Revision Notes
Revision Notes: Balance-Date Adjustments and Preparation of a Sole Proprietor's Financial Statements
This chapter explains how to make balance-date adjustments under the accrual concept and prepare a complete set of Financial Statements for a sole proprietor. Learn the definitions, formulas and effect of each adjustment on the Profit and Loss Account and the Statement of Financial Position.
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Basic Concepts: Cash Basis, Accrual Basis and Adjustments
- Cash basis recognises revenue and expenses only when cash is received or paid; accrual basis recognises them in the period they are earned or incurred, regardless of cash flow.
- An adjustment is an entry made at the balance date to ensure revenue and expenses are correct under the accrual and matching concepts.
- Main adjustment types: accrued and prepaid revenue/expenses, bad debts and provision for doubtful debts, depreciation, and disposal of assets.
- If accrual is not applied, net profit and financial position will be misstated (overstated or understated) and will not reflect true performance.
Nominal Account Adjustments: Four Main Items
- Prepaid Expense: expense of a future period already paid. Deduct from the expense in the Profit and Loss Account; show as a Current Asset in the Statement of Financial Position.
- Accrued Expense: current-period expense not yet paid. Add to the expense in the Profit and Loss Account; show as a Current Liability.
- Accrued Revenue: current-period revenue not yet received. Add to revenue in the Profit and Loss Account; show as a Current Asset.
- Unearned Revenue: future-period revenue already received. Deduct from revenue in the Profit and Loss Account; show as a Current Liability.
- Quick memory aid: 'prepaid/unearned' involve cash that has already moved; 'accrued/not yet received/not yet paid' involve cash that has not yet moved.
Bad Debts, Bad Debts Recovered and Provision for Doubtful Debts
- A Bad Debt is an amount in Accounts Receivable confirmed as uncollectible (e.g. the debtor is bankrupt or has absconded). It is an expense debited to the Profit and Loss Account.
- Bad Debts Recovered are debts written off earlier but later repaid by the debtor; they are treated as revenue credited to the Profit and Loss Account.
- Provision for Doubtful Debts is created under the prudence concept to estimate possible losses from net Accounts Receivable (after deducting bad debts).
- Formula: Provision for Doubtful Debts = percentage rate x net Accounts Receivable. Only the change (increase or decrease) in the provision is recorded in the Profit and Loss Account each year.
- In the Statement of Financial Position, Provision for Doubtful Debts is deducted from Accounts Receivable to show realisable value. If there is no Accounts Receivable balance, the existing provision is removed (credited in full to the Profit and Loss Account).
Depreciation and Accumulated Depreciation
- Depreciation is the systematic allocation of a Non-Current Asset's cost over its useful life. Accumulated depreciation is the total depreciation charged up to a given date.
- Causes of depreciation: wear and tear from use, passage of time, technological obsolescence, and physical deterioration.
- Straight-line method: Depreciation = (Cost - Residual Value) / Useful Life, or Cost x percentage rate. The charge is the same each year.
- Reducing-balance method: the percentage rate is applied to the net book value (cost less accumulated depreciation); the charge gets smaller each year.
- Revaluation method: Depreciation = opening value + purchases - closing (revalued) value, suitable for small, varied assets such as loose tools.
- Current-year depreciation is debited to the Profit and Loss Account; accumulated depreciation is deducted from asset cost in the Statement of Financial Position to show net book value.
Disposal of Non-Current Assets for Cash
- Disposal is the removal of a Non-Current Asset, for example because it is damaged, obsolete, no longer needed, or replaced by a new one.
- Profit/Loss on Disposal = Selling Price - Net Book Value. Net Book Value = Cost - Accumulated Depreciation up to the disposal date.
- Steps to prepare the Disposal Account: debit the asset cost; credit accumulated depreciation and sale proceeds; the balancing figure is profit (credit) or loss (debit).
- Profit on disposal is credited to the Profit and Loss Account (revenue); loss on disposal is debited to it (expense). The related asset and accumulated depreciation accounts are closed.
Adjusted Trial Balance and Financial Statements
- The Adjusted Trial Balance is a list of ledger balances after all balance-date adjustments are taken into account; total debits must equal total credits.
- It is needed to confirm the accuracy of records after adjustments and forms the basis for preparing accurate Financial Statements.
- A complete set of Financial Statements comprises the Income Statement (Trading and Profit and Loss Account) and the Statement of Financial Position, prepared in 'T' form or statement format.
- Order of the Statement of Financial Position: Non-Current Assets (cost less accumulated depreciation), Current Assets, less Current Liabilities to obtain Working Capital, and Owner's Equity (Capital + Net Profit - Drawings).
- Financial Statements may be prepared manually or using ICT applications (electronic spreadsheet software).
| 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 Revenue | Add to revenue | Current Asset |
| Unearned Revenue | Deduct from revenue | Current Liability |
| Year | Straight-Line (RM) | Reducing-Balance (RM) |
|---|---|---|
| Year 1 | 2,000 | 2,000 |
| Year 2 | 2,000 | 1,800 |
| Year 3 | 2,000 | 1,620 |
Straight-line: 10% x cost (unchanged); Reducing-balance: 10% x the declining net book value.
| Details (Debit) | RM | Details (Credit) | RM |
|---|---|---|---|
| Vehicle (cost) | 10,000 | Accumulated Depreciation | 6,000 |
| Bank | 3,000 | ||
| Profit and Loss (loss on disposal) | 1,000 | ||
| 10,000 | 10,000 |
Net book value RM4,000 > selling price RM3,000, so a loss on disposal of RM1,000 arises.
What is the difference between Bad Debts and Provision for Doubtful Debts?
Bad Debts are an actual loss confirmed as uncollectible and written off directly from Accounts Receivable. Provision for Doubtful Debts is an estimate of future loss under the prudence concept, calculated as a percentage of the net Accounts Receivable balance, and it does not remove any specific debtor.
How is profit or loss on disposal of an asset calculated?
First find the Net Book Value (Cost less Accumulated Depreciation up to the disposal date). If the selling price exceeds net book value, there is a profit on disposal (credited to the Profit and Loss Account). If the selling price is below net book value, there is a loss on disposal (debited to the Profit and Loss Account).
Why must an Adjusted Trial Balance be prepared?
An Adjusted Trial Balance is prepared after all balance-date adjustments are recorded to confirm that total debits and credits still balance. It verifies ledger accuracy after adjustments and provides the basis for preparing an accurate Income Statement and Statement of Financial Position.
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