CHAPTER ELEVEN END OF PERIOD ADJUSTMENT

11.0 Learning Objectives………………………………………………………………..
11.1 Introduction………………………………………………………………………..
11.2 Deferred Revenue and Prepayments……………………………………………….
11.3 Accrued Expenses………………………………………………………………….
11.4 Accrued Revenue………………………………………………………………….
11.5 Other Adjustments…………………………………………………………………
11.5.1 Depreciation Expenses……………………………………………………………
11.5.2 Bad Debts…………………………………………………………………………
11.5.3 Provision for Doubtful Debts………………………………………………………
11.5.4 Bad Debt Recovered……………………………………………………………….
11.5.5 Provision for Discount on Trade Receivables……………………………………..
11.6 Summary………………………………………………………………………….



CHAPTER ELEVEN

END OF PERIOD ADJUSTMENTS

11.0  Learning Objectives
After you have studied this chapter, you should be able to:
• Differentiate between capital expenditure and revenue expenditure
• Explain the effect on profit if a revenue expenditure has been wrongly
classified as a capital expenditure, and vice versa
• Explain prepayments and accruals
• Pass adjusting entries in respect of prepayment and accruals
• Explain and pass entries in respect of bad debts and provision for doubtful debts
• Record increases and decreases in the provision for doubtful debts
• Calculate and make entries with respect to provisions for discount on receivables and creditors
Prepare Income statement and statement of financial position (extracts) showing the treatment of bad debts provision for doubtful debts, depreciation and provision for discount on trade receivables and payables and provision for doubtful debts, depreciation and provision for discount on trade receivables and payables

11.1  Introduction
Many changes in a company’s economic resources and obligations occur continuously. For example, interest accrues daily on debts, as does rent expense on an office building. Other resources and obligations such as employee salaries originate as service is rendered, with payment to follow at specified dates. The end of the accounting period generally does not coincide with the receipts or payment of cash associated with all the types of resource changes. Adjusting entries are therefore, used to record such resource changes to ensure the accuracy of the financial statements. This chapter will consider some of the adjustments most commonly used in the preparation of the final accounts.  As well as discussing why such adjustments are required, their treatment in both the Income statement and statement of financial position will be reviewed in detail.
Accountants rely on two principles in the adjusting process – revenue recognition and matching principles. The revenue recognition concept requires that revenue be reported when earned, not before and not after. Revenue is earned for most firms when services and products are delivered to customers. If a firm sells goods in 2003 to a customer, the revenue was earned in 2003 and as such should be reported in the 2003 Income statement, even if the customer paid for the goods in a period other than 2003.
The matching principle aims to report expenses in the same accounting period as the revenues that are earned as a result of incurring these expenses. The matching of expenses with revenue is a major part of the adjusting process. As an example if a business earns monthly revenue while operating out of rented store space, the matching concept stipulates that rent must be reported on the income statement for December, even if rent is paid in a month either before or after December. This ensures that the rent expense for December is matched with December revenue.
At the end of an accounting period it is likely that an organization will find that some expenses have been paid which relate to the next accounting period, whilst other amounts, which relate to the current period remain outstanding. In order that the account shows a true and fair view of the firm’s financial performance, adjustments for such items are necessary.  Adjustments are classified into three categories:
(1) Deferrals and prepayments
(2) Accruals
(3) Other adjustments

11.2  Deferred Revenue and Prepayments
Deferrals or prepayments refer to transactions where cash is paid or received before a related expense or revenue is recognized.  These transactions are recorded when cash is paid for expenses that apply to more than one accounting period or when cash is received for revenue that relates to more than one accounting period.  The portion of the expense or revenue that applies to the future periods is deferred as a prepaid expense (asset) or unearned revenue (liability).  If we do not make adjustments for prepayments and unearned revenues, profit for the current period will be understated or overstated respectively. Items, which normally need to be prepaid, include rates, insurance and road licensing fee.
The accounting entry requires the prepayment to reduce the relevant expense in the Income statement thereby increasing profit.  The same applies to the unearned revenue, where the adjusting entry reduces the relevant revenue in the Income statement thereby increasing profit.  Since conceptually the prepayment represents an amount owing to the firm from a third party and unearned revenue represents amounts owed by the business to third party, it is included under current assets and current liabilities respectively in the statement of financial position. The accounting entries are as follows:
Debit:  Prepayments (Statement of financial position)
Credit: Expenses (Income statement)
Debit:  Revenue (Income statement)
Credit: Unearned revenue (Statement of financial position)
Illustration 11.1
As an illustration let us assume that Santo Ltd. paid ¢240,000 for two years insurance protection beginning on December 1, 2000.
The cash payment of ¢240,000 will be debited to the insurance account. With the passage of time, the benefit of the insurance protection gradually expires and a portion of the unexpired insurance is transferred to the next accounting period as a prepaid expense.  For instance, one month‟s insurance coverage expires by December 31, 2000.  This expense is ¢10,000, or 1/24 x ¢240,000 and will be as follows:
Insurance Account
¢ ¢
1/12/2000 Cash     240,000  31/12/2000 Profit and loss         10,000
Prepaid c/f       230,000
    240,000         240,000
1/1/2001 Prepaid b/f     230,000   31/12/2001 Profit and loss (12/24  x  240,000)       120,000
31/12/2001 Prepaid c/f       110,000

