1. Accounting for Executive Week 4 1/4/2011 (Fri) Lecture 4

2. 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.

3. Adjustment for accruals, prepayments Accruals Costs 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. Prepayments Expenditure on goods or services for future benefit, which is to be charged to future operations, e.g. rentals paid in advance.

4. 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

5. 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.

6. Accruals Before adjustmentAfter adjustment $ $ Gross Profit15,00015,000 Less: Expenses Electricity (12000+4950)** (12,000)(16,950)** Net Profit3,000(1,950) Accounting entries Dr. Expenses-Electricity4,950 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.

7. Accruals ABC Company Statement of financial position BeforeAfter Non-current Assets10,00010,000 Current Assets20,00020,000 Less: Current Liabilities Accruals0(4,950) 20,00015,050 30,00025,050 Financed By Owner’s capital27,00027,000 Retained profit / (loss)3,000(1,950) 30,00025,050

8. 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.

9. 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

10. Prepayment Before adjustmentAfter adjustment $ $ Gross Profit1,0001,000 Less: Expenses Motor vehicles taxation (180X 6/12)** (180)(90)** Net Profit820910 Accounting entries Dr. Prepayments (current asset)90 Cr. Expenses- Motor vehicles taxation90 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.

11. Prepayments ABC Company Statement of Financial Position BeforeAfter Non-current Assets10,00010,000 Current Assets Prepayments090 10,00010,090 Financed By Owner’s capital9,1809,180 Retained profit / (loss)820910 10,00010,090

12. 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

13. Bad Debts and Allowance for Bad Debts To write off the sum owned by debtor with an amount $500 Debtor A 20X4$20X4$ 1.4 Sales50030.4 Bad debt written off500 Bad Debts 30.4 Debtor A50030.4 Income statement 500 Income statement (extract) for the year ended 31.12.20X4 Gross Profit 10,000 Less Expenses: Bad debts written off(500)

14. 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.

15. Allowance for Bad Debts $450,000 X 2% = $9,000 Dr. Income statement$9,000 Cr. Provision for Bad Debts$9,000 Jacky Company Income statement (extract) for the year ended 31.12.20X4 Gross Profit b/d60,000 less: Expenses Increase in allowance for bad debts(9,000) Jacky Company statement of financial position as at 31.12.20X4 Current assets $ $ Debtors450,000 less: Allowance for bad debts(9,000) 441,000

16. Allowance for Bad Debts In the next year the outstanding balances of debtors $400,000 the 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

17. Allowance for Bad Debts Jacky Company Income statement (extract) for the year ended 31.12.20X5 Gross Profit b/d50,000 Add: Decrease in allowance for bad debts 1,000 51,000 Less: ExpensesXX,XX Jacky Co. statement of financial position (extract) as at 31.12.20X5 Current assets $ $ Debtors400,000 Less: Allowance for bad debts(8,000) 320,000

18. Allowance for Bad Debts 20X4$20X4$ 31.12 Balance c/d9,00031.12 Income statement9,00020X5 31.12 Income statement1,0001.1 Balance b/d9,000 31.12 Balance c/d8,0009,00020X6 1.1 Balance b/d8,000

19. Differences between Bad Debt and Allowance for Bad Debt Bad 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

20. 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.

21. 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