Lecture 6 End of year adjustments II: Accruals & Prepayments, Bad Debts & Provision for Doubtful Debt

Adjusting entries for accruals Adjusting entries for prepayments Entries for bad debts and provision for doubtful debts Summary of journalizing and posting RECAP Fiscal and calendar years Periodicity concept Applying revenue & matching principle Where to put the items in the financial statements The Basics of Adjusting Entries How it effects the Financial Statements End of Year Adjustments

Adjusting Entries Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. A company must make adjusting entries every time it prepares financial statements. Revenues - recorded in the period in which they are earned Revenues - recorded in the period in which they are earned. Expenses - recognized in the period in which they are incurred Expenses - recognized in the period in which they are incurred. Adjusting entries- needed to ensure that the revenue recognition and matching principles are followed. Adjusting entries - needed to ensure that the revenue recognition and matching principles are followed.

Accruals It is an amount owing for a service provided during a particular accounting period and still unpaid for at the end of it. The amount due will normally be paid in a subsequent accounting period.

Accrued expenses An adjusting entry serves two purposes: i)It records the obligations; and ii)It recognizes the expenses

Rent of $1200 per year is payable at the end of every three months. The rent was paid on time in March, however this is not always the case AmountRent dueRent paid $30031 March 2010 $30030 June July 2010 $30030 September October 2010 $30031 December January 2011 Accrued expenses

Which account to use for accruals? Don’t open a separate account for accruals. Accrual entry will be made to the account that relates to that particular service. Since the expense account now has a credit balance, it becomes a current liability. Accruals

Rent account Debit Credit Cash$ P&L account$1, Cash$ Cash$ Accrued c/d $300 $1, Accrued b/d$300 Rent of $1200 per year is payable at the end of every three months. The rent was paid on time in March, however this is not always the case Accrued expenses

End-of-year entry will be as follows: Dr Profit and Loss account $1,200 Cr Rent account $1,200 What happens to the accrued expense amount of $300? Effect of Accruals

Review: You owed $500 to the telephone company at 31 December During the year to 31 December 2008 you paid the company $4,000. At 31 December 2008 you owed the company $1,000. What amount for telephone charges would you debit to the profit and loss account for 2008?

Prepayments It is a current asset representing amount paid in cash for a service that will be provided in a subsequent period. Example: If the year end of a company is 31 December and it buys a van on 1 July 2008 and pays the full year road license fee up to 30 June 2009, then half of the license fee paid will relate to 2008 and the other half to An adjustment for this effect is therefore needed at the end of 2008.

Road license fee ledger account Debit Credit Bank$1, P&L account$ Prepaid c/d$500 $1, Prepaid b/d$500 The van is used only 6 months during 2008, so only $500 of license fee should be charged to P&L account (matching rule), the remaining part will carry forward as prepayment for year following year. Prepayments

Don’t open a separate account for prepayments. Prepayment entry will be made to the account in which we have first recorded the payment. Since the expense account at the end of year has a debit balance, it becomes a current asset. End-of-year entry will be as follows: Dr Profit and Loss account $ 500 Cr Road license fee account $ 500 Prepayments

For a prepayment at the year end: 1)Subtract the amount from the expenses in P&L. 2)In the balance sheet show the amount of the prepayments as a current asset under the subheading “Prepayments” Prepayments

Review A company had paid $3,000 in advance for insurance at 31 December During the year to 31 December 2005, it paid the insurance company $10,000, out of which $2,000 is for insurance cover for the following year. What amount for insurance charges should the company debit to the profit and loss account for the year to 31 December 2005?

Bad & doubtful debts Realization rule requires to include amount of credit sales in Revenue account even if the cash is not received at that date. Some of debtors might default on payments when they become due. By eliminating bad debt and creating a provision for other uncertainties, “accounting profit” is adjusted and becomes more reliable.

Bad debt – highly unlikely it will be paid/recovered; long-time owing and proven to be bad. Doubtful debts – are the debt that are likely to be bad but have not yet been proven to be so. Bad & doubtful debts

On 5 January, we sold $200 and $50 of pens to Chumi and Chiki respectively. However, at the year end, Chumi only managed to pay $120 and Chiki business already went bankrupt. Bad & doubtful debts

Writing off a bad debt completely removes the debt from the accounting books And the double entry will be: Dr Bad debts (it is an expense account) Cr Debtors (reduce the debtor figure by the amount of the bad debt) The balance of Bad Debts account is then transferred to Profit and Loss account at the end of accounting period. Bad & doubtful debts

Provision for d. debts How do you decide how much to provide? Why do we need provision? The estimated figure can be made: i)By looking at each debt, and deciding to what extent it will be bad; ii)By estimating, on the basis of experience, what percentages(%) of the total amount due from the remaining debtors will ultimately prove to be bad debts. Ageing Schedule for Doubtful Debts Period debt owingAmount ($)Estimated % doubtful Provision for doubtful debts ($) Less than 1 mth5, – 2 months3, – 3 months months – 1 year Over 1 year ,160214

On 31 December 20x9 (year in which provision is first made), debtors amounted to $10,000 and provision for bad and doubtful debts is 2% or $200. The accounting entries would be as follows: Dr Profit and Loss account $200 Cr Provision for bad and doubtful debts $200 Provision for d. debts

Increasing the provision: suppose that at the end of the following year, 31 December 2010, debtors had risen to $12,000 but the provision is still kept at 2%, or $240. Since a provision of $200 had been brought forward from 2002, in 2010 a provision for the additional $40 only should be made. The accounting entries on 31 December 2010 would be as follows: Dr Profit and Loss account $40 Cr Provision for bad and doubtful debts $40 Provision for d. debts

Reducing the provision: suppose that at the end of the following year, 31 December 2011, debtors fell to $10,500 but the provision remained at 2%, or $210. Since a provision of $240 had been brought forward from 2010, the provision in 2011 needs to be reduced by $30. The accounting entries on 31 December 2011 would be as follows: Dr Provision for bad and doubtful debts $30 Cr Profit and Loss account $30 Provision for d. debts

New account which is contra-account to the debtors account, thus the rules of debit and credit for this account should be the opposite to the debtors account. If there is an increase in the provision, a credit entry should be made; a decrease in the provision will require a debit entry. Once original (first) entries have been made, subsequent entries in the provision for bad and doubtful debts account will only be made for the additional or the reduced amounts of the provision. Provision for d. debts

References: 1.Wood, F & Sangster, A (2001) Business Accounting 1, chapters 5, 6, 25, 26, 28 2.Dyson, J.R (2004) Accounting for Non-Accounting Students, chapter 5. 3.ACCA (2006) Approved text for the professional qualification, Study Text 2006/07, Paper 1. INT,Kaplan publishing: Foulks Lynch, chapter 5. 4.Glautier, M & Underdown B (2001) Accounting Theory and Practice, 7 th edition, chapters 9 & 10