Key Terms
Key Terms: Balance-Date Adjustments and Preparation of a Sole Proprietor's Financial Statements
This chapter has many adjustment terms you need to understand before preparing Financial Statements. Learn the meaning, two-way effect and placement of each term instead of just memorising definitions.
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Cash Basis, Accrual Basis and Adjustments
- Cash basis means revenue and expenses are recorded only when cash is received or paid. Accrual basis records revenue and expenses in the accounting period in which they occur, regardless of whether cash has changed hands.
- An adjustment is an entry made on the balance date so that revenue and expense figures match the current accounting period, in line with the accrual and matching concepts.
- Memory hook: "Accrual follows activity, cash follows collection." Adjustments make the ledger reflect the period accurately, not only the money in and out.
- How it is tested: you are asked to explain both bases, list the types of adjustment at the balance date, and describe the effect on the Financial Statements if the accrual concept is not applied (net profit and assets/liabilities over- or understated).
The Four Nominal Account Adjustments
- Unearned revenue: income already received in cash but the service is not yet rendered, so it is a current liability and is deducted from revenue in the Profit and Loss Account.
- Accrued revenue: income already earned but not yet received, so it is a current asset and is added to revenue in the Profit and Loss Account.
- Prepaid expense: expense already paid but not yet used, so it is a current asset and is deducted from the expense in the Profit and Loss Account.
- Accrued expense: expense already used but not yet paid, so it is a current liability and is added to the expense in the Profit and Loss Account. Memory hook: two "not yet" items become ASSETS (accrued revenue, prepaid expense) and two become LIABILITIES (unearned revenue, accrued expense).
- How it is tested: General Journal and ledger entries, inclusion in the Profit and Loss Account, and presentation in the Statement of Financial Position. Most common error: placing an item on the wrong side (asset or liability).
Bad Debts, Bad Debts Recovered and Provision for Doubtful Debts
- Bad debts are Accounts Receivable balances confirmed to be uncollectible, for example a debtor who is bankrupt or has absconded; they are written off as an expense in the Profit and Loss Account.
- Bad debts recovered are debts previously written off as bad but later repaid by the debtor; they are recorded as income in the Profit and Loss Account.
- Provision for doubtful debts is an estimate of the portion of Accounts Receivable that may not be collected; it is created on the prudence principle and calculated on net receivables (after deducting bad debts).
- Memory hook: only the CHANGE in the provision (increase or decrease) goes to the Profit and Loss Account, not the whole balance; the full provision balance is deducted from receivables in the Statement of Financial Position.
- How it is tested: new versus existing provision calculations, journal entries, and the effect if no provision is created despite credit sales (profit overstated, receivables overstated).
Depreciation and Accumulated Depreciation
- Depreciation is the systematic allocation of a non-current asset's cost over its useful life; it arises from wear and tear, obsolescence or the passage of time, and is recorded as an annual expense.
- Accumulated depreciation is the total depreciation charged since the asset was acquired; it is a contra-asset account deducted from the asset cost to give Net Book Value in the Statement of Financial Position.
- Three methods: straight line (fixed annual charge), reducing balance (a percentage on the shrinking book value), and revaluation (depreciation = opening balance + purchases - closing value). Memory hook: straight line = equal amounts; reducing balance = shrinking amounts.
- How it is tested: calculations under the three methods, journal and ledger entries, the Adjusted Trial Balance, and discussion of the factors in choosing a method and how different methods affect net profit.
Disposal of Non-Current Assets
- Disposal means letting go of a non-current asset (in this chapter, through a cash sale); reasons include the asset being damaged, obsolete, no longer needed or replaced by a better one.
- The Disposal of Asset Account is a temporary account: the asset cost is debited, and accumulated depreciation and cash proceeds are credited; the balance shows the profit or loss on disposal.
- If proceeds exceed net book value there is a profit on disposal (income in the Profit and Loss Account); if less, a loss on disposal (expense). Memory hook: compare sale price against Net Book Value.
- How it is tested: profit/loss calculation, General Journal entries, preparing the Disposal Account, and the effect on the Financial Statements (the asset and its accumulated depreciation are removed from the records).
Adjusted Trial Balance and Financial Statements
- The Adjusted Trial Balance is a trial balance prepared after all balance-date adjustments are taken into account; it confirms that debits equal credits before the Financial Statements are prepared.
- It is needed as a bridge that gathers the adjusted figures (expenses, revenue, assets, liabilities) so that statement preparation is accurate and orderly.
- From the Adjusted Trial Balance, the Income Statement (Profit and Loss Account) and the Statement of Financial Position are prepared in 'T' form or statement format, manually or using ICT applications.
- Memory hook: each adjustment has a TWO-fold effect: once in the Income Statement and once in the Statement of Financial Position. How it is tested: preparing both statements in full from a given Adjusted Trial Balance.
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