CHAPTER 4

End of period
adjustments and
Depreciation

LEARNING
OBJECTIVES
1. Describe the difference between the cash basis
and the accrual basis of measuring profit
2. Explain the accounting cycle and the need for
end-of-accounting-period adjusting entries
3. Identify and prepare the different types of
adjusting entries
4. Explain the nature of property, plant and
equipment
5. Compute the cost of property, plant and
equipment
6. Discuss the nature of depreciation and
2
determine the amount of depreciation
expense

MEASUREMENT OF
PROFIT
Cash Basis
Income is recorded when cash is received
Expenses are recorded when cash is paid

Accrual Basis
Income recognised when the anticipated
inflow of economic benefit can be reliably
measured
Expenses recognised when the
consumption of benefits can be reliably
measured
3

TEMPORARY AND
PERMANENT ACCOUNTS
Temporary (Nominal) Accounts
Income Statement Accounts
Reduced to zero balance at the end
of each accounting period (closed)
Reset the business stopwatch

Permanent (Real) Accounts

Balance Sheet Accounts
Ending balances carried forward to next
accounting period
4

EXPANDED ACCOUNTING CYCLE

INCLUDING ADJUSTING ENTRIES
1. Recognise & record
transactions

Source
documents

2. Journalise
transaction

General journal

3. Post to ledger
accounts

General ledger

4. Prepare unadjusted
trial balance of
general ledger

Trial balance
(unadjusted)

Continued Next Slide

EXPANDED ACCOUNTING CYCLE

INCLUDING ADJUSTING ENTRIES
5. Determine adjusting
entries and
journalise

General journal

6. Post adjusting
entries to general
ledger

General ledger
(Accounts
Adjusted)
Trial balance
(Adjusted)

7. Prepare adjusted
trial balance
8. Prepare financial
statements

Wor
ksh
eet

Financial
Statements
6

THE NEED FOR

ADJUSTING ENTRIES
In many cases the period in which cash is
paid or received does not coincide with
period in which expense and income are
recognised
Therefore, in order for our statements to
reflect what has actually happened, some
accounts must be adjusted on the last day
of the accounting period to correctly
recognise income and expenses not
reflected in cash receipts or payments
7

CLASSIFICATION OF
ADJUSTING ENTRIES
Deferrals
(Prepayme
nts)
Accruals
(Unrecorde
d)

Prepaid
Expense

Unearned
Revenue

Costs/expenses paid
before they are
consumed

Revenues that are

collected or received
but not yet earned

Accrued
Expense

Accrued
Revenue

Expenses incurred
but not yet paid

Revenue earned but

not yet received

THE RULES OF
ADJUSTING ENTRIES
Attempting to account for the timing
difference between receipt/payment of
cash, and recognition of income/expense
One side of the entry affects an income
statement account
That is revenue or expense

The other side of the entry affects an

account reported in the balance sheet
That is asset or liability

Cash is never adjusted!

9

ADJUSTING ENTRIES
Revenue
Unearned
revenue

Accrued revenue

Revenues collected in
advance, but not yet
earned
e.g. magazine
subscription received in
advance

$$$
Last Year

Revenue

Revenues earned, but not

yet received in cash or
entered
e.g. interest earned on a
bank term deposit but not
paid

Revenue

Current Year

$$$
Next Year

ADJUSTING ENTRIES
Expenses
Prepaid expenses

Accrued expenses

Expenses paid for before

they are consumed
e.g. Insurance premium
paid 12 months in advance

Expenses incurred, but

not yet paid for or entered
e.g. wages earned by
employees, but not yet
paid

$$$
Last Year

Expense

Expense

Current Year

$$$
Next Year

DEFERRALS: PREPAID
EXPENSES
Cash paid before benefits are
consumed/expire
Initially recorded as an asset when
paid
At ASSET
the ACCOUNT
end of the period
the
EXPENSE
ACCOUNT
Prepaid Expense
amount
consumed/expired is
Initial Cost
Adjusting
Adjusting
expensed.
Debit
Entry
Entry
Credit

Debit

Costs consumed or expired

12

EXAMPLE: PREPAID
RENT
On 1 June the following entry was
made to record rent covering the a
period of 3 months:
General Journal
Jun 5 Prepaid Rent

1 200

GST Outlays

120

Cash at Bank

1 320

(Payment of rent for 3 months)

13

EXAMPLE: PREPAID
RENT
On 30 June only one month of rent
has expired ($1,200 3 months =
$400)
General Journal
Jun 30 Rent Expense

400

Prepaid Rent

400

(Adjusting entry for rent)

