Accounting for Executive

Week 4 1/4/2011 (Fri)

Lecture 4

Adjustment for accruals, prepayments

Profit is measured not by comparing ‘cash received’ during the financial period with ‘cash spent’, but by matching expenditure incurred with income earned.

The accruals concept states that when computing profit the sales revenue earned should be matched only against the expenditure incurred when earning it. They should be included in the profit and loss account (income statement) of the period to which they relate.

Adjustment for accruals, prepayments

AccrualsCosts which have not so far been taken into account at

the end of a period because they have not yet been invoiced – for example, gas or electricity, invoiced in arrears.

PrepaymentsExpenditure on goods or services for future benefit,

which is to be charged to future operations, e.g. rentals paid in advance.

Adjustments for Accruals

Example: Electricity bills

Bills issue date usually the first week of next month and it is charging for the consumption of previous month, the payment period is different from the actual consumption period.

Accounting period 1/Jan/2005 to 31/ Dec/ 2005

Billing date 5/ Jan /2006, Accounting period 1/ Jan /2005 to 31/ Dec/ 2005

Payment related to 2006, but the expenses are incurred in 2005

Accruals

A business has a financial year ending on 31 December and during

that year it had paid £12,000 for electricity to 30 September. The

electricity bill of £4,950 for the final quarter (October–December) was

not received and paid until 31 January in the next year.

The business will need to make an adjustment for this outstanding

electricity bill of £4,950 when preparing the accounts for the year

ended 31 December.

In the income statement when listing the expenses for the year the

business will include the total of the £12,000 paid the accrued expense

owing of £4,950, i.e. £16,950 is the expense of electricity consumed

during the financial year.

At the same time the £4,950 will be shown in the statement of financial

position under current liabilities as an accrual or expense owing.

Accruals

Before adjustment After adjustment

$ $

Gross Profit 15,000 15,000

Less: Expenses

Electricity (12000+4950)** (12,000) (16,950)**

Net Profit 3,000 (1,950)

Accounting entries

Dr. Expenses-Electricity 4,950

Cr. Accruals 4,950

The Accruals will be stated as current liabilities in the company’s statement of financial position.

The expenses item- electricity will be increased by $4,950 in the current period as above stated and the profit of the current period will be decreased by the same amount accordingly.

Accruals

ABC Company Statement of financial position

Before After

Non-current Assets 10,000 10,000

Current Assets 20,000 20,000

Less: Current Liabilities

Accruals 0 (4,950)

20,000 15,050

30,000 25,050

Financed By

Owner’s capital 27,000 27,000

Retained profit / (loss) 3,000 (1,950)

30,000 25,050

Prepayment

A business has a financial year ended 31 December 200X and it purchased a new car on 1 July 200X.On that date the business paid 12 months’ vehicle taxation of £180. When preparing its profit and loss account for the year ending 31 December 200X the business needs to recognise that the cost of vehicle taxation is for the period 1 July-31 December 200X which would be 6 months or £90. The other £90 is a prepayment for following year and should be shown in the statement of financial position – current assets as a prepayment, or payment in advance.

Prepayment

Example: Motor vehicle taxation

Period covered: 1/ July /2004 to 30/ June/ 2005

Accounting period :1/Jan/2004 to 31/ Dec/ 2004

£180

Accounting period 1/Jan/2004 to 31/ Dec/ 2004

Billing date 1/ July /2004, period covered 1/ July /2004 to 30/ June/ 2005

Half of the payment related to 2005 and half of the expenses are incurred in 2004

Prepayment

Before adjustment After adjustment

$ $

Gross Profit 1,000 1,000

Less: Expenses

Motor vehicles taxation (180X 6/12)** (180) (90)**

Net Profit 820 910

Accounting entries

Dr. Prepayments (current asset) 90

Cr. Expenses- Motor vehicles taxation 90

The Prepayments will be stated as current asset in the company’s statement of financial position

The expenses item- Motor vehicles taxation will be decreased by $90 in the current period as above stated and the profit of the current period will be increased by the same amount accordingly.

