Time Tracer Ltd - Publishing

ACCOUNTING INSIGHT

2nd Edition by Edwin Olima FCCA

ISBN 0-9543820-1-3

 

 

 

 

 

 

 

 

 

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Chapter 12           Accounting Adjustments

(Prepayments, Accruals, Depreciation & Stock Journals)

 

 

While the trial balance  (the T.B.) is a good stage to reach in book-keeping, when one looks at the actual nature of the transactions  closely, it is possible to make further adjustments to get a more accurate picture of the business transactions within a given period of time.  In our example as we are preparing accounts for the year to 31st December 3000 , the following accounting adjustments will be required:

 

Telephone Charges

Looking at the invoice from A Phone Call Ltd. we can see that the business has been charged for calls made up to 30th June 3000 . The Company has not yet received the invoice for the second half of the year to 31st December 3000 even though it has been using the Telephone service through out the year.

 

We should therefore provide a charge in the Companyís accounts for the estimated telephone charges for the period 1st July 3000 to 31st December 3000 . And assuming the same rate of usage as in the first half of the year, we shall estimate this at about £47.00 (excluding VAT ). In accounting we use a Journal  to record this adjustment as shown in Journal 1 below:

 

Journal  1                                                                                              Debit (Flow in)                    Credit (Flow Out)

Estimated Telephone Expense                                                                      £47.00

Estimated Liability for Telephone Expense                                                                                                 £47.00

Being the estimated telephone expenses  for July to December 3000

 

Accounting estimates for expenses  incurred but for which the invoice has yet to be received are called Accrued Expenses  (or Accruals ).

 

Insurance

Once again when we look closely at the invoice for insurance we can see that the company has paid for insurance from 1st April 3000 to 31st March 3001 . However, given that we are preparing accounts to 31st December 3000 , part of the insurance expense will relate to the first quarter of the year 3001. This portion of unused expense calculated at £62.50 (that is one quarter of £250.00) and will need to be adjusted for as shown in Journal  2 below:

 

Journal  2                                                                                              Debit      (Flow in)               Credit (Flow Out)

Insurance Yet to be Used (Resource available)                                               £62.50

Insurance Expense Reduced (Opposite of expense increase)                                                                    £62.50

Being the unused Insurance expenses  as at 31st December 3000

 

Accounting adjustments for expenses  not yet utilized but that have been paid for are called Prepaid Expenses  (or Prepayments ).

 

Reversing accrual and prepayment journals in the following period

In the following accounting period, 3001 in this case, the actual telephone bill for the second half of the year 3000 will be received and recorded. The accrued telephone expense adjustment will then need to be reversed to avoid double counting . 

 

Furthermore the prepaid insurance expense will need to be released to be shown as the proportionate expense for year 3001 to avoid understatement.  In both cases this is done by further journals in the year 3001 reversing the journals 1 and 2 above.

 

Deferring income or Accruing income

The same principle used for adjusting expenses  as shown above, can be used to adjust income.  Income received in advance is usually deferred to the date that goods are delivered to the customer (deferred income). Where goods have been delivered but the invoice has not been raised then the sale value of those goods can be accrued (accrued income).

 

Where the business is registered for VAT then all accruals and prepayments are journalized into the accounts net of VAT. If the business is not registered for VAT then accruals and prepayments are put through gross (i.e. including VAT).


 

Fixed Asset Expenditure and Depreciation

In the working example the van purchased by the company is expected to be used for at least four years before it is replaced or scrapped. It is thus a fixed asset. Fixed assets  generally have a useful economic life of two or more years.

 

Based on this assumption, it would be fair to spread the cost of the van over the four years rather than write it all off in the first year. Thus matching the cost of the van with the benefits expected from it over time.

 

There are various ways of doing this but the simplest method is dividing the cost of the van by the number of years of its expected useful life.

 

Using this method in our example, we would get a charge of £750.00 per year for four years, which is £3,000 divided by 4 years. The annual charge is called depreciation . This method of calculating depreciation is called the straight-line method . So using this method over the years the fixed asset (van) would be accounted for as follows (note that Net Book Value - NBV, is the cost of an asset less accumulated depreciation to date):

 

Straight Line Depreciation

Year ending on:

Details

Net Book Value - £ís

Accumulated Depreciation - £ís

31st Dec 3000

Cost of Van

3,000.00

 

 

Less: Depreciation for year

(750.00)

(750.00)

 

Net Book Value at year end

2,250.00

 

31st Dec 3001

Less: Depreciation for year

(750.00)

(1,500.00)

 

Net Book Value at year end

1,500.00

 

31st Dec 3002

Less: Depreciation for year

(750.00)

(2,250.00)

 

Net Book Value at year end

750.00

 

31st Dec 3003

Less: Depreciation for year

(750.00)

(3,000.00)

 

Net Book Value at year end

0.00

 

 

To enter the amount of depreciation  for the year ending 31st December 3000 a journal would be required as shown below:

Journal  3                                                                                              Debit (Flow In)                    Credit (Flow Out)

Depreciation charge for the year                                                                    £750.00

Accumulated depreciation  (reduction in value of fixed asset)                                                                      £750.00