Prepaid Rent
Initial Entry
1 200

Adjusting
Entry
400

Rent Expense
Adjusting
Entry
400

Costs expired and allocated to current

14period

EXAMPLE:
DEPRECIATION
Depreciation = Allocation of the historic cost
of an asset (less any residual) over the useful
lifeNon-Current
of that asset
Asset
Initial Cost
Debit
Contra-Asset Account
Accumulated
Depreciation
Adjusting
Entry
Credit

Depreciation Expense
Adjusting
Entry
Debit

Costs consumed and allocated

15
to current period

DEFERRALS:
UNEARNED REVENUE
Cash received in advance for
services that are to be preformed
in the future
Initially recorded as liability when
received
LIABILITY ACCOUNT
INCOME ACCOUNT
Unearned Revenue
Recognised
Adjusting
as revenue as earned
Adjusting
Entry
Debit

Cash Receipt

Entry
Credit

Revenue earned during the current period

16

EXAMPLE:
SUBSCRIPTIONS
On 8 September a monthly
magazine publisher received $264
for a 1 year subscription beginning
October
General Journal
Sept 8 Cash at Bank

264

GST Collections

24

Unearned Subscription
Revenue

240

(Receipt of subscriptions in
advance)
17

EXAMPLE:
SUBSCRIPTIONS
On 31 December 3 months of
revenue has been earned (3/12 x
$240 = $60)General Journal
Dec Unearned Subscriptions Revenue
31

60

Subscriptions Revenue

60

(Adjusting entry for subscriptions

Subscriptions Revenue
Unearnedearned)
Subscriptions
Revenue
Adjusting
Entry
Adjusting
Cash
60
Entry
240
60
Revenue earned during the current period
18

ACCRUALS: ACCRUED
EXPENSES
Expenses that have been
consumed but payment has not
yet been made
Expense must be recognised along
with
a liability
for future
payment
LIABILITY
ACCOUNT
EXPENSE ACCOUNT
Expense Payable

Adjusting
Entry
Credit

Adjusting
Entry
Debit

Expenses Incurred
19

EXAMPLE: ACCRUED
SALARIES

20

EXAMPLE: ACCRUED
SALARIES
On 30 June an adjusting entry is
required to correctly determine
Junes expenses
General Journal
Jun 30 Salaries Expense

3 980

Salaries Payable

3 980

(Adjusting entry for salaries

payable)
Salaries Expense
Salaries Payable
Adjusting
Entry
3 980

Adjusting
Entry
3 980

Expenses Incurred

21

EXAMPLE: ACCRUED
SALARIES
The liability is eliminated on 6 July
when the next payment is made to
employees
General Journal
Jul 6 Salaries Payable
Salaries Expense

3 980
3 420

Cash at Bank

7 400

(Payment of salaries earned 23

June
to 6 July)
22

ACCRUALS: ACCRUED
REVENUE
Usually recorded when service is
performed
No adjusting entry would be necessary

Any unrecorded revenue earned

needs
to be recorded INCOME ACCOUNT
ASSET ACCOUNT
Accounts Receivable

Revenue

Adjusting
Entry
Debit
Revenue earned but not yet received

Adjusting
Entry
Credit

EXAMPLE: MARKET
SERVICES
On 1 June an agreement was
signed to provide marketing
services for a monthly fee of $800.
On 30 June cash is yet to be
received and no invoice has been
General Journal
issued
Jun 30 Accounts Receivable

800

Marketing Services Revenue

800

(Marketing services fee

receivable for June)
24

Now try the 4 journal

entries
1. Wages earned by employees but not paid at year-end,
$3100.
2. Depreciation on vehicles not recorded, $8000.
3. Rental revenue earned but not collected or recorded, $840.
4. The company requires the first-day rental in advance as a
deposit for making a reservation. The deposit is either
deducted from the total rental charges or is forfeited. During
the last week of December, deposits earned were not
recorded as revenue, $550.
25

Solution
1. Wages Expense 3 100
Wages Payable 3 100
Wages owing to employees

2. Depreciation Expense - Vehicles 8 000

Accum. Depreciation - Vehicles 8 000
Depreciation on vehicles

3. Accounts Receivable 840

Rental Revenue 840
Rent revenue earned

4. Unearned Rental Revenue 550

Rental Revenue 550
Rent deposits in advance earned
26

WHAT IS PROPERTY,
PLANT AND EQUIPMENT?
Any asset with physical substance that
is expected to be used over more
than 1 year
Because future economic benefit of
property, plant and equipment will be
received over 2 or more accounting
periods
Depreciable amount must be
allocated in a systematic manner
over useful life to measure 27