    230,000         230,000

1/1/2002 Prepaid b/f       110,000


The balance carried forward of ¢230,000, and ¢110,000 represents insurance prepaid to be shown under current assets in the statement of financial position for the years 2000 and 2001 respectively.

The adjusting entries will be journalized as follows:
2000
Debit: Insurance Prepaid    ¢230,000
Credit: Insurance expense       ¢230,000
2001
Debit:  Insurance Prepaid    ¢110,000
Credit: Insurance expense       ¢110,000
Let us now illustrate the treatment of deferred revenue as follows: Illustration 11.2
Assume that Santo Ltd rented a small office in its building to a customer on January 1, 2001.
The rental agreement required the payment of ¢180,000 cash in advance for 18 months rent.

This transaction is recorded as a debit to cash and a credit to rent received account.  On December 31, 2001, the unadjusted Trial Balance will report ¢180,000 as rent received, which is overstated by ¢60,000 (6/18 x ¢180,000) relating to 2002.  The rent received account will be as follows:


The balance carried forward of ¢60,000 in 2001 represents unearned revenue which will be recorded under current liabilities in the statement of financial position for the financial statement for the year 2001. The adjusting entry will be journalised as follows:

Debit: Rent receivable A/c                            ¢460,000
Credit: Deferred Rent Revenue    ¢460,000
11.3  Accrued Expenses
Accrued expenses and accrued revenues reflect transactions where cash is paid or received after a related expense or revenue is recognized. It represents an item, the use of which the firm has already benefited from during the current accounting period, but which will not be paid for until the next accounting period. If we do not make an adjustment the profit for the current period will be overstated.  Examples of items that need to be accrued for include electricity, since it is not likely that these bills will exactly coincide with the firm’s accounting year-end. The accounting entry for accrued expense is:
Debit: Expense (Income statement)
Credit: Accrued expense (Statement of financial position)

In this case, the relevant expense in the Income statement is increased by the accrued amount whilst in the statement of financial position, accruals appear under current liabilities, reflecting an amount owing by the business.

Illustration 11.3
As an example, let us assume that Santo Ltd’s Trial Balance  recorded electricity expenses of ¢600,000 which cover the period up to 31st October 2000.  A careful examination of the previous electricity bills of Santo Ltd shows that the company’s consumption of energy is even throughout the period.

The above example tells us that the electricity charge in the Trial Balance does not cover the entire year. This means that an accrual is required for the period of November to 31 December 2000. Since electricity is used evenly throughout the year, we can estimate the outstanding amount based on the bills received to date. The ¢600,000 recorded in the Trial Balance  represents 10 months of electricity charge, therefore the accrual is estimated as follows:
Accrual = ¢600,000 x 2/10 = ¢120,000
The electricity expense recorded as follows:


The balance carried forward of ¢120,000 in 2000 represents accrued expense and will be recorded under current liabilities in the statement of financial position . The adjusting entry will be as follows:

Debit: Electricity expense A/c                           ¢120,000
Credit: Accrued Expense A/c       ¢120,000
11.4  Accrued Revenue
Accrued revenue refers to transactions where cash is received after related revenue is recognized. It represents an item, the use of which the firm has already dispensed with during the current accounting period, but which will not be received until the next accounting period. If we do not make an adjustment the profit for the current period will be understated.  Examples of items that need to be accrued for include interest earned on treasury bills of which payment has not been received, since it is not likely that the maturity of these bills will exactly coincide with the firm’s accounting yearend. The accounting entry for accrued revenue is:

Debit: Accrued income (Statement of financial position)
Credit: Interest Receivable (Income statement)

In this case the relevant income in the Income statement is increased by the accrued amount.  Whilst in the statement of financial position the accrued income will appear under current assets, reflecting an amount owned by the business.

