Adjustments
Adjusting entries assure that both the balance sheet and the income statement are up-to-date on the accrual basis of accounting. A reasonable way to begin the process is by reviewing the amount or balance shown in each of the balance sheet accounts. We will use the following preliminary balance sheet, which reports the account balances prior to any adjusting entries:
Depreciation for fixed asset
Fixed assets are those assets of material value that are purchased for use in the business, are not for resale and which have a long life. Whilst assets such as buildings, machinery, fixtures and fittings are used in the business for many years they do not last indefinite;y, therefore, when they are disposed of, the difference between the cost price and the amount received on disposal is call depreciation.
Causes of depreciation
Physical depreciation
- Wear and tear
- Erosion, rust, rot and decay
Economic factors
- Obsolescence (This occurs when an asset becomes out of date due to advanced technology or a change in processes)
- Inadequacy (This arises when an asst is no longer used because of the growth and change in the size of the business due to new regulation)
The time factor (There are some assets that have a legal life fixed in terms of years)
Depletion (Some assets are of a "wasting nature" such as the extraction of raw materials from mines or quarries, or oil from oil wells)
Methodsof calculating Depreciation
Straight Line Method
This Method invloves the cost price of an asset, the estimated years of its use and the expected disposal value. The depreciation charge each year can be calculated thus:
Depreciation charge per year = (Cost price - Disposal Value)/Number of years of use
For example, if a car was purchased for $22,000 and the business decide to keep it for four years and then sell it for $2,000, the depreciation to be charged would be:
(Cost price - Disposal Value)/Number of years of use = ($22,000 - $2,000)/4 = 5,000
Reducing Balance Method
Depreciation to be charged involves deciding on a percentage amount to be used each year. This percentage is then deducted from the cost price for the first year and in subsequent years from the reducing balances. This is illustrated in the following example:
If a machine is bought for $10,000 and depreciation is to be charged at 20%, the calculations for the first three years would be as follows:
Cost
First year: depreciation (20% of $10,000)
$
10,000
2,000
Second year: depreciation (20% of $8,000)
8,000
6,400
Third year: depreciation (20% of $6,400)
Net book Value at the end of the third year
1,280
5,120
Depreciation for double entry
When a business purchases fixed assets the cost price is recorded the respective fixd asset account. Any depreciation subquently charged on that asset is recorded seperately in a Provision for depreciation account where the depreciation charge accumulates each year. The following example illustrates the purchase of machinery and the depreciation charge which is recorded using double entry principles:
Example: A business purchases machinery for use in their workshop for $2,000 on 1 january 2001. The company uses the reducing balancemethod of depreciation and a rate of 20 per annum, their year end is 31 December. The accounting records for the first three tears are shown below:
1. The machinery is purchased on 1 January 2001 and paid for cheque
- Debit the machinery account $2,000
- Credit the bank account $2,000
2. At the end of the year the asset is depreciated at 20% per annum using the reducing balance method. First of all, we need to calculate the amount of depreciation to be charged each year:
Cost machinery
First year: depreciation (20% of $2,000)
Reduced balance year 1
Second year: depreciation (20% of $1,600)
Reduced balance year 2
Third year: depreciation (20% of 1,280)
Reduced balance year 3
Net book value at end of third year
$
2,000
400
1,600
320
1,280
256
1,024
Note: Net book value = Cost price - Depreciation
= 2,000 - 976 = $1,024
3. To record the depreciation
- Debit the "profit and loss account" with the amount of depreciation each year
- Credit the "provision for depreciation - Machinery account" with the amount of the depreciation charged each year.
4. In the balance sheet the asset and total depreciation would be shown under the fixed asset section as follows:
- The asset i.e. "machinery", is always shown at cost price i.e. $2,000
- The total depreciation to date, i.e. $400 + $320 + $256 = $976, is shown as a deudction from the cost price of the machiner to arrive at the net boook value, $2,000 - $976 = $1,024.
Bad debts
If a business finds that it is impossible to collect a debt, then that debt should be written off as a bad debt. This could happen if the debtor is suffering a loss in the business, or may even have gone bankrupt and is thus unable to pay the debt. A bad debt is therefore, an expense on the business that is owed the money.
Provision for doubtful debt
Allowance for doubtful debts is created by forming a credit balance which is netted off against the total receivables appearing in the balance sheet. A corresponding debit entry is recorded to account for the expense of the potential loss. Accounting entry to record the allowance for receivable is as follows:
Allowance for doubtful debts (expense)
Debit
Credit
Allowance for doubtful debts (Balance sheet)
Once an allowance for doubtful debts has been created, only the movement in the allowance will need to be charged to the income statement in future accounting period. So if estimated allowance for doubtful debt is same as last accounting period, no accounting entry will be required in the current period as the total receivables will be reduced by the amount of allowance which has already been created.
Prepayments (amounts paid in advance)
1. If a trial balance is provided in a question then ensure that you deduct the amount of the prepayment from the appropriate expense account and put the resultant figure in the profit and loss acount. Ensure that only the expenses incurred for that particular period are charged against the profits for that period.
2. In the balance sheet show the amount of the prepayment in the current assets section directly under the debtors
Accruals (amount owing)
1. If a trial balance is provided in a question then add the amount of the accrual to the appropriate expense account and put thhis figure in the profit and loss account.
2. In the balance sheet show the amount of the accrual under the current liabilities section directly under the creditors.
