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 learnPosting 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 conceptThe 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. Accruals and prepayments2. 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 XXCr Revenue 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

RecordingDr Interest expense account $400Cr Accruals

$400

PREPAYMENTS

Arise when payments are made in advance

Are of two types; Prepaid expenses Prepaid revenues / unearned incomes

PREPAID EXPENSES

Relate to expenses paid before service is enjoyed.

IllustrationBakari 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 $500Cr Expenses $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 XXCr Deferred revenueXX

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