Balance Day Adjustments PDF

Balance day adjustments to fully classified financial statements As discussed previously, a business must be able to determine how efficiently it has been operating in the past and what its prospects are for the future. To enable this to be done, the life of the business is divided into arbitrar...

Balance day adjustments to fully classified financial statements As discussed previously, a business must be able to determine how efficiently it has been operating in the past and what its prospects are for the future. To enable this to be done, the life of the business is divided into arbitrary periods (the accounting period assumption) and a profit figure is determined for that period (usually one year and commonly referred to as the financial year). Monthly, fortnightly or weekly financial reports can also be prepared if necessary. Not all transactions fit exactly into this period, so certain adjustments have to be made. Traditionally, the approach was to match the expenses for the period against the relevant revenues for the period so that the profit was as accurate as possible. This was called the matching concept. However, rather than using a matching process the emphasis now is on determining conceptually whether an item fits the definition of revenue, whether an item fits the definition of an expense, and then subtracting all expenses from all revenues to obtain a profit figure. As well, the approach is much broader than concentrating on only the revenues and expenses. This broader approach entails recognising that all the relevant assets, liabilities, revenues and expenses for the period are recorded, to ensure that both the resultant financial statements are accurate. Adjusting entries are required because the general ledger may not be complete for the accounting period under consideration. This could occur for the following reasons: Events may occur daily in the business but are not recorded daily. For example, it is not practical to pay employees daily. They are generally paid weekly, fortnightly or monthly, and the records may not be complete at balance day. Another example is the use of supplies that may be used daily, but will not be tracked and expensed daily. Unrecorded transactions may relate to external parties. For example, interest may be earned for a month, but has not yet been received in cash. Another example is electricity, which might be paid quarterly, but the expense for electricity is brought to account each month. Events may occur through the passage of time. This means the future economic benefit is used up over time. For example, a payment for a year's insurance is treated as an asset and for each period (month) the relevant expense is brought to account (used up). Another example is the cost of an asset being allocated over its life in the form of depreciation. Current assets are shown at a realistic amount. For example, the amount of accounts receivable is reduced by the estimated amount that may be bad. Another example, which will be explained shortly, is the amount for inventories adjusted at balance day for inventory shortages and 'the lower of cost and net realisable value' rule. In all these situations, there will be a change in two places -- to the Statement of Profit or Loss (either a revenue or an expense) and a change to the Statement of Financial Position (either an asset or a liability). We have discussed some balance day adjustments previously. They are summarised here to show the adjustments necessary at the end of an accounting period/year and only brief explanations will be given. For further details, refer back to Chapter 9 of Units 1 & 2 and Chapter 1 in this book. The major balance day adjustments are for: inventories accrued expenses accrued revenues prepaid expenses unearned revenues provision for doubtful debts accumulated depreciation. 130ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 In most situations with these balance day adjustments, it is easier to concentrate first on the asset or the liability being affected. For example, if there is outstanding interest on an investment bank account, then money is owed to us so it is an asset and therefore an accrued revenue. If at the end of the period, money is owed for wages, then we have a liability and therefore an accrued expense. If the balance of the provision for doubtful debts has to be 4 per cent of accounts receivable, then that is a negative asset being affected. Think about what is happening to the asset or liability first and the other side of the double entry involving a revenue or an expense will follow. In addition to these balance day adjustments, entries must also be made to clear the accounts for GST. This was discussed in Chapter 9 in Units 1 & 2. The complete accounting process we have developed is shown in Figure 2.2. Transactions Statement of Profit or Loss Statement of Financial Position Statement of Cash Flows Profit or Loss Summary account Balance day adjustments Closing entries End of period reports Reversing entries Source documents Journal Ledger and trial balance End of accounting year End of accounting period -- month/year New accounting year Figure 2.2 The complete accounting process Inventories Inventory adjustments can be made for two reasons. The first was mentioned in Units 