Unit 4

Adjustments
Overview
In this unit we will look at some of the adjustments that may have to be made to the accounts of a firm before its final accounting statements can be prepared. First we will review the accounting treatment of accrued and prepaid expenses and income, then move on to review the effects of bad debts and the recovery of bad debts. The unit concludes with the adjustments to be made to the accounts when the firm makes a provision for bad debts.

Objectives
After reading the unit text and completing the supplementary learning activities, you will be able to: 1. 2. 3. 4. 5. 6. 7. Distinguish between accrued revenue and accrued expenses Distinguish between prepaid income and prepaid expenses Adjust appropriate accounts for accruals and prepayments Define the term bad debt Adjust the accounts to reflect bad debts Adjust the accounts to reflect the recovery of bad debts Differentiate between the bad debts account and the provision for bad debts account 8. Make provision for doubtful debts

83

84

Session

1
Accruals and Prepayments
Introduction
So far, we have been following the accounting cycle which we introduced in unit 2. We have examined how to collect data from source documents, record and post accounting information in the books of the business and prepare the unadjusted trial balance. The next step in the accounting cycle is to make adjustments to the accounts. These adjustments are usually made at the end of the firms financial or accounting year. We will start our discussion about these adjustments by looking at accrued and prepaid income and expenses. Accruals and prepayments are based on the accrual concept. The accrual concept states that income and expenses should be taken into account when they are incurred, not when they are actually paid. Accrued income and expenses are therefore those which are paid for after they are incurred in an accounting period. Prepaid income and expenses are paid before they are incurred in an accounting period.

If you own an apartment building, and the rent on each unit is $200 per month, at the end of the year you would have collected $2,000 in rent from one apartment. In your income account you would record an amount of $2,400, even though the entire amount has not yet been received from the tenant. Any amount that remains unpaid by the tenant at the end of the year is referred to as accrued income. We will now explore accrued expenses and income in more detail.

Accrued Expenses
An accrued expense is one that is incurred in one financial accounting period, but not paid within that same financial period. The accrual principle of accounts states that once an expense is incurred in an account period, the

85

entire amount must be charged against the income of that period even though the cash has not actually been paid out. Since the expense was incurred in earning the income for that period, it cannot be deferred to the accounting period in which it will actually be paid. Lets look at an example. Blacks Grocery Shop pays the electricity bill on a quarterly basis. During the financial year ending December 31, 1995, the following payments were made: Mar 31 Jun 30 Sep 30 $1,500 1,500 1,500

The bill of $1,500 for the quarter ending December 31, was not received until January 2 of the following year, and therefore was not paid at the end of the financial year. Here is how this would be reflected in the accounts. Blacks Grocery Shop Electricity A/C
Details Bank Bank Bank Bal c/d F $ 1,500 1,500 1,500 1,500 6,000 6,000 Date 31/12/95 Details Profit & Loss F

Dr Date 31/3/95 30/6/95 30/9/95 31/12/95

Cr $ 6,000

2/1/96

Bal b/d

1,500

Blacks Grocery Shop Profit & Loss (Extract) For Year Ending Dec 31, 1995 Dr $ 6,000 Cr

Electricity

Blacks Grocery Shop Balance Sheet (Extract) As at Dec 31, 1995 $ Current Liabilities: Accrued Electricity 1,500

86

As seen in the Profit and Loss (P & L) extract above, even though $4,500 was actually paid for electricity, the charge against the profit and loss account for that period is the entire $6,000; that is, the amount incurred over the one year period. The amount owing of $1,500, an accrued expense, is shown as a current liability in the balance sheet.

Accrued Income
If income earned for a financial period is not received at the end of the period, it is referred to as accrued income. At the end of the financial year, the income owing is added to the income actually received to show the true income earned for the period. Here is an example. Blacks Grocery Shop owns property and rents a part of it for $9,600 per year. Rent is collected on a quarterly basis. During the year 1996, the following amounts were collected: Mar 31 Jun 30 Sep 30 $2,400 2,400 2,400

However, rent for the quarter ending December 31, 1996 was still outstanding at that date. Lets look at the accounts.

