Accounting for Executive Week 4 1/4/2011 (Fri) Lecture 4.
-
Upload
holly-williamson -
Category
Documents
-
view
214 -
download
1
Transcript of Accounting for Executive Week 4 1/4/2011 (Fri) Lecture 4.
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.
Adjustment for accruals, prepayments
AccrualsCosts 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.
PrepaymentsExpenditure on goods or services for future benefit,
which is to be charged to future operations, e.g. rentals paid in advance.
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
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.
Accruals
Before adjustment After adjustment
$ $
Gross Profit 15,000 15,000
Less: Expenses
Electricity (12000+4950)** (12,000) (16,950)**
Net Profit 3,000 (1,950)
Accounting entries
Dr. Expenses-Electricity 4,950
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.
Accruals
ABC Company Statement of financial position
Before After
Non-current Assets 10,000 10,000
Current Assets 20,000 20,000
Less: Current Liabilities
Accruals 0 (4,950)
20,000 15,050
30,000 25,050
Financed By
Owner’s capital 27,000 27,000
Retained profit / (loss) 3,000 (1,950)
30,000 25,050
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.
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
Prepayment
Before adjustment After adjustment
$ $
Gross Profit 1,000 1,000
Less: Expenses
Motor vehicles taxation (180X 6/12)** (180) (90)**
Net Profit 820 910
Accounting entries
Dr. Prepayments (current asset) 90
Cr. Expenses- Motor vehicles taxation 90
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.
Prepayments
ABC Company Statement of Financial Position
Before After
Non-current Assets 10,000 10,000
Current Assets
Prepayments 0 90
10,000 10,090
Financed By
Owner’s capital 9,180 9,180
Retained profit / (loss) 820 910
10,000 10,090
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
Bad Debts and Allowance for Bad Debts
To write off the sum owned by debtor with an amount $500Debtor A
20X4 $ 20X4 $
1.4 Sales 500 30.4 Bad debt written off 500
Bad Debts
30.4 Debtor A 500 30.4 Income statement 500
Income statement (extract) for the year ended 31.12.20X4
Gross Profit 10,000
Less Expenses:
Bad debts written off (500)
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.
Allowance for Bad Debts
$450,000 X 2% = $9,000Dr. Income statement $9,000Cr. Provision for Bad Debts $9,000
Jacky CompanyIncome statement (extract) for the year ended 31.12.20X4
Gross Profit b/d 60,000less: ExpensesIncrease in allowance for bad debts (9,000)
Jacky Company statement of financial position as at 31.12.20X4Current assets $ $Debtors 450,000less: Allowance for bad debts (9,000)
441,000
Allowance for Bad Debts
In the next year the outstanding balances of debtors $400,000the 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
Allowance for Bad Debts
Jacky CompanyIncome statement (extract) for the year ended 31.12.20X5
Gross Profit b/d 50,000Add: Decrease in allowance for bad debts 1,000
51,000Less: Expenses XX,XX
Jacky Co. statement of financial position (extract) as at 31.12.20X5Current assets $ $Debtors 400,000Less: Allowance for bad debts (8,000)
320,000
Allowance for Bad Debts
Allowance for Bad Debts
20X4 $ 20X4 $
31.12 Balance c/d 9,000 31.12 Income statement9,000
20X5 20X5
31.12 Income statement 1,000 1.1 Balance b/d 9,000
31.12 Balance c/d 8,000
9,000 9,000
20X6 20X6
1.1 Balance b/d 8,000
Differences between Bad Debt and Allowance for Bad DebtBad 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
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.
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