Illustration 11.4
As an illustration, assume that the Trial Balance of Sky Ltd. shows interest receivable of
¢855,000. Excluded from the Trial Balance  is a 182 days Bank of Ghana Bond purchased on
August,  1 2001 at an interest rate of 15% per annum at a cost of ¢12,000,000. Sky Ltd Prepares account to December, 31 each year.

From the illustration above, Sky Ltd. will receive a total of ¢900,000 (15% x ¢12,000,000 x 6/12) representing interest that will be earned on the bond for the period August, 1 2001 to January, 31  2002. Since five months interest amounting to ¢750,000 (5/6 x ¢900,000) relates to 2001 financial year, it must be accrued in the Income statement for 2001 though the amount will be received after 2001. The interest receivable account will be recorded as follows:


The adjusting entry will be as follows:
Debit: Interest accrued A/c                           ¢750,000
Credit: Interest receivable A/c    ¢750,000
11.5  Other adjustments
11.5.1 Depreciation Expense
Non-current assets are the statement of financial position classification used to account for many productive assets with useful lives exceeding one year. The capital expenditures for these assets are matched against the revenues that the assets help to generate in an accounting period.  Depreciation is the process in which we spread the cost of a non-current asset over the accounting periods that benefited from its use.  Irrespective of the method of depreciation used, the accounting treatment is always the same:

Debit: Depreciation expenses (Income statement)
Credit: Provision for Depreciation (Statement of financial position)

The effect of the entry is to show depreciation as a business expense in the income statement, thereby reflecting the proportion of cost or valuation attributable to the current period. It should be cautioned that depreciation is a non-cash item. This means it is a book adjustment, which does not involve the physical movement of cash.

Illustration 11.5
The example below illustrates depreciation recorded for Santo Ltd.. at the end of 2002 under the straight-line method.

                         Assets Cost   Residual Estimated  Proportionate use by function
                             Value             Useful live  Selling         Administrative
           ¢                   ¢    Function       Function
Building  1,600,000     100,000            15 yrs               46%           54%
Equipment         910,000       10,000            10 yrs      

Computation:        40%          60%
Total ¢   ¢
Selling   Administration
Building [(¢1,600,000-¢100,000)÷15yrs]        100,000         46,000             54,000
Equipment[(910,000-10,000)÷10yrs]              90,000         36,000             54,000
Totals                                                            190,000         82,000           108,000


The adjusting entry for these two assets is: 
Dr Cr
¢ ¢
Depreciation  Selling expense     82,000 
Administration expense   108,000 
          Provision for Depreciation: Building   100,000
Equipment     90,000


The adjusting entry reduces the net book value of the building and equipment accounts.  The provision for depreciation is a contra account that has a balance opposite that of the assets account to which it relates.  Thus, the provision for depreciation is subtracted from the gross building and equipment accounts, leaving the net undepreciated account balances of ¢1,500,000 (¢1,600,000-¢100,000) and ¢820,000 (¢910,000-¢90,000) for building and equipment respectively in the statement of financial position.
11.5.2  Bad Debts
Where a business sells its goods on purely cash basis, does not have to worry about customers not paying for such goods. This is however not always the case. Goods and services are usually sold or rendered on credit, giving rise to trade receivables.  The business is therefore taking the risk of some customers defaulting in the payment of their receivables. Trade receivables that are not collected are called bad debts, which is a risk of doing business on credit terms.

Where a customer‟s debt is found to have gone bad, steps must be taken to remove such debts from the list of customers owing the business. This is done by completely writing off the debt from the receivables account. Writing off of a particular debt from the list of receivables accounts means that the value of the assets of the business has reduced or diminished. This in effect means that the business has incurred losses that must be accounted for by increasing the expense account of bad debt, which will eventually reduce profit and also reduce assets of receivables, which will also result in the reduction of the net assets of the business.