Blacks Grocery Shop Rental Income A/C

Dr Date 31/12/96 Particulars Profit & Loss $ 9,600 Date 31/3/96 30/6/96 30/9/96 31/12/96 9,600 2/1/97 Bal b/d 2,400 Particulars Bank Bank Bank Bal c/d $ 2,400 2,400 2,400 2,400 9,600 Cr

Blacks Grocery Shop Profit & Loss (Extract) For Year Ending Dec 31, 1996 Dr Rental Income $ 9,600 Cr

87

Blacks Grocery Shop Balance Sheet (Extract) As at Dec 31, 1996 $ Current Assets: Accrued Rental Income 2,400

From the P & L extract, you can see that the entire $9,600 of rental income for the year is credited to the P & L account. This will be added to the gross profit. Note that the income still owed, that is, the accrued income, is reflected as a current asset in the balance sheet.

Prepayments
It is possible for income and expenses to be paid before a good or service is received. These advance payments are called prepayments when they are paid in one accounting period but when the good or service will not be provided until a subsequent accounting period. Prepayments, therefore, must not be reflected in the profit and loss account of the period in which they were made. They must be carried forward to the accounting period to which they relate.

Prepaid Expenses
Prepaid expenses are expenses paid in advance. Usually the amount is paid in an accounting period for a service that will not be received until a subsequent accounting period. This means that although payment is made in the present accounting period, the expense is recorded as if it belongs to another accounting period. For example, Blacks Grocery Shop advertises in the lobby of a downtown cinema. The advertising space costs $1,000 per month. Blacks financial year ends on December 31, 1995 and at that time, the firm had made payments of $15,000 to the cinema. The accounts of Blacks Grocery Shop would look like this: Blacks Grocery Shop Advertising A/C
Particulars Bank $ 15,000 Date 31/12/95 " 15,000 Particulars Profit & Loss Bal c/d $ 12,000 3,000 15,000

Dr Date 31/3/95

Cr

2/1/96

Bal b/d

3,000

88

As with the previous examples, the advertising charge for the period would be shown in the P & L account as $12,000 for the year from January 1, 1995 to December 31, 1995. The excess or the prepaid expense of $3,000 will appear in the balance sheet as a current asset, as this amount is owing to Blacks Grocery Shop.

Prepaid Income
Prepaid income is income received in the current accounting period for services to be rendered or goods to be received in a future accounting period. But the revenue is only taken into account in the period in which the service is rendered or the goods received. For example, for the period ending December 31, 1996, Blacks Grocery Shop received $40,000 from a tenant. The annual rental, however, is only $36,000. The accounts will look like this:

Blacks Grocery Shop Rental Income A/C

Dr Date 31/12/95 31/12/96 Particulars Profit & Loss Bal c/d $ 36,000 4,000 40,000 40,000 Date 31/12/96 Particulars Bank $ 40,000 Cr

2/1/97

Bal b/d

4,000

Note that only the $36,000 is actually credited to the P & L account as this reflects the rental income earned for the period. The balance of $4,000 would be shown in the balance sheet as a current liability, as it is owed to the tenant.

Activity 4.1 Accruals and Prepayments

1. What is the difference between accrued income and accrued expense? Provide an example of each. What is the difference between prepaid income and prepaid expense? Again, provide an example of each. Using your examples from (1) and (2) above, post these transactions in the appropriate accounts and make entries into the profit and loss account and balance sheet extracts.

2.

3.

89

90

Session

2
Bad Debts
Many businesses use short term credit to increase the sale of goods and services. The provision of credit requires that customers who purchase goods and services pay for them at some later date. When credit is provided for customers, the business does not only produce income in the form of sales but also creates an asset in the form of debts or accounts receivables. However, the business may not be able to collect from all its customers who have purchased on credit. After all efforts at collection have failed, these debts are deemed to be bad. When a debt is classified as bad, the business has to bear a trading loss. This is because when the goods were sold on credit, the revenue generated was recorded in the books of the business. When these debts cannot be collected, the revenue is not realised, and the profits expected for the particular period have to be reduced. When accounting for bad debts, we transfer the bad debt from the debtors account or accounts receivables account to a bad debts account. At the end of the accounting period, the bad debts account is closed off to the profit and loss account to reflect the trading loss. In other words, writing off a bad debt represents an expense to the business. The accounting entries in the general journal would appear like this: 1. To transfer the bad debt from the debtors account to the bad debts account: DR bad debts account CR debtors account/accounts receivables account 2. To close off the bad debts account to the profit and loss account: DR profit and loss account CR bad debts account Here is an example. On March 31, 1997, the end of Berts Supermarkets financial year, it was decided to write off the debt of Miss. A. Lee who had an amount of $6,590 outstanding for over two years. The accounts in the books of Berts would appear as follows:

91

Dr Date 1/4/96 Details Bal b/f $ 6,590

A. Lee Date 31/3/97 Details Bad Debts

Cr $ 6,590

Dr Date 31/3/97 Details A. Lee $ 6,590

Bad Debts Date 31/3/97 Details P&L

Cr $ 6,590

Dr

Profit and Loss (Extract) for the year ended Mar. 31, 1997 $6,590

Cr

Bad Debts

Note that once the debtors account is credited with the bad debt that has been written off, it has the effect of reducing the total debtors figure shown in the trial balance and balance sheet.

Bad Debts Recovered

A bad debt is recovered when a debt that was previously written off as bad is now being collected. The collection of this debt represents income to the business and is reflected in the income statement. The accounting treatment of such an event can take one of two forms. Method 1 Some businesses may undertake to reinstate in their books the debt that was previously written off as bad, or the amount paid in settlement of the debt. This method would require the creation of a bad debts recovered account, which is an income account as well as an account for the debtor. If this method is used, then the following entries would apply. (a) DR debtors account/accounts receivables account CR bad debts recovered account With the amount of the debt recovered, this reinstates the debt in the books of the business. (b) DR cash or bank account CR debtors account

92

With the amount paid, this will have the effect of closing off the debtors account. (c) DR bad debts recovered account CR profit and loss account This will close off the bad debt recovered account to the profit and loss account at the end of the accounting period. The following example shows how the accounts would look if method 1 were used. Perkins & Co. wrote off the debt of Mr. P. Anderson on December 31, 1994, at the end of the companys financial year. On November 25, 1996, Mr. Anderson, who had owed the firm $4,500, paid $3,750 in settlement of the debt. The accounting entries of the debt as reinstated are shown below in the books of Perkins & Co.: Dr Date 25/11/96 Details Bad Debts Recovered P. Anderson $ 3,750 Date 25/11/96 Details Cash Cr $ 3,750

Dr Date 31/12/96 Details P&L

Bad Debts Recovered $ 3,750 Date 25/11/96 Details P. Anderson

Cr $ 3,750

Dr

Profit and Loss (Extract) for the year ended Dec. 31, 1996 $3,750

Cr

Bad Debts Recovered

Method 2 If the business does not wish to reinstate the debt on its books, then the following entries would be made when a bad debt is recovered. (a) DR cash or bank account CR bad debts recovered account

93

The accounts are debited and credited with the amount received in settlement of the debt that was previously written off. (b) DR bad debts recovered account CR profit and loss account This closes off the bad debt recovered account and credits the profit and loss account at the end of the accounting period. The accounts would appear as follows if method 2 were used.

Dr Date 31/12/96 Details P&L

Bad Debts Recovered $ 3,750 Date 25/11/96 Details Cash

Cr $ 3,750

Dr

Profit and Loss (Extract) for the year ended Dec. 31, 1996 Bad Debts Recovered

Cr $3,750

Activity 4.2 Bad Debts and Recovery of Bad Debts

1. 2. 3. 4. 5. What is a bad debt? How are bad debts that are written off reflected in the accounts of a business? How would bad debts affect the financial statements of a firm? How are bad debts that are recovered shown in the accounts of a business? How would bad debts that are recovered affect the financial statements of a firm?

94

Session

3
Bad Debts Provision
A provision for bad debt is usually made in respect of a debt, the recovery of which is doubtful. The bad debt provision may be specific, that is, related to a particular debt, or it may be general and not based on any particular debt but rather on a historical percentage of debtors, after bad debts have been written off. An aged list of balances relating to debtors may be a useful guide in determining the provision for bad debts. An aged schedule of debtors/accounts receivables is a listing of the debtors of the firm, ordered alphabetically, along with the amount owed by each debtor. The amount owed is categorised by the length of time, usually expressed in days, that these debts have been outstanding or unpaid. Below is an example of an aged schedule of accounts receivables for Blacks Grocery Shop. Name Total 0-30 days 31-60 days $ $ 650 2,000 730 800 2,300 $ 3,830 61-90 days $ 1,020 1,740 990 $ 3,750 $3,570 1,120 $4,690 Over 90 days