Prepayments

ABC Company Statement of Financial Position

Before After

Non-current Assets 10,000 10,000

Current Assets

Prepayments 0 90

10,000 10,090

Financed By

Owner’s capital 9,180 9,180

Retained profit / (loss) 820 910

10,000 10,090

Bad Debts and Allowance for Bad Debts

When sales are on credit there will have the risk that the buyer fail to fulfill his obligation to paid for the goods purchased

This may due to many reasons, for example:- Miscommunication between buyer and seller Bankruptcy of the buyer Fraud

When the debtor declare bankrupt, the money owned by the debtor become irrecoverable then we need to write off the loan outstanding

Bad Debts and Allowance for Bad Debts

To write off the sum owned by debtor with an amount $500Debtor A

20X4 $ 20X4 $

1.4 Sales 500 30.4 Bad debt written off 500

Bad Debts

30.4 Debtor A 500 30.4 Income statement 500

Income statement (extract) for the year ended 31.12.20X4

Gross Profit 10,000

Less Expenses:

Bad debts written off (500)

Bad Debts and Allowance for Bad Debts

Why make allowance for bad debts ? Prudence True and fair view of the financial statement

Usually it is difficult for a business to look at each debtor’s balance and determine for how much of the allowance should be provide, therefore it is common for the accountant to provide a certain percentage of the total balances and charge it against the income statement

Example

Jacky company has a total debtors balance of $450,000, according to the company experience that around 2% of the total outstanding balances will be irrecoverable, therefore the accountant makes an allowance of 2% of the total balance.

Allowance for Bad Debts

$450,000 X 2% = $9,000Dr. Income statement $9,000Cr. Provision for Bad Debts $9,000

Jacky CompanyIncome statement (extract) for the year ended 31.12.20X4

Gross Profit b/d 60,000less: ExpensesIncrease in allowance for bad debts (9,000)

Jacky Company statement of financial position as at 31.12.20X4Current assets $ $Debtors 450,000less: Allowance for bad debts (9,000)

441,000

Allowance for Bad Debts

In the next year the outstanding balances of debtors $400,000the policy of making allowance for doubtful debts remains unchanged, therefore:-

$400,000 X 2%=$8,000

Allowance decreased by:$ 9,000 - $8,000 = $1,000 Then the amount should be debited to the allowance for bad debts account, and credited to the income statement.

Dr. Allowance for Bad Debts $1,000

Cr. Income statement $1,000

Allowance for Bad Debts

Jacky CompanyIncome statement (extract) for the year ended 31.12.20X5

Gross Profit b/d 50,000Add: Decrease in allowance for bad debts 1,000

51,000Less: Expenses XX,XX

Jacky Co. statement of financial position (extract) as at 31.12.20X5Current assets $ $Debtors 400,000Less: Allowance for bad debts (8,000)

320,000

Allowance for Bad Debts

Allowance for Bad Debts

20X4 $ 20X4 $

31.12 Balance c/d 9,000 31.12 Income statement9,000

20X5 20X5

31.12 Income statement 1,000 1.1 Balance b/d 9,000

31.12 Balance c/d 8,000

9,000 9,000

20X6 20X6

1.1 Balance b/d 8,000

Differences between Bad Debt and Allowance for Bad DebtBad Debt Account

Expenses Account

Charged against P/L a/c to eliminate the balance of asset (debtors)

Balance will not carry forward to next year

Allowance for BD A/C

Allowance Account

Charged against P/L a/c

to reduce the carrying balance of asset (debtors)

Balance will carry forward

to next year

Debtor adjustments-Key points

Bad debts and allowance for doubtful debts are different in

nature and require different adjustments in the financial

statements.

Bad debts are a fact in that they comprise debtors who cannot

or will not pay their debts.

An allowance for doubtful debts is a reasonable estimate of

the value of debts which may not be collected.

Bad debts relate to specific debtors who the business knows

for a fact have failed to pay the debt owed by them.

An allowance for doubtful debts is different from bad debts in

that it does not normally relate to specific debtors.

The prudence concept requires that assets should not be valued in the balance sheet at a value more than they can reasonably be considered to be worth. At any time there is always a risk that debts will not be collected, which makes it difficult to value debtors exactly. Therefore a prudent business should make reasonable adjustments so that debtors reflect the value of debts that may not be collected.

Debtor adjustments-Key points