TOPIC 4

1. TOPIC 4 Adjusting Entry PowerPoint presentation by AFSH @ 2007 UPM

2. Learning Objectives • Explain criteria for revenue recognition and expense recognition. • Differentiate between the cash basis and the accrual basis of accounting. • Explain why adjusting entries are needed and examine the steps for adjusting process. • Identify the major types of adjusting entries. • Prepare adjusting entries for prepayments and accruals. • Describe the nature and purpose of the adjusted trial balance.

3. Timing Issues • Accounting divides the economic life of a business into artificial time periods (period assumption) • A fiscal year is a financial year (not necessarily the same as calendar year) usually for 12 months period used for calculating annual financial reports in business organizations.

4. Cash-based accounting Revenue recognised when the cash is received or paid. Expenses recognised when the cash is received or paid. Accrual versus Cash Basis of Accounting Accrual-based accounting • Revenue recognised when goods and services are provided. • Expenses recognised when assets are consumed or liabilities incurred.

5. Year 1 Year 2 Activity Purchased paint, painted Received payment for work building, paid employees done in Year 1 Accrual Revenue $ 80 000 Revenue $ - basis Expense 50 000 Expense - Profit $ 30 000 Profit $ - Cash Revenue $ - Revenue $ 80 000 basis Expense 50 000 Expense - Loss $(50 000) Profit $ 80 000 Accrual versus Cash Basis (cont'd) Example:

6. Adjusting Entries • Adjusting entries are necessary to ensure: • Revenues and expenses are recorded in the correct accounting period (matching principle) • Recognition criteria are followed for assets, liabilities, revenues and expenses

7. Adjusting Process • Record adjusting entries in journal. • Post adjusting entries into ledger/ T account. • Prepare an adjusted trial balance.

8. Types of Adjusting Entries Prepayments • Amounts paid in cash and recorded as assets until used. • Revenue received from customers and recorded as a liability until services performed or goods delivered. Accruals • Amounts not yet received and recorded for which goods or services have been provided. • Amounts not yet paid or recorded for goods or services already received.

9. Expense Debit adjusting entry (+) Asset Unadjusted Credit balance adjusting entry (-) Revenue Credit adjusting entry (+) Liability Debit Unadjusted adjusting balance entry (-) Adjusting Entries for Prepayments Prepayments are either: • Prepaid expenses • Prepaid revenues

10. Oct. 31 Supplies Expense 1 500 Supplies 1 500 (To record supplies used) Prepayments:Prepaid Expenses 1. Supplies • Supplies on hand 31 October: $1000 • Supplies expense of $2500 originally recorded as an asset • Journal entry:

11. Supplies Oct. 5 2 500 Oct. 31 Supplies Expense 1 500 Supplies Expense Oct. 31 Supplies 1 500 cross-reference cross-reference Prepayments:Prepaid Expenses (cont'd) • Supplies on hand 31 October: $1000 • General Ledger entry:

12. Oct. 31 Insurance Expense 50 Prepaid Insurance 50 (To record insurance expired) Prepaid Insurance Insurance Expense Oct. 4 600 Oct. 31 Adj. 50 Oct. 31 Adj. 50 Prepayments:Prepaid Expenses (cont'd) 2. Insurance • Insurance paid for 1 year in advance: $600 • Insurance for October $600/12 = $50 • Journal entry: • General ledger:

13. Oct. 31 Prepaid service revenue 400 Service Revenue 400 (To record revenue) Prepaid service revenue Service Revenue Oct. 31 Adj. 400 Oct. 2 1 200 Oct. 3 10 000 Oct. 31 Adj. 400 Prepayments:Prepaid revenues 3. Service revenues • $1200 received 2 October for advertising services to be completed 31 December • Journal entry: • General Ledger:

14. Revenue Credit adjusting entry (+) Asset Debit adjusting entry (+) Liability Credit adjusting entry (+) Expense Debit adjusting entry (+) Adjusting Entries for Accruals Accruals may be either: • accrued revenues • accrued expenses

15. Accruals: Accrued Revenue • Accrued revenues are revenues earned from providing goods or services that have not as yet been recorded. • Revenue and receivable are recorded for revenue not received and not recorded. • Once cash is received, receivable is reduced.

16. Oct. 31 Accrued commissions 200 Commissions Revenue 200 (To accrue commissions revenue not recorded or collected) Accrued commissions Commissions Revenue Oct. 31 Adj. 200 Oct. 31 Adj. 200 Accruals: Accrued Revenue (cont'd) E.g. Commission revenue • Commission Revenue earned, but not yet received or recorded: $200 • Journal entry: • General Ledger:

17. Accruals: Accrued Expenses • Accrued expenses are expenses not yet paid or recorded at balance date. 1. Accrued Interest • Accrued interest owing on loan of $5000 • Interest rate: 12% p.a. • Interest owing: $5000 x 12% x 1/12 = $50

18. Oct. 31 Interest Expense 50 Accrued Interest 50 (To accrue interest on bank loan) Interest expense Accrued interest Oct. 31 Adj. 50 Oct. 31 Adj. 50 Accruals: Accrued Expenses (cont'd) • Journal entry • General Ledger:

19. Accruals: Accrued Expenses (cont'd) 2. Accrued Salaries • Salaries outstanding for October: $1200 (3 days x $400)

20. Oct. 31 Salaries Expense 1200 Accrued salaries 1200 (To record accrued salaries) Salaries expense Accrued salaries Oct. 26 4000 Oct. 31 Adj. 1200 Oct. 31 Adj. 1200 Accruals: Accrued Expenses (cont'd) • Journal entry • General Ledger:

21. SUMMARY

22. OTHER ADJUSTMENTS (A) Bad debts and doubtful debt • Bad debts If it is clear that a debt is bad (that it is highly unlikely it will ever be paid by the debtor) then it must be written off immediately. Journal entries Dr Bad debt expense Cr Debtor

23. ii) Provisions for bad and doubtful debts • To allow some possibility that some debts may become bad. • This is to be done by setting up provision for bad and doubtful debts and to open a special account for that purpose. • Provision is an amount set aside for something that is highly likely to happen. • The provision is expressed as a percentage of the outstanding debtors.

24. Oct. 31 Depreciation Expense 40 Accumulated Depreciation - Office Equipment 40 (To record monthly depreciation) (B)Depreciation • Allocation of the cost of the asset to expense over its useful life • Depreciation of office equipment: $480 p.a. or $40 monthly • Journal entry:

25. Office Equipment Oct. 2 5 000 Accumulated Depreciation - Office EquipmentDepreciation Expense Oct. 31 Adj. 40 Oct. 31 Adj. 40 Office Equipment $5 000 Less: Accumulated Depreciation 40 Carrying Value $4 960 Depreciation expense • General Ledger • Balance Sheet

26. WONG PTY LTD Trial Balances as at 31 October 2008 Before adjustment After adjustment Dr Cr Dr Cr Cash $15 200 $15 200 Prepaid commissions 200 Advertising Supplies 2 500 1 000 Prepaid Insurance 600 550 Office Equipment 5 000 5 000 Accumulated Depreciation – Office Equipment $ 40 Accounts Payable $ 2 500 2 500 Accrued interest 50 Accrued service revenue 1 200 800 Accrued salaries 1 200 Bank Loan 5 000 5 000 Share Capital 10 000 10 000 Retained Earnings -- -- Dividends 500 500 Service Revenue 10 000 10 400 Commissions Revenue -- 200 Salaries Expense 4 000 5 200 Advertising Supplies Expense 1 500 Rent Expense 900 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 Profit $28 700 $28 700 $30 190 $30 190