Acme Co. L. Barrett P. Chin D. Francis N. Howe

$ 1,750 650 4,540 3,570 10,300 $20,810

5,890 $ 8,540

It is usually assumed that the older the debt, the more likely it is that it will remain outstanding in the future. Therefore, when the provision for doubtful debts is based on an aged schedule, the younger debts will have a smaller percentage going to the provision in comparison to older debts. For example, Blacks may estimate that only 1% of debts aged between 31 and 60 days will go bad in the future, compared with an estimate that 50% of debts older than 90 days will remain unpaid in the future. The provision for bad debts is used to keep the accounting for bad debts more in alignment with the accrual concept. This is because revenue earned in a period is matched against possible losses of that same revenue within the same period. It should be noted that the provision for bad debts is a trading expense, like bad debts. The two, however, are different transactions. A bad debt account records the removal of debts which are known to be unrecoverable at present, while the provision for bad debts account records a provision for debts which are likely to become unrecoverable in the future.

95

When accounting for the provision of bad debts, the entire amount that is to be provided for doubtful debts must be determined each year. In the first year of the provision, the accounting entries will reflect the total sum provided, while in subsequent years the accounting entries will reflect the difference between the total provision of the current year and the prior year. Note that the provision for doubtful debts is based on the total trade debtors amount after writing off any bad debts. Lets look at another example. A firm has provided for doubtful debts over a three year period on the following basis: Year 1: the provision is to be 5% of debtors ($50,000) = $2,500 Year 2: the provision is to be $2,800 Year 3: the provision is to be $2,000 The accounting entries will be: (a) In the first year of the provision, the accounting entries will show the total amount provided. DR CR (b) Profit & Loss account Bad Debts Provision account $2,500 $2,500

As the provision for bad debts account would already have a balance on it, only the amount needed to increase the provision will be shown in the accounting entries for the second year. In the second year of the provision, it has moved from $2,500 to $2,800. This indicates that the provision has increased by $300 from the first year to the second year. DR CR Profit & Loss account Bad Debts Provision account $300 $300

(c)

In year 3, the provision for bad debts shows a reduction of $800 over that of the second year. When the provision is decreased, the accounting entries will differ from those in (a) and (b). DR CR Bad Debts Provision account Profit & Loss account $800 $800

At the end of the accounting period, the balance on the provision for bad debts account will be carried forward to the next accounting period. It is not closed off to the P & L account. The expense for the provision for doubtful debts is charged to the P & L account when the provision account is credited and the P & L account is debited. On the balance sheet, the balance on the bad debts provision account will be used to reduce the value of debtors. The balance sheet will therefore show a net figure for debtors which is the difference of the total of all debtors account and the balance on the provision for bad debts account.

96

Note that the individual debtors accounts are not affected by the provision for doubtful debts. This is because a provision is made for debts which may become uncollectible in the future but which at present cannot be termed bad. Assuming that the firms financial year ends on June 30, the accounts for the above example are now shown as follows: Dr Date 30/6/95 30/6/96 Details Bal c/d Bal c/d Provision for Bad Debts $ 2,500 2,800 2,800 30/6/97 30/6/97 P&L Bal c/d 800 2,000 2,800 1/7/96 1/7/97 Bal b/d Bal b/d Date 30/6/95 1/7/95 30/6/96 Cr Details P&L Bal b/d P&L $ 2,500 2,500 300 2,800 2,800 2,800 2,000

Dr 1995 1996

Profit and Loss (Extract) for year ended June 30 Bad Debts Prov. Bad Debts Prov. $2,500 300 1997 Bad Debts Prov.

Cr

$800

Here is the balance sheet extract at the end of the first year:

Balance Sheet (Extract) as at June 30, 1995

$ CURRENT ASSETS Total Debtors Less Bad Debt Prov. Net Debtors 50,000 2,500 47,500 $

97

Activity 4.3 Provision for Bad Debts

1. 2. Why would a firm create a provision for doubtful debts? Why is the provision for bad debts based on the total trade debtors figure after writing off any bad debts? At the end of Electronic & Computers Ltd.s financial year, it is owed $1,591,000 by trade debtors. The following is the aged accounts receivables schedule of the firm as at April 30, 1997, along with the percentage of the debts that are not expected to be collectable in the future. Percentage for Provision 0% 0.5 1 3 8 15

3.

