ABAB113

Business Accounting
Semester 1 2016/2017

Topic 4

Year-end
Adjustments

Course Outcome 3

After studying this topic students should be

able to:
Prepare the financial statements taking into
consideration year-end adjustments covering
accruals and prepayments, bad debts and
provision for doubtful debts, and depreciation.

Introduction

Year-end adjustments is a process of

adjusting the entry to an account at the end
of the calendar or fiscal year in order to
properly state it for financial statements
preparation purposes. Types of required
adjustments can be summarised as follows:
Accruals and prepayments
Bad and doubtful debts
Depreciation

Accruals and
prepayments

ADJUSTING ENTRIES

ACCRUALS
ACCRUED
EXPENSES

PREPAYMENTS

ACCRUED
REVENUES

PREPAID
EXPENSES

PREPAID
REVENUES

CURRENT
ASSETS
CURRENT LIABILITIES

The nature of accruals

The accruals concept dictates that costs are

recognised as they are incurred, not when money
is paid. That is, goods and services are deemed
to have been purchased on the date they are
received.

The ledger entries for accruals

Accrued expenses
Debit the expense account as a balance carried down

The bal c/d will thus be shown as a current liability on the

balance sheet.
The charge to the income statement (I/S) therefore reflects the
total value of the services received/consumed during the
accounting year.
ExpensesAccount
Date Particulars

31/1 Bank or cash

31/1 Bal c/d (Accrued)

RM

Date Particulars

RM

xxx 1/1 Bal b/d (Accrued)

xxx 31/1 I/S
xxxx

xxx
xxx
xxxx

The ledger entries for accruals

Accrued revenue
Credit the revenue account as a balance carried down

The balance c/d (Accrued) will thus be shown as a current asset

on the balance sheet.
The charge to the income statement (I/S) therefore reflects the
total value of the revenue earned during the accounting year.
RevenuesAccount
Dat
e

Particulars

RM

Date

Particulars

RM

31/1 Bal b/d (Accrued)

31/1 I/S

xxx
xxx

31/1 Bank or cash

31/1 Bal c/d (Accrued)

xxx
xxx

xxxx

xxxx

The nature and composition of prepayments

The accruals concept also gives rise to

prepayments/prepaid
expenses
which
are
receivables in respect of services that have been
paid for but not received at the end of the
accounting year.
Prepaid expenses arise where services are paid for in
advance; e.g. rent, road tax, insurance.

prepaid revenue - revenue received but not yet

earned
ABC Company receives RM1200 for one year rental,
starting 1 August 2012. The financial year end is on 31
December.

The ledger entries for prepayments

Prepaid expenses
Credit the expense account as a balance carried down

The bal c/d is shown as a current asset on the balance

sheet.
The charge to the income statement (I/S) therefore
reflects the total value of the services received/
consumed during the accounting year.
ExpensesAccount
Date Particulars

31/1 Bal b/d (Prepaid)

31/1 Bank or cash

RM

Date Particulars

RM

xxx 31/1 I/S

xxx 31/1 Bal c/d (Prepaid)
xxxx

xxx
xxx
xxxx

10

The ledger entries for accruals

Prepaid revenue
Debit the revenue account as a balance carried down
The bal c/d will thus be shown as a current liabilities on the
balance sheet.
The charge to the income statement (I/S) therefore reflects the
total value of the revenue earned during the accounting year.
RevenuesAccount
Dat
e

Particulars

RM

31/1 I/S
31/1 Bal c/d (Prepaid)

xxx
xxx

xxxx

Date

Particulars

RM

1/1 Bal b/d (Prepaid)

31/1 Bank or cash

xxx
xxx

xxxx

11

Balance sheet presentation:

Accruals and prepayments
ABC Enterprise
Balance sheet extract as at 31 December 20x3
Current assets
Accrued revenue
Prepaid expense

xx
xx

Current liabilities
Accrued expense
Prepaid revenue

xx
xx

12

Bad and doubtful debts

13

Bad/ irrecoverable debts

Bad debts arise when a trade receivable (credit
customer/debtor) is unable (or unwilling) to pay the
amount owed in respect of goods sold on credit.
Treating a debt as bad is a matter of judgement. A
debt may be irrecoverable because:
the credit customer cannot be traced;
is not worth taking to Court; or
has been declared bankrupt (and the final
dividend in bankruptcy received).