1 & 2, where stock item records show the value of inventory that should be on hand. This method gives better control because inventory losses are readily determined. It is also usual to have a yearly stocktake so that the inventory losses and shortages can be brought into the accounts. If the stocktake reveals fewer items in stock than are represented on the stock item record, the record is adjusted to show the actual quantity on hand. The value of the inventory shortage is then recorded by a balance day adjustment. The general journal entry is: Dr Cr Inventory Adjustment Inventories Control XXX XXX This entry has the effect of: decreasing the gross profit figure, as the inventory shortage is a cost of sales expense to the business. This account is closed off to the Profit or Loss Summary at the end of the accounting year and appears with cost of goods sold in the Statement of Profit or Loss decreasing the Inventories Control account, as the inventories are no longer on hand. If the actual quantity on hand is found to be greater than that recorded, the reverse of this balance day adjustment is made. This would result in an inventory gain. 131CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890 The following ledger accounts illustrate this adjustment. Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ 2020 2020 Inventories Control No 3106 Apr 30 Balance b/d 250 Apr 30 Cost of Goods Sold 2 350 30 Cash/Accounts Payable 3 600 May 3 Accounts Payable May 31 Cash/Accounts Payable 2 500 (purchases returns) 100 June 30 Cash/Accounts Payable 3 000 31 Cost of Goods Sold 3 000 30 Cost of Goods Sold (sales returns) 300 June 30 Cost of Goods Sold 3 480 On 30 June, a physical stocktake revealed a shortage of \$120 worth of stock. The adjusting entry required is: General Journal Date Particulars Ref Dr \$ Cr \$ 2020 June 30 Inventory Adjustment Inventories Control (Inventory shortfall found by physical stocktake) 2106 3106 120 120 This would be posted as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ 2020 2020 Inventory Adjustment No 2106 June 30 Inventories Control 120 June 30 Profit or Loss Summary 120 \$120 \$120 Inventories Control No 3106 Apr 30 Balance b/d 250 Apr 30 Cost of Goods Sold 2 350 30 Cash/Accounts Payable 3 600 May 3 Accounts Payable May 31 Cash/Accounts Payable 2 500 (purchases returns) 100 June 30 Cash/Accounts Payable 3 000 31 Cost of Goods Sold 3 000 30 Cost of Goods Sold (sales returns) 300 June 30 Cost of Goods Sold 3 480 30 Inventory Adjustment 120 30 Balance c/d 600 \$9 650 \$9 650 July 1 Balance b/d 600 132ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 The Statement of Profit or Loss shows: Statement of Profit or Loss (extract) for year ending... \$ \$ Sales XXX Less Cost of Sales Cost of Goods Sold XXX Inventory Adjustment 120 XXX Gross profit XXX The second reason for an inventory adjustment concerns the valuation of inventories. It is generally agreed that inventories are valued at cost. This usually means historical cost. However, if management suspects that particular inventory items have a net realisable value lower than cost, the 'lower of cost and net realisable value' rule will be applied. As an example, this could occur for inventories of technology or fashion items. This rule simply means that, when valuing inventories, the accountant should: determine the cost of the inventories determine the net realisable value of the inventories use the lower amount. One of the main problems with this rule is trying to determine the 'cost' of the inventories. As previously shown, cost can be ascertained by using any one of the following methods: specific identification, First-In First-Out (FIFO) or weighted average cost. The accountant has to decide which method is to be used to determine cost. Once this decision is made it must be applied consistently from year to year. Net realisable value (NRV) is the amount that the business estimates it could sell the item for, less any estimated marketing, selling or distribution costs that are necessary to make the sale. The NRV may be lower than cost because of deterioration, obsolescence or a change in demand. A problem with NRV is actually obtaining a value, as it will be an estimated figure. In Illustrative example 3, where the NRV is lower than the cost price, the NRV is used. This results in recognising a \$50 anticipated loss and therefore gives a lower gross profit figure. (This loss corresponds to the difference between cost and NRV.) Illustrative example 3 A business bought the following inventories: Item X \$100 Item Y \$300 Item Z \$200 Sales for the period were \$900 and cost of goods sold were \$300. At the end of the period, the following details were available for closing inventories: Cost NRV Lower of cost and NRV Item X 50 \$ 60 50 Item Y 150 \$100 100 Item Z 100 \$120 100 \$300 \$250 133CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890 Profit calculation using cost Profit calculation using the rule 'the lower of cost and NRV' Sales 900 Sales 900 Less Cost of Sales Less Cost of Sales Cost of Goods Sold 300 Cost of Goods Sold 300 Inventory adjustment 50 350 Gross profit \$600 Gross profit \$550 \$50 loss recognised The general journal entry to record the \$50 loss would be: General Journal P1 Date Particulars Ref Debit Credit June 30 Inventory Adjustment Inventories Control (Loss due to lower of cost and NRV) 2106 3106 50 50 In the Statement of Financial Position, the amount for inventories would be shown as \$250 instead of \$300. Also note that under accrual accounting, revenue is recognised for the sale of inventories when the goods have been delivered not when the cash is received. 