Session 4 Adjusting Entries Accounting PDF

# Part.4: Understanding accounting information and data ## Adjusting entries (or closing / End-of-period entries) ### Summary - **Definition** - **Depreciation** - **Impairment of Assets / Provisions** ### Adjusting entries: Definition - Adjusting journal entries are used to record transactions...

# Part.4: Understanding accounting information and data ## Adjusting entries (or closing / End-of-period entries) ### Summary - **Definition** - **Depreciation** - **Impairment of Assets / Provisions** ### Adjusting entries: Definition - Adjusting journal entries are used to record transactions that have occurred but have not yet been appropriately recorded in accordance with the accrual method of accounting. - Adjusting journal entries are recorded in a company's general ledger at the end of an accounting period to abide by the matching and revenue recognition principles. - The most common types of adjusting journal entries are: - **Accruals**: are revenues (and expenses) that have not been received (or paid) and have not yet been recorded through a standard accounting transaction. - **Example**: prepaid expense, accrued revenues... - **Deferrals**: refer to revenues (or expenses) that have been received (or paid) in advance and have been recorded, but have not yet been earned or used. - **Example**: Unearned revenue... - **Estimates**: adjusting entries that record non-cash items. - **Example**: Depreciation, Impairments of assets, Provisions - An adjusting entry involves an income statement account (revenue or expense) along with a balance sheet account (asset or liability). ## 1 Depreciation ### Types of non-current assets | Type of assets | Terms used for allocating the cost of their use | | ------------------------ | --------------------------------------------------------------------------------------------------------- | | **Tangible assets:** | | | Land | Not depreciated (as it does not wear out or become obsolete) | | Plant and equipment, Furniture and fixtures, Motor vehicles | Depreciation | | Natural resources | Depletion | | **Intangible assets:** | | | Goodwill | Amortisation | | Patents, copyrights, etc. | Amortisation | | Leasehold improvements | Amortisation | | Research | Expensed when incurred | | Development | Amortisation | ### Depreciation - Fixed assets gradually lose value. - "Consumption” of the fixed asset. - Consumption = "Depreciation expense” since it reflects the gradual loss of value of these assets. - Depreciation starts on the 1st day of use. | Fixed Asset | Balance sheet | Income statement | | ----------- | -------------------------------------------------------------- | ----------------------------------------------------- | | | Asset | Expenses | | | Gross value Depreciation Net Book value | Depreciation expense | | | 200 20 180 | 20 | ### The calculation of depreciation To calculate a depreciation charge for a period, four factors have to be considered: - The cost (or fair value) of the asset - The useful life of the asset - The residual value of the asset - The depreciation method ### Calculating an annual depreciation charge - **Annual depreciation = (Original cost - Salvage value) / useful life** | | | | | | --- | --- | --- | --- | | Cost (fair value) | less | Residual value | equals | | | | | Depreciable amount | | Year 1 | Year 2 | Year 3 | Year 4 and so on | | Depreciati | Depreciati | Depreciatio | Depreciatio | | | | | | | Asset life (Number of years) | | | | ### Exercise - Straight line method **Example:** 1. Doune market acquires a new equipment by paying €35,000. 2. Estimated useful life is 4 years with a salvage value of €3,000. **Solution** 1. Equipment +35 000 Cash -35 000 2. Accumulated Depreciation + 8 000 Depreciation expense + 8 000* 4. * 8 000 = (35000 – 3000) / 4 ### Depreciation table using the straight-line method | Ye | Original cost | Yearly depreciatio | Cumulative depreciatio | Carrying amount Net book value | | --- | -------------- | ------------------ | ---------------------- | -------------------------------- | | 1 | 35 000 | 8 000 | 8 000 | 27 000 | | 2 | 35 000 | 8 000 | 16 000 | 19 000 | | 3 | 35 000 | 8 000 | 24 000 | 11 000 | | 4 | 35 000 | 8 000 | 32 000 | 3 000 | ## 2 Impairment of assets / Provisions - **Prudence/conservatism principle** - Cover expected loss - Potential gains not recorded | | | | --- | --- | | Expected loss | | | Within assets: | Within liabilities: potential liabilities | | Potential reduction in value | (the timing or the amount are not yet precisely determined) | | IMPAIRMENT OF ASSETS: | PROVISION FOR POSSIBLE LOSSES LIABILITIES AND EXPENSES | | Fixed assets, stock, receivables, Inventories | Legal disputes, sales returns etc. | ### Provision - **Provisions of assets (or impairment of assets)**: cover a risk of loss of value in the assets (decrease of assets) - **Operating:** - inventory, AR - Fixed assets - **Financial:** Shares - **Provisions for possible losses:** cover other risks of loss of value (increase of liabilities) - **Increase of provision** decreases profit through an expense called "expense for provision”. - **Decrease of provision** increases profit through a revenue called "reversal of provision".