14

The ledger entries for bad debts

When it is decided that a debt is irrecoverable:
Debit Bad debts account
Credit Trade receivables account
Bad debts is an income statement item

15

The nature of a provision

A provision is the setting aside of income to
meet a known or highly probable future
liability or loss, the amount and/or timing of
which cannot be ascertained exactly, and is
thus an estimate.
It is an application of the prudence concept
(providing for losses) and the matching
concept (it recognises the loss against the
revenue that generates it).
16

The ledger entries for a provision for

doubtful debts
To create or increase a provision:
Debit
Income statement
Credit
Provision for doubtful debts account
>> New and increase in provision are expenses

Decrease in provision:
Debit
Provision for doubtful debts account
Credit
Income statement
>> Decrease in provision is other income

The balance on the provision for doubtful debts account is

deducted from trade receivables in the balance sheet.

17

Balance sheet presentation:

Provision for doubtful debts
ABC Enterprise
Balance sheet extract as at 31 December 20x3
Current assets
Trade receivables
xx
Less: Provision for doubtful debts
xxx

(xx)

18

Summary some key points

Bad debts are amounts due from credit customers which

are deemed to be irrecoverable.

Bad debts written off reduce trade receivables and create

an expense in the income statement.

Provisions for doubtful debts are amounts that are set aside
to cover expected losses, wherein there it is reasonable to
suspect that a trade receivable will not be received.

The provision for doubtful debts reduces the overall

balance reported for trade receivables (but does not write
the balances off yet).

Movements in the provision for doubtful debts affect the

income statement
Increases treated as expense
Decreases treated as other income
19

Depreciation

20

The nature of non-current

assets

Non-current assets (NCA) are items not

specifically bought for resale but to be used
in the production or distribution of those
goods normally sold by the business.
durable goods that usually last for several years,
and are normally kept by a business for more than
one year.
expected to generate revenue over a number of
future years, and be of a material amount.
NCA are referred to as capital expenditure. All
other costs are revenue expenditure.

21

The valuation of non-current

assets

In historical cost accounting, NCA are

valued at their historical cost less the
accumulated depreciation from the date of
acquisition to the date of the statement of
financial position. This is known as the
written down value (WDV), net book value,
or carrying amount.

Historical cost refers to the cost of getting

the asset at inception to working order.
22

Historical cost

The historical cost of NCA can include:

legal expenses, extensions and improvements, as in
the case of buildings, but not repairs and renewals;
delivery charges and installation expenses, as in the
case of plant and machinery.

The historical cost of NCA must exclude:

the costs of any extended warranty, maintenance
agreement and replacement/spare parts where
these have been included in the invoice price of, for
example, machinery or vehicles;
any road tax and fuel included in the invoice price of
a vehicle.
23

Example
Moden Sdn Bhd bought a machine with a purchase
price of RM200,000 from a company in the USA. The
company had to pay RM15,000 for import duty. The
cost of transferring the machine to Malaysia was
RM10,000 borne by Moden Sdn Bhd. The company
also paid for a one-time installation cost of RM2,800
and general overhead cost amounting to RM 4,000
when the machine arrived at the factory. Assume the
company paid the bill using cheque.
What is the amount to be recognised as cost for the
machine?

24

Example
What are the journal entries for that transaction?

What are the ledger entries for that transaction?