Being the depreciation  charge of the van for the year to 31st December 3000

 

It can be argued that the best use of the van will be extracted in the early years of its life rather than in the later years when the van becomes rusty, unreliable and needs more maintenance. Given this argument accountants would use the reducing balance method  of computing depreciation . Assuming a depreciation rate of 25.00% per year on the reducing NBV balance of the van, depreciation would be computed as follows:

 

Reducing Balance Depreciation

Year ending on:

Details

Net Book Value (NBV) £ís

Accum. Depr. £ís

31st Dec 3000

Cost of Van

3,000.00

 

 

Less: Depreciation for year (25% of  NBV)

(750.00)

(750.00)

 

Net Book Value (NBV) at year end

2,250.00

 

31st Dec 3001

Less: Depreciation for year (25% of  NBV)

(562.50)

(1,312.50)

 

Net Book Value (NBV) at year end

1687.50

 

31st Dec 3002

Less: Depreciation for year (25% of  NBV)

(421.88)

(1,734.38)

 

Net Book Value (NBV) at year end

1,265.62

 

31st Dec 3003

Less: Depreciation for year (25% of  NBV)

(316.41)

(2,050.79)

 

Net Book Value (NBV) at year end

949.21

 

 

As you can see the reducing balance method  results in a higher depreciation  charge per year in the earlier years than in the later years of the vanís life. Thus attempting to match the depreciation charge with the expected benefit from the use of the van.

 

 

The closing stock  journal

You will have noticed that closing stock  is still shown within the value of the purchases made during the year. We however need to show this value separately as it represents an asset to the company and is yet to be sold. The journal used to do this is listed below:

Journal  4                                                                                              Debit (Flow In)                    Credit(Flow Out)

Closing stock shown as an asset to the company                                          £1,500.00

Closing stock deducted from total purchases during the year                                                                   £1,500.00

Being the extraction of closing stock  from purchases and to be shown as an asset. Thus reducing purchases to cost of goods  sold only.

 

The extended Trial Balance

Now that we have identified all accounting adjustments we can enter them by extending the trial balance in Chapter 11 as follows:

 

       THE COMPANY LIMITED Ė FINAL TRIAL BALANCE AS AT 31ST DECEMBER 3000

 

Detail of Transactions

Debit

Credit

Journals

Debit

Credit

 

£ís

£ís

No.

Debit-£ís

Credit-£ís

£ís

£ís

Sales

 

23,000.00

 

 

 

 

23,000.00

Trade Debtors

3,525.00

 

 

 

 

3,525.00

 

Purchases of goods

13,000.00

 

 

 

 

13,000.00

 

Closing Stock  of Goods

 

 

4

 

1,500.00

 

1,500.00

Trade Creditors

 

5,909.08

 

 

 

 

5,909.08

Rent

800.00

 

 

 

 

800.00

 

Phone

47.10

 

1

47.00

 

94.10

 

Motor Expenses

578.00

 

 

 

 

578.00

 

Van Cost

3,000.00

 

 

 

 

3,000.00

 

Accumulated Depreciation

 

 

3

 

750.00

 

750.00

Stationery

29.00

 

 

 

 

29.00

 

Insurance

250.00

 

2

 

62.50

187.50

 

Interest received

 

10.00

 

 

 

 

10.00

Share Capital

 

100.00

 

 

 

 

100.00

Bank Charges

10.50

 

 

 

 

10.50

 

Drawings (dividends)

900.00

 

 

 

 

900.00

 

Motor Tax

75.00

 

 

 

 

75.00

 

Bank Account  Balance

7,775.01

 

 

 

 

7,775.01

 

VAT  Account Balance

 

970.53

 

 

 

 

970.53

Salary Costs

1,000.00

 

 

 

 

1,000.00

 

Employer NIC

120.00

 

 

 

 

120.00

 

Tax & NIC  due to the Govít.

 

420.00

 

 

 

 

420.00

Net Pay due to employee

 

700.00

 

 

 

 

700.00

Accruals

 

 

1

 

47.00

 

47.00

Prepayments

 

 

2

62.50

 

62.50

 

Depreciation Charge

 

 

3

750.00

 

750.00

 

Closing Stock  Balance

 

 

4

1,500.00

 

1,500.00

 

Totals

31,109.61

31,109.61

 

2,359.50

2,359.50

33,406.61

33,406.61

Corporation tax Journal

 

 

 

 

 

 

 

Corporation tax charge

 

 

5

1,573.00

 

1,573.00

 

Corporation tax liability

 

 

5

 

1,573.00

 

1,573.00

Totals

31,109.61

31,109.61

 

3,932.50

3,932.50

34,979.61

34,979.61

 

Check the additions across the rows and you should note the following patterns:

         debits + debits = debits,                                            

         debits Ė credits = debits (or credits if result is negative),

         credits + credits = credits,                                         

         credits Ė debits = credits (or debits if result is negative)

 

The corporation tax journal will be clarified in the next chapter.

 

The trial balance  as presented above is called an extended trial balance. This is what your accountant will prepare from your first trial balance (Chapter 11 ) in order to get the figures for your final accounts


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