DETERMINING COST OF
PROPERTY, PLANT AND
EQUIPMENT
Must be accounted for at cost
The amount of cash or the fair value of other
consideration given to acquire an asset

Cost includes
Purchase price
Any directly attributable costs such as transport,
installation, testing the equipment
Also initial costs of insurance and registration (car)
Estimate of costs of dismantling, removing and
restoring
28

EXAMPLE DETERMINING
COST OF PROPERTY, PLANT
AND EQUIPMENT

example the buyer has been given various amounts for the
ase of the machine. Eg the RRP (list price), his special discou
discount), and ALWAYS eliminate the GST if it is included
machine cost.
List price of the machine

$22 000

Less: Trade discount (10% x $22

000)

2 200
19 800

Less: GST (1/11)

- 1 800

Purchase price

18 000

Freight inwards (net of GST)

Installations costs (net of GST)

Cost of machine

29

820
+
675

$19 495

SUBSEQUENT COSTS
How do we treat costs incurred after we
have purchased or used the asset?
Repairs to the asset are expensed
Maintenance costs are expensed
Improvement costs can be capitalised-an
asset
Modification costs can be capitalised- an asset
When making the decision we need to
consider the impact on useful life/future
economic benefits of the asset
30

DEPRECIATION
Nature of depreciation
Expected usage
Expected wear and tear
Technical and commercial obsolescence
Legal or similar limits

Cost needs to be apportioned over

expected useful life

31

Depreciation
Factors in computing depreciation

32

Depreciation methods
1. Straight-line method
Allocates and equal amount of
depreciation to each full
accounting period in assets
useful life
Annual depreciation = depreciable
amount*
useful life
* Depreciable amount is cost33less

EXAMPLE
STRAIGHT-LINE METHOD
On 1 July, assume a machine has a cost of
$33 000 (net of GST), a residual value of
$3000, and a useful life of 4 years.
Annual
Depreciation

Depreciable
amount
Useful life
$33 000 - $3
000

=
General Journal
4 years
Jun 30 Depreciation Expense
=

$7 500 p.a. 7 500

Accumulated Depreciation
Machine

7 500
34

Depreciation methods
continued

2. Diminishing-balance method
Results in decreasing depreciation
charge over the useful life of the
asset
Asset more productive in its earlier
years and earns more revenue

r
Rate 1 n
c

n = useful life in years

r = residual value (in $)
c = original cost or gross revalued amt (in $)
35

EXAMPLE
DIMINISHING-BALANCE METHOD
On 1 July, assume a machine has a cost of
$33 000 (net of GST), a residual value of
$3000, and a useful life of 4 years.

Ye
ar

=1-

Carrying
amount at
beginning
of the year

Annual
deprecia
Rat
tion
e
expense

$33 000 x

45
%

18 150 x

45

$14 850

Carryin
g
amount
at end
of year
18 150

8 168 36 9 982

Depreciation methods
continued

3. Sum-of-years digits
Different way of applying
diminishing value method
Depreciation each period is
determined by multiplying the
residual amount by
successively smaller fractions

37

EXAMPLE
SUM-OF-YEARS-DIGITS METHOD
On 1 July, assume a machine has a cost of
$33 000 (net of GST), a residual value of
$3000, and a useful life of 4 years.

Ye
ar

Deprecia
ble
amount

Fracti
on

Total
Annual accumula
deprecia
ted
tion
deprecia
expense
tion

Carrying
amount

$30 000 x

4/10

$12 000

$12 000

$21 000

30 000 x

3/10

9 000

21 000

12 000

30 000 x

2/10

6 000

2738
000

6 000

Depreciation methods
continued

4. Units-of-production method
Determines fixed amount of
depreciation per unit of output
Annual depreciation is
depreciable amount divided by
the production capacity or
useful life in units
Depreciation per = depreciable amount
operating hr
operating
hours
39

EXAMPLE
UNITS-OF-PRODUCTION
METHOD
On 1 July, assume a machine has a cost of
$33 000 (net of GST), a residual value of
$3000, and a useful life of 15 000 hours.

Annual
Depreciation

Depreciable
amount
Operating hours

$33 000 - $3
000
15 000 hours

$2 per hour
40

DEPRECIATION ISSUES
All methods will show the same total
depreciation expense over life of the asset
However each method will show different
annual charges
The method used should reflect the nature of
the underlying asset
Residual values and useful lives should be
reviewed every few years
Depreciation is an estimate and does not
equal cash!
41