25

The nature of depreciation

Depreciation is the allocation of the cost of
a NCA over the accounting periods that
comprise its useful economic life to the
business, according to some criterion
regarding the amount which is used up or
consumed in each of these periods.
There is no actual cash outflows

26

The nature of depreciation

Depreciation is the systematic allocation of the depreciable
amount of an asset over its useful life.
With that, accountants can match the cost of NCA (depreciation charge) against its
revenue generated. [matching concept]
The depreciation charge for each period shall be recognised in income statement as
an expense.

It reflects the amounts of the economic benefits of the tangible NCA that
have been consumed during the period.

Wherein consumption includes the wearing out, using up or other

reduction in the useful economic life of the asset whether arising from use,
effluxion of time or obsolescence through either changes in technology,
price or demand for the goods and services produced by the asset.

27

The essential data to compute

depreciation (4 determinants)
1.

Historical cost

2.

Useful life

3.

Residual value

4.

The method

28

The depreciable amount

Depreciable amount is the cost of an asset less its residual
value.

The depreciable amount of a tangible NCA

should be allocated on a systematic basis
over its useful economic life.
The depreciation method used shall reflect the pattern in
which the assets future economic benefits are expected to
be consumed by the entity.

29

Useful life
Useful life is:
a) the period over which an asset is expected to be
available for use by an entity; or
b) the number of production or similar units expected to
be obtained from the asset by an entity.

30

Residual value
The residual value of an asset is the estimated amount that
an entity would currently obtain from disposal of the asset,
after deducting the estimated costs of disposal, if the asset
were already of the age and in the condition expected at
the end of its useful life.

31

The straight line/fixed instalment

method
The annual depreciation expense/charge to
the income statement =
1.

Cost - Residual value

Useful economic life (in years)

0R
2.

Given percentage rate x Historical cost

This gives the same amount of depreciation in

each year of the assets useful economic life.
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Arguments for the straight-line method

FOR:
1. It is most appropriate for assets that are
depleted as a result of the passage of time (e.g.
buildings, leases, patents).
2. It may be suitable where an assets utilization is
the same in each year.
3. It is easy to understand and simple to calculate.
AGAINST:
It may not give an accurate measure of the loss
in value or reduction in useful life (e.g. the large
decrease in resale value of vehicles in the first
year of their life).
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The diminishing/reducing balance

method
percentage rate of depreciation =
The

1 - ( Cost x 100)

The annual depreciation expense/charge to the

income statement account =
Rate x WDV at the start of the year

This gives a decreasing annual amount of

depreciation over the assets useful life.
34

Arguments for the reducing balance

method
FOR:
1. It is most appropriate for assets that deteriorate as a result of
usage where this is greater in earlier years (e.g. plant &
machinery, motor vehicles, office equipment).
2. It may also be suitable where the utilization is the same in
each year. The decreasing annual depreciation combined with
increasing repair costs give a relatively constant combined
annual charge.
3. It gives a more realistic approximation of the reduction in
resale value.
AGAINST:
4. It contains an arbitrary assumption about the rate of decline.
5. It is relatively complex.

35

Example: Computation of depreciation

Plant and machinery that was bought on the 1
January 20X3 at a cost of RM1,000, has an
expected useful economic life of 3 years, and an
estimated residual value of RM343.
Straight line method:
Reducing balance method:

36

Accumulated depreciation/
Provision of depreciation

The total amount of depreciation charged to

date, which is recorded in the balance sheet
and deducted from the respective NCA to
arrive at their carrying amounts.
Carrying amount is the amount at which an asset is
recognised after deducting any accumulated depreciation
and accumulated impairment losses.

37

The ledger entries for annual

depreciation
Debit
Depreciation expense account
Credit Accumulated depreciation account

Depreciation is an income statement item

Accumulated depreciation is a balance sheet item

38

Balance sheet presentation:

Accumulated depreciation
ABC Enterprise
Balance sheet extract as at 31 December 20x3
Non-current assets
Plant & machinery
Less: accumulated depreciation
Carrying amount

39