Common Mistakes

Common Mistakes: Balance-Date Adjustments and Preparation of a Sole Proprietor's Financial Statements

This chapter combines many types of balance-date adjustment, so a small error in the direction of an entry or the placement of an item can spoil the whole set of Financial Statements. This list gathers the most common mistakes and how to avoid them.

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Accrual basis vs cash basis and the meaning of adjustments

Nominal account adjustments: Prepaid, Accrued expenses, Accrued income, Unearned income

Mistake: confusing the direction of Prepaid and Accrued expenses. Avoid: a Prepaid expense (paid in advance) is deducted from the expense in the Profit and Loss Account and shown as a Current Asset; an Accrued expense (still owing) is added to the expense and shown as a Current Liability.
Mistake: misplacing Accrued income and Unearned income. Avoid: Accrued income (earned but not yet received) is added to revenue and becomes a Current Asset; Unearned income (received in advance, not yet earned) is deducted from revenue and becomes a Current Liability.
Mistake: adding a prepaid item to the expense or subtracting an accrued item from it (reversed). Avoid: always think 'true amount for the period': start with the amount paid, subtract prepaid and add accrued to get the actual expense for the period.
Mistake: forgetting that this year's prepaid/accrued item becomes next year's opening balance. Avoid: bring down the balance in the expense or revenue ledger so the adjustment carries correctly into the next period.

Bad Debts, Bad Debts Recovered and Provision for Doubtful Debts

Mistake: mixing up Bad Debts (a real loss, written off) with Provision for Doubtful Debts (an estimate of future loss). Avoid: Bad Debts reduce Accounts Receivable directly; the Provision for Doubtful Debts is only an estimate and does not reduce any particular debtor.
Mistake: calculating the Provision for Doubtful Debts on the gross Accounts Receivable balance. Avoid: first write off any new bad debts, then calculate the provision on the net Accounts Receivable balance (after deducting bad debts) at the given percentage.
Mistake: transferring the whole provision amount to the Profit and Loss Account every year. Avoid: after the first year, only the increase in provision (an expense) or the decrease in provision (income, or a lower expense) is taken to the Profit and Loss Account.
Mistake: treating Bad Debts Recovered as a reduction of Accounts Receivable. Avoid: Bad Debts Recovered are income to the business because a written-off debtor has paid; record it as income in the Profit and Loss Account, not as a deduction from debtors.
Mistake: showing the Provision for Doubtful Debts in the wrong place in the Statement of Financial Position. Avoid: show the provision as a deduction from Accounts Receivable under Current Assets to arrive at the net realisable value.

Depreciation and Accumulated Depreciation

Mistake: calculating the reducing balance method on the original cost every year. Avoid: the straight line method is calculated on cost (same each year), but the reducing balance method is calculated on the net book value (cost less accumulated depreciation), which falls each year.
Mistake: confusing Depreciation (the current year's expense) with Accumulated Depreciation (the total of all years). Avoid: Depreciation goes to the Profit and Loss Account as an expense; Accumulated Depreciation is shown as a deduction from the asset's cost in the Statement of Financial Position.
Mistake: using the revaluation method without accounting for assets added during the year. Avoid: revaluation depreciation = (opening balance + purchases/additions) − revalued amount at year end; do not forget assets bought during the period.
Mistake: not stating the factors for choosing a method or the effect of different methods. Avoid: state factors such as the asset's usage pattern and how quickly it loses value; explain that different methods give different expense and net profit figures in early years compared with later years.

Disposal of Non-Current Assets for cash

Mistake: forgetting to transfer the Accumulated Depreciation of the disposed asset to the Disposal Account. Avoid: open a Disposal Account, debit it with the asset's cost, credit it with that asset's accumulated depreciation, then credit it with the cash proceeds.
Mistake: getting the sign wrong when computing profit or loss on disposal. Avoid: profit/loss = proceeds − net book value; if proceeds exceed net book value it is a profit (income); if less, it is a loss (expense) in the Profit and Loss Account.
Mistake: not removing the cost and accumulated depreciation of the disposed asset from the asset and accumulated depreciation ledgers. Avoid: credit the Asset Account with the cost and debit the Accumulated Depreciation Account with the related amount so the ledger balances show only assets still owned.

Adjusted Trial Balance and the Financial Statements

Where adjustment items are recorded in the Financial Statements

Adjustment item	Profit and Loss Account	Statement of Financial Position
Prepaid expense	Deduct from expense	Current Asset
Accrued expense	Add to expense	Current Liability
Accrued income	Add to revenue	Current Asset
Unearned income	Deduct from revenue	Current Liability
Provision for Doubtful Debts	Only the change in provision	Deduct from Accounts Receivable
Accumulated Depreciation	Current year depreciation as expense	Deduct from cost of Non-Current Asset

Every adjustment item appears in two places because double entry affects both statements.

Example General Journal entry: depreciation of vehicles RM5,000

Particulars	Debit	Credit
Depreciation of Vehicles (Dr)	5,000
Accumulated Depreciation of Vehicles (Cr)		5,000
Total	5,000	5,000

The depreciation expense is transferred to the Profit and Loss Account, while accumulated depreciation builds up and is deducted from the asset's cost in the Statement of Financial Position.

How do I know whether an adjustment item becomes an asset or a liability?

Ask who owes whom. If the business has paid in advance (Prepaid) or is entitled to receive money (Accrued income), it is a Current Asset. If the business still owes (Accrued expense) or has received money not yet earned (Unearned income), it is a Current Liability.

Which debtors figure is the Provision for Doubtful Debts calculated on?

It is calculated on the net Accounts Receivable balance, that is after first writing off any new bad debts. Do not use the gross Trial Balance balance if there are still bad debts not yet adjusted.

Why does only the change in the Provision for Doubtful Debts go to the Profit and Loss Account, not the full amount?

The original provision was already charged as an expense in the year it was created. In later years, only the increase (an extra expense) or the decrease (credited as less expense) needs to be adjusted so net profit is not charged twice.

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