Adjustments

So, you’ve kept meticulous records of your general ledger accounts, balancing each off at regular intervals. You have accounts for capital, bank and petty cash, a motor vehicle, fixtures and fittings, various expense items incurred in running the business, and of course sales. You might want to draw up a trial balance, and transfer everything to the profit and loss account and balance sheet right away. Draw up your trial balance, yes, but you’re not quite ready to transfer to the financial statements. There is still some more work to be done. The accounts are as yet incomplete.

Depreciation

First, we bought some fixed assets, such as a motor van, and all we did was create an entry called motor vehicles at cost. So we have an asset, but so far none of this has appeared as an expense incurred in running the business. The solution is to make a charge for depreciation each year, thereby spreading the cost of the asset over its useful lifetime.

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Accruals and Prepayments

Secondly, payments for services are often made in advance or in arrears. Suppose we have been using electricity for 1 month and won’t be billed until 2 months after the accounting period. Should we just ignore it and wait until we receive the bill?

In accountancy there is something called the accruals concept.  This is a rule that says that expenses and income should be accounted for in the period in which they were incurred or earned, and it is absolutely bedrock to the bookkeeping art. For this reason we must account for the 1 month of consumed electricity in this year’s accounts, and we do this by recognising the expense and creating an accrual.

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Doubtful Debts Provision

Thirdly, there may be debtors on the books, but we can honestly say that not all of them will pay up. Should we ignore this and take a wait and see approach, or reflect the uncertainty in the accounts? The prudence concept says we should require more evidence to record an asset than is required to record a liability. The debtors form an asset, so if there is doubt about settling their debts, we should recognise this in the accounts by creating a provision for doubtful debts.

The way to do this is to decide on a value - if this is related to a specific debtor it would be that amount, or else we can apply a percentage of the debtors balance. We would then credit a provision for doubtful debts (a balance sheet account) which reduces the amount of that asset. The other side of the double entry is to create a debit entry in an expense for doubtful debts account.

Closing Stock

Fourthly, unless we have sold every last item we purchased, we will have unsold items remaining. The accruals concept tells us that costs should be recognised in the period in which they were incurred, and furthermore, that revenue should be matched to the same period in which their costs were incurred. Since we haven’t yet sold these items of stock, their costs should not be recognised in this period. This becomes an adjustment to cost of sales.

First we value the stock left over - this must be the lower of cost or net realisable value. This implies that if stock is damaged or worth less than cost, then it must be written down to that value.

Next we create a credit entry in the stock (profit and loss) account and a debit entry in stock (balance sheet) account. Finally, when we prepare the final accounts, we transfer the profit and loss stock item to the profit and loss account as a reduction in cost of sales, and transfer the balance sheet stock to the current assets.

Discounts

When we sold goods or purchased supplies on credit, the invoice may contain terms that allow the buyer to reduce the invoiced amount by a certain percentage for early settlement. When this happens we find that our debtors or creditors balance does not net off to zero when the payment is made. An adjustment must be made.

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