Where an account containing a debt is declared „bad‟ you must pass a journal entry as follows:
Debit: Bad debts expense account (Income statement)
Credit: Trade receivables‟ account (Statement of financial position)
It is important for companies to review its receivables periodically and identify those debts from which full payment is unlikely. These bad debts may then be written-off in the statement of financial position.  This practice prevents overstatement of both profit and assets and is required if bad debts are probable and can be estimated. At the end of the accounting period the total debt written off is transferred from the bad debt account to the Income statement as follows:
Debit: Income statement
            Credit: Bad debt account

Illustration 11.6
Jack Terror has been in business for several years dealing in the sale of second hand cloths. During the three years ended October, 31 2005, he presented the following information relating to receivables:
  Receivables
(including bad debts)
¢  Bad Debt
¢
October, 31 2003  4,500,000  1,200,000
October, 31 2004  8,750,000  3,850,000
October, 31 2005  12,200,000  6,300,000

You are required to show the above information for the year ended October, 31 2003, 2004, 2005 in the following accounts:
(a) Trade receivables
(b) Bad debt
(c) Income Statement (extracts)
Solution to Illustration 11.6

  Trade Debtors Account
¢ ¢
31/10/2004 Sales   8,750,000 31/10/2004 Bad debt    3,850,000
31/10/2004 Balance c/f    4,900,000
   8,750,000

11/01/2005 Balance b/f

Trade Debtors Account
¢   ¢

¢
2003 Gross profit xxxxxx
Less bad debts      1,200,000
2004 Gross profit xxxxxx
Less bad debts      3,850,000
2005 Gross profit xxxxxx
Less bad debts        6,300,000

11.5.3  Provision for doubtful debts
This refers to the possibility of a debt going bad in the future but for which the amount cannot be calculated with substantial accuracy. In the case of doubtful debts, the amount or estimate still remains in the list of receivables and is not cancelled from the receivables account as in the case of debts that have actually gone bad. Doubtful debt does not relate to any specific debtor, but the business recognizes the fact that not all the existing debts will be collected and as such, it is prudent that such uncertainty is reflected in the Income statement and the statement of financial position.  The accounting treatment necessary to make a provision for doubtful debts is:

1. When a provision is made for the first time: Debit: Income Statement
                        Credit: Provision for doubtful debts Account With the initial provision.

In this way the current year’s profit is reduced, whilst in the statement of financial position the provision is clearly shown and deducted from trade receivables.

2. In subsequent accounting period’s new estimate must be made in respect of debt that may be considered doubtful. The new provision should be compared with the existing one and where the current provision is greater than the previous one, the difference representing an increase in provision for doubtful debts should be accounted for as: Debit: Income statement
                        Credit: Provision for doubtful debts
                        With the increase in provision (i.e. the difference)
If the current provision is less than the previous one, the difference representing a decrease in provision for doubtful debts should be accounted for as: Debit: Provision for doubtful debts account
                        Credit: Income statement
With the decrease in provision (i.e. the difference)
Illustration 11.7
Viscosity Ltd. has been in business since 2003 dealing in the sale of mobile phones. During the three-years period ended December, 31 2005 the company presented the following information relating to receivables:
        Date   Trade
Receivables(excluding bad debts)
¢   Bad Debts
     ¢
31 December 2003  7,000,000  1,000,000
31December 2004  18,250,000  2,500,000
31December 2005  10,000,000  4,300,000

Viscosity Ltd. makes provision for doubtful debts at the rate of 6% on receivables. There was no balance on the provision for doubtful debt at the beginning of 2003 financial year.   You are required to show the above information for the year ended 31October, 2003,2004, 2005 in the following accounts:
(d) Bad debt
(e) Provision for doubtful debt
(f) Income Statement extracts
(g) Statement of financial position  (extracts)
Solution to Illustration 11.7
Bad debts Account
¢ ¢
31/12/2003 Trade debtors    1,000,000 31/12/2003 Profit and loss      1,000,000
31/12/2004 Trade debtors      2,500,000   31/12/2004 Profit and loss        2,500,000
31/12/2005 Trade debtors      4,300,000   31/12/2005 Profit and loss        4,300,000
Provision for doubtful debt
¢ ¢
31/12/2003 Balance c/f      420,000     31/10/2003 Profit and loss     420,000

31/12/2004 Balance c/f     1,095,000               01/01/2004 Balance b/f       420,000
                                       31/10/2004 Profit and loss       675,000
  1,095,000    1,095,000
31/12/2005 Profit and loss        495,000   01/01/2005 Balance b/f    1,095,000
31/12/2005 Balance c/f        600,000   31/10/2005
  1,095,000    1,095,000

/01/2006 Balance b/f       600,000


Income Statement (extract) for the year ended 31 December xxxxxxx
¢
2003 Gross profit xxxxxx
Less bad debts    1,000,000
           Increase in Provision for doubtful debt       420,000      1,420,000
2004 Gross profit xxxxxx
Less bad debts    2,500,000
           Increase in Provision for doubtful debt       675,000      3,175,000
2005 Gross profit xxxxxx
Add  Decrease in Provision for doubtful debt      495,000 
Less bad debts  (4,300,000)     (3,805,000)