2.28 a Explain the 'lower of cost and NRV' rule. b What is the meaning of 'cost' and 'NRV'? 2.29 The following information relates to an item of inventory held by a stereo supplier. Calculate the NRV. Normal selling price \$1 200 Selling costs 10 Freight to customer 55 2.30 Calculate the NRV for the following inventory item: Normal selling price \$400 Cost of purchase 250 Selling costs 14 Freight 26 134ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 2.31 You are given the following information about the inventory items of P Johnson: Item Cost NRV Item A \$200 \$250 Item B 175 150 Item C 614 604 Item D 314 320 Calculate the total value of inventories on hand and show the journal entry to record the loss. Accrued expenses Accrued expenses are expenses incurred in the current accounting period, but not yet paid. The general journal entry for the adjustment of accrued expenses is: Dr Cr Expense Account Accrued Expenses XXX XXX The entry has the effect of: increasing the expense account to the amount it should have been creating a liability account (Accrued Expenses) because at balance day this amount is owed. Consider the following trial balance extract as at 30 June: Trial Balance (extract) as at 30 June... Account Debit \$ Credit \$ Advertising 500 Adjustment Advertising still owing, \$200. The ledger appears as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Advertising No 2301 June 30 30 Amount to date Accrued Expenses 500 200 Accrued Expenses No 4104 June 30 Advertising 200 135CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890 As a result of the adjustment, \$700 worth of advertising appears in the Profit or Loss Summary account at the end of the accounting year and in the selling expenses section of the Statement of Profit or Loss. The Statement of Financial Position shows: Statement of Financial Position (extract) as at 30 June... \$ Current Liabilities Accrued Expenses 200 Accrued revenues Accrued revenues are revenues that have been earned in the current accounting period but have not yet been received. The general journal entry for the adjustment of accrued revenues is: Dr Cr Accrued Revenues Revenue XXX XXX The entry has the effect of: creating the asset account (Accrued Revenues) to show that money is owed to the business on balance day increasing the revenue account to the correct amount. Consider the following trial balance extract as at 30 June: Trial Balance (extract) as at 30 June... Account Debit \$ Credit \$ Commission Revenue 600 Adjustment Outstanding commission, \$50. The ledger after adjustment appears as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Commission Revenue No 1103 June 30 30 Amount to date Accrued Expenses 600 50 Accrued Revenues No 3108 June 30 Commission Revenue 50 136ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 As a result of the adjustment, an amount of \$650 for commission revenue appears in the Profit or Loss Summary account at the end of the accounting year and as other revenue in the Statement of Profit or Loss. The Statement of Financial Position shows: Statement of Financial Position (extract) as at 30 June... \$ Current Assets Accrued Revenues 50 Prepaid expenses Prepaid expenses are expenses that have been paid in the current accounting period and recorded as assets until the economic benefits are used up in a future accounting period. Benefits from this prepayment will occur over the next accounting period. The general journal entry for the adjustment of prepaid expenses is: Dr Cr Expense account Prepaid Expenses XXX XXX The entry has the effect of: increasing the expense account as the future economic benefit has been used up decreasing the asset account (Prepaid Expenses) because the business has paid an extra amount of money and is owed that money at balance day. For example, the following is the trial balance extract as at 30 June. Trial Balance (extract) as at 30 June... Account Debit \$ Credit \$ Prepaid Insurance 350 Adjustment Insurance paid in advance, \$70. The ledger after adjustment appears as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Insurance No 2408 June 30 Prepaid insurance 280 Prepaid Insurance No 3109 June 30 Amount to date 350 June 30 Insurance As a result of the adjustment, an amount of \$280 for insurance appears in the Profit or Loss Summary account at the end of the accounting year and in the administrative expenses section of the Statement of Profit or Loss. The Statement of Financial Position shows: Statement of Financial Position (extract) as at 30 June... \$ Current Assets Prepaid Expenses 70 Unearned revenues Unearned revenues are revenues that have been received in the current accounting period, but that will be earned in a future accounting period. The general journal entry for the adjustment of revenue received in advance is: Dr Cr Revenues Unearned Revenue XXX XXX The entry has the effect of: decreasing the revenue account, as the extra money received does not belong to this period creating