accounting deferred income
overstate income for the period
 Under accruals concept, it should be removed by

Dr Revenue
XX
Cr Deferred revenue
XX
Generally, deferred income for one accounting period
will be earned in the subsequent accounting period.
Therefore, it is treated as a current liability in the
balance sheet.
SUMMARY

In this lesson we have learnt;
How to record accrued expenses
 Recording accrued revenues
 Recording prepaid expenses
 Recording prepaid/unearned income

Posting accruals and prepayments adjustments
is important in ensuring that accounting
concepts and conventions such as time period
and matching are not violated.
SUMMARY
The topic covers one leg of adjustments,
prepayments and accruals
 Topic 5 will cover non cash transactions

QUESTIONS
Solutions of questions arising from the detailed
illustration in Topic 3
 Multiple choice questions for Topic 4