11.5.4 Bad Debts Recovered
It normally occurs that a debt, which has previously been written off in past accounting periods, may be repaid or recovered. When this is the case it is usually advisable that such recovered debt be reinstated. The debt is reinstated in the sales ledger account to ensure that a detailed and concise history and behaviour of the debtor or customer is available to serve as a guide for future granting of credit in respect of the same customer. It will therefore assist the company in its credit rating of all customers that buy goods from them on credit.
The accounting entries when a debt is recovered are:
   Debit: Trade Receivables account
                           Credit:Bad debts recovered account                 With the amount of debt reinstated
   Debit: Cash or bank account
                           Credit:Trade Receivables account
With the amount recovered from receivables in settlement of all or part of the debt.

At the end of the accounting period the balance in the bad debt recovered account will either be transferred directly to the Income statement or to the main bad debt account. Either mode of transfer will produce the same result since the dab debt account will eventually be transferred to the Income statement with the net value.

11.5.5 Provision for Discount on Trade Receivables

In certain businesses provision is made for cash discount that is expected to be offered to customers on the trade receivables balance at the statement of financial position date. Proponents of this concept argue that since companies allow discounts from credit sale for prompt payment recording net realisable value of receivables as the balance on receivables account less provision for doubtful debt will not give the best estimate of the amount expected to be collected from trade receivables. They argue that to estimate the realisable value of receivables, consideration should be given to the impact or effect of cash discount, hence the determination of provision for discount on receivables.
The manner in which provision for discount on receivables is calculated is almost the same as that obtained when calculating provision for doubtful debts. You must however remember to apply whatever rate or percentage on the net amount of trade receivables less provision for doubtful debts. This is so because discounts are allowed on debts expected to be paid and not bad debts.  

Illustration 11.7
Mahatma Ltd. has been in business since 2003 dealing in the sale of Italian executive shoes. During the three years ended 31December 2005 the company presented the following information relating to receivables:
  Trade
Receivables  Provision  for doubtful debts  Provision for cash discount allowed
  ¢  ¢  %
31st December 2003   17,000,000  1,000,000  4
31st December 2004  28,550,000  4,500,000  4
31st December 2005  22,000,000  2,800,000  4


You are required to show the above information for the years ended 31 October, 2003, 2004, and 2005 in the following accounts:
Provision for discount on receivables
Income Statement extracts
Statement of financial position extracts
Solution to Illustration 11.8


Income Statement (extract) for the year ended 31 December xxxxxxx
¢
2003 Gross profit
Less  Provision for doubtful debt      1,000,000 xxxxxx
            Provision for discount on debtors         640,000      1,640,000
2004 Gross profit
Less  Provision for doubtful debt      3,500,000 xxxxxx
            Provision for discount on dereceivables         322,000      3,822,000
2005 Gross profit
Add  Decrease in provision for doubtful debt     1,700,000  xxxxxx
            Decrease in provision for discount on debtors         194,000

Statement of Financial Position (extract) as at 31 December xxxxxxx
                                                         ¢               ¢          ¢
Debtors                                                                       17,000,000
Less  Provision for doubtful debt      1,000,000
            Provision for discount on debtors      640,000      1,640,000     1,894,000

                                                                                                                       15,360,000
Debtors                                                                     28,550,000
Less  Provision for doubtful debt      4,500,000
            Provision for discount on debtors      962,000      5,462,000
   23,088,000
Debtors                                                                     22,000,000
Less  Provision for doubtful debt     2,800,000
      768000           3,568,000
      18,432,000

11.6   Summary
In this chapter we have considered some of the adjustments that are often made to improve the quality of the year-end accounts used to prepare the financial statements.  We should also understand that these adjustments are needed in order to record the actual expenses incurred and the actual revenue earned for the accounting year. It must be remembered that each of the adjustments considered will impact upon the Income statement and the statement of financial position.

We have also learned that depreciation is a business expense that must be charged in the Income statement of any period that a non-current asset has been in use. In addition we learned that any business debt that an organization is unable to collect is called a bad debt and that there is the need to also record provision for bad debts so that the receivable figures in the statement of financial position  will reflect the amount that the business is likely to collect from receivables.

Finally we have also learnt how to record bad debts, provisions for doubtful debts, provision for cash discount in the ledger, Income statement and the statement of financial position.  It is hoped that, students will have a better understanding of the purpose and accounting treatment for depreciation, bad debts provision and accruals and prepayments.