the liability account (Unearned Revenues) as, at the balance date, this amount is owed by the business. Consider the following trial balance extract as at 30 June: Trial Balance (extract) as at 30 June... Account Debit \$ Credit \$ Rent Revenue 1 000 Adjustment Rent received in advance, \$100. The ledger after adjustment appears as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Rent Revenue No 1106 June 30 Unearned Revenues 100 June 30 Amount to date 1 000 Unearned Revenues No 4105 June 30 Rent Revenue 100 As a result of the adjustment, an amount of \$900 for rent revenue appears in the Profit or Loss Summary account at the end of the accounting year and in the other revenue section of the Statement of Profit or Loss. 138ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 The Statement of Financial Position shows: Statement of Financial Position (extract) as at 30 June... \$ Current Liabilities Unearned Revenues 100 Provision for doubtful debts The provision for doubtful debts shows the estimated amount of accounts receivable that are unlikely to be received when due in the following period. Two balance day adjustment entries are necessary: 1 Bad and doubtful debts are transferred to the Provision for Doubtful Debts account set up to accommodate them. This is accomplished by the entry: Dr Cr Provision for Doubtful Debts Bad and Doubtful Debts XXX XXX The entry has the effect of: decreasing the Provision for Doubtful Debts account to make way for this year's estimate decreasing the Bad and Doubtful Debts account to offset those bad debts that occurred during the period against the provision that was originally set up to provide for them. 2 The new Provision for Doubtful Debts balance is calculated and the adjustment is recorded to ensure this is the balance. This is accomplished by the entry: Dr Cr Bad and Doubtful Debts Provision for Doubtful Debts XXX XXX The entry has the effect of: increasing the expenses of the period (bad and doubtful debts). This is the amount that is closed off to the Profit or Loss Summary account at the end of the accounting year increasing the Provision for Doubtful Debts account by an amount that makes the closing balance equal to the estimated doubtful debts on the present accounts receivable. Remember that the whole year's doubtful debts are not being estimated, but only the portion that appears in the balance of accounts receivable that is likely to become bad in the next accounting period. For example, at 30 June 2020 the trial balance extract appears as follows: Trial Balance (extract) as at 30 June 2020 Account Debit \$ Credit \$ Bad and Doubtful Debts 3 200 Accounts Receivable Control 50 000 Provision for Doubtful Debts 300 Adjustment Desired provision for Doubtful Debts to be 1 per cent of Accounts Receivable Control. 139CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890 The ledger after adjustment appears as follows. Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Bad and Doubtful Debts No 2501 2020 2020 June 30 Amount to date 3 200 June 30 Provision for Doubtful Debtsa 3 200 30 Provision for Doubtful Debtsb 3 400 Accounts Receivable Control No 3104 2020 June 30 Balance 50 000 Provision for Doubtful Debts No 3104A 2020 2019 June 30 Bad and Doubtful Debtsa 3 200 July 1 Balance 300 30 Balance c/d 500c 2020 June 30 Bad and Doubtful Debtsb 3400 \$3 700 \$3 700 July 1 Balance b/d 500c Notes to the ledger a Closing the Bad and Doubtful Debts account to the existing Provision for Doubtful Debts account. b Creating the new provision (amount must be sufficient to leave a balance of \$500, which is the amount of the new provision). c Being 1 per cent of Accounts Receivable Control. As a result, bad and doubtful debts of \$3400 would be closed to the Profit or Loss Summary account at the end of the accounting year and appear in the finance expenses section of the Statement of Profit or Loss. The amounts that appear in the Statement of Financial Position are: Statement of Financial Position (extract) as at 30 June 2020 \$ \$ Current Assets Accounts Receivable Control 50 000 Less Provision for Doubtful Debts 500 49 500 If the unusual situation arises where the Provision for Doubtful Debts is greater than the bad debts for the year (an over-provision), refer back in this chapter to see how this is accounted for. Should no provision exist, the step in note a would not apply. Accumulated depreciation The aim of providing for depreciation is to spread the cost of the asset over each of the years it is used (cost allocation concept). Therefore, the adjusting entry is: 140ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 Depreciation on... Accumulated Depreciation on... XXX XXX This entry has the effect of: creating an expense account (Depreciation on...) because part of the asset has been consumed. This account is closed to the Profit or Loss Summary account at the end of the accounting year and appears in the Statement of Profit or Loss as an administrative expense (unless it is a selling item) increasing the Accumulated Depreciation on... account to show the accumulated depreciation over the life of the asset. This appears in the Statement of Financial Position as a negative non-current asset. Consider the following trial balance extract as at 30 June. Trial Balance (extract) as at 30 June 2020 