Age of Debt 0 - 30 days 31 - 60 days 61 - 90 days 91 -180 days 181- 360 days over 360 days

Amount $ 540,000 420,000 295,000 146,000 103,000 87,000 $1,591,000

(a) What would the balance in the provision for doubtful debts be as on April 30, 1997? (b) At the beginning of the financial year (May 1, 1996) the balance on the provision account was $27,840. How would the provision for doubtful debts and the profit and loss accounts be affected based on your answer to (a) above? (c) Based on your answer to (a) above, how would the provision for doubtful debts and profit and loss accounts be affected if the provision account had a balance of $33,960 as on May 1, 1996?

Practice Exercises
1. How are the following items treated in the income statement and balance sheet: (a) accrued income (b) prepaid income 2. (c) accrued expenses (d) prepaid expenses

Soils Ltd. owed $2,850 for electricity on January 1, 1995. During the year, the company was billed $27,810 for electricity, while it paid $28,320 over the same period. Prepare the electricity account and extracts of the Profit and Loss Account and Balance Sheet as at December 31, 1995.

98

3.

Rolls Cigarette Co. rents office space. During the financial year ended June 30, 1987, the company paid $16,800 for rent. The monthly rental charge is $1,200 per month. Prepare the rent account and extracts of the Profit and Loss Account and Balance Sheet as at June 30, 1987. The Fernando Sports Complex rents advertising space along its football field. On October 1, 1995 the advertising account had a debit balance of $64,050 and a credit balance of $25,620. During the year ended September 30, 1996, Fernando Sports Complex received $775,630 for advertising income. The advertising account had debit and credit balances of $67,950 and $14,590 respectively at the end of the financial year. Prepare the advertising account showing the income earned for the year and extracts of the Profit and Loss Account and Balance Sheet at September 30, 1996. Describe two methods used to account for the recovery of bad debts. What is an aged schedule of debtors? How is this schedule used in determining the provision for doubtful debts? Compare and contrast the accounting for bad debts and the provision of bad debts. Mart operates a butcher shop and his financial year ends on March 31. On April 1, 1992, the balance on the provision for doubtful debts account amounted to $3,940. The provision is based on 8% of trade debtors outstanding at the end of the accounting year. On March 31, 1993, total trade debts amounted to $67,850, of which $5,350 could not be collected and are to be written off. Prepare the bad debts and provision for doubtful debts accounts as well as extracts of the Profit and Loss Account and Balance Sheet as on March 31, 1993. Toni Stone, a caterer, is having her accounts prepared for the financial year ended June 30, 1990. Total trade debtors at that date amounted to $328,300. Based on an aged schedule of debtors her accountants have advised her to write off debts totalling $16,800. At the beginning of the financial year, the balance of the provision for bad debts account was $34,470 and the provision is based on 5% of debtors. Toni was able to collect $9,360 on August 16, 1989 from D. Deslandes, whose debt had been written off in a prior financial period. Prepare, in the books of Toni Stone, the following accounts: (a) D. Deslandes (b) Bad debts recovered (c) Bad debts (d) Provision for doubtful debts (e) Profit and loss extract (f) Balance sheet extract

4.

5. 6.

7.

8.

9.

99

10. You are given the following information for Shop Bahamas for the year ended June 30, 1995: Trade debtors at July 1, 1994 $40,000 Trade debtors at June 30, 1995 (including $6,000 of bad debts) 66,000 Provision for doubtful debts at July 1, 1994 2,000 It is the policy of Shop Bahamas to maintain a provision for bad debt that is equivalent to 5% of the trade debtors at the end of the year. (a) Prepare the trade debtors, bad debts and provision for doubtful debts accounts. The Profit and Loss Extract for the year ended June 30, 1995, and a Balance Sheet Extract as at that date.

(b)

11. Vincent Montego, who operates a grocery store, gives credit to some of his customers. He makes a provision of 3% per annum of the total debtors. On January 2, 1993, and at December 31, 1993 debtors owed $106,800 and $98,400 respectively. Montego is to write off $2,100 in bad debts. He receives $900 from C. Wynter, a debtor whose firm went into receivership three years ago. Prepare the bad debts, provision for bad debts and the bad debts recovered accounts as well as extracts of final accounting statements at December 31, 1993 to reflect the above transactions.

100