Account Debit \$ Credit \$ Motor Vehicle 15 000 Accumulated Depreciation on Motor Vehicle 6 000 Adjustment Write off Depreciation on Motor Vehicle using 20 per cent straight line method (i.e. \$3000). The general journal entry would be: General Journal Date Particulars Ref Dr \$ Cr \$ June 30 Depreciation on Motor Vehicle Accumulated Depreciation on Motor Vehicle (Depreciation of 20 per cent straight line on \$15 000) 3 000 3 000 The ledger after adjustment appears as follows: Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ Depreciation on Motor Vehicle No 2406 June 30 Accumulated Depreciation 3 000 Motor Vehicle No 3303 June 30 Balance 15 000 Accumulated Depreciation on Motor Vehicle No 3303A June 30 Balance c/d 9 000 June 30 Balance 6 000 30 Depreciation 3 000 \$9 000 \$9 000 July 1 Balance b/d 9 000 141CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890 As a result of the adjustment, depreciation on the motor vehicle worth \$3000 appears in the Profit or Loss Summary account at the end of the accounting year and in the administrative expenses section of the Statement of Profit or Loss. The Statement of Financial Position shows: Statement of Financial Position (extract) as at 30 June... \$ \$ Non-Current Assets Property, Plant and Equipment Motor Vehicle (at cost) 15 000 Less Accumulated Depreciation on Motor Vehicle 9 000 6 000 GST Clearing entries Although this entry is not a balance day adjustment because it does not affect profit, it is necessary to clear the GST Collected and GST Credits Received accounts to the GST Clearing (Payable) account at the end of every month. This is required to complete the accounting process, to show the net amount of GST in the Statement of Financial Position and to determine the amount payable to the Australian Taxation Office (ATO). The general journal entry to clear the GST Collected is: Dr Cr GST Collected GST Clearing (Payable) XXX XXX This entry has the effect of: clearing the liability account (decreasing) GST Collected increasing the liability account GST Clearing (Payable). The general journal entry to clear the GST Credits Received is: Dr Cr GST Clearing (Payable) GST Credits Received XXX XXX This entry has the effect of: clearing the negative liability account (decreasing) GST Credits Received decreasing the liability account GST Clearing (Payable). Consider the following trial balance extract as at 30 June. Trial Balance (extract) as at 30 June... Account Debit \$ Credit \$ GST Collected 7 400 GST Credits Received 4 800 142ACCOUNTING: AN INTRODUCTORY FRAMEWORK UNITS 3&4, 4E 9780170401890 Dr Ledger Cr Date Particulars Ref Amount \$ Date Particulars Ref Amount \$ GST Clearing (Payable) No 4102.1 June 30 GST Credits Received 4 800 June 30 GST Collected 7 400 30 Balance c/d 2 600 \$ 7 400 \$ 7 400 July 1 Balance b/d 2 600 GST Collected No 4102.2 June 30 GST Clearing (Payable) 7400 June 30 Amount to date 7 400 GST Credits Received No 4102.2A June 30 Amount to date 4 800 June 30 GST Clearing (Payable) 4 800 As a result of the clearing entries, GST Clearing (Payable) \$2600 appears in the Statement of Financial Position as a liability. This amount will be paid to the ATO at the appropriate time. Preparing financial statements from the trial balance incorporating adjustments The Statement of Profit or Loss and Statement of Financial Position can be prepared by working from a trial balance prepared before adjustments are taken into account. Of course, adjustments would have to be made to some of the figures in the trial balance because the balance day adjustments occur after doing the trial balance. Imagine that the following balance day adjustments still have to be recorded: 1 inventory recorded at \$10 000 to be adjusted for a shortage of \$95 2 insurance paid in advance \$2400; insurance for period \$200 3 wages owing \$500; wages recorded at \$800 4 rent owing \$500; rent revenue recorded at \$2000 5 commission revenue of \$100 has been unearned; commission revenue recorded at \$1000. The adjustments to the balances in the trial balance could be determined and simply pencilled in alongside existing figures, and any new accounts noted underneath. For example, with insurance paid in advance, an original prepaid insurance figure of, say, \$2400 in the trial balance would need to be decreased by the period amount of \$200 to leave the insurance expense of \$200 to appear in the Statement of Profit or Loss. A new account, Insurance Expenses of \$200, will be pencilled in underneath the trial balance. This process for the above balance day adjustments has been summarised in the table on page 144. Make sure you can understand how each balance day adjustment affects the Statement of Profit or Loss and the Statement of Financial Position. Of course, each of these figures can be checked against the amounts appearing in the ledger accounts. From the table, you should see that for each one of the balance day adjustments outside the trial balance, two accounts are affected: one account in the Statement of Profit or Loss one account in the Statement of Financial Position. This is to be compared to those items inside the trial balance. They will only appear once -- either in the Statement of Profit or Loss or the Statement of Financial Position. 143CHAPTER 2: FInAnCIAL STATEmEnT REPoRTInG9780170401890