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Financial Accounting Lecture 4 Reporting Financial Performance – adjustments Reading: McLaney & Atrill Chapter 3 Sue Davey-Evans Learning outcomes Identify and apply appropriate adjustments required to the final accounts for stock, prepayments and accruals

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Financial AccountingLecture 4Reporting Financial Performance – adjustmentsReading: McLaney & Atrill Chapter 3Sue Davey-Evans


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Learning outcomes

  • Identify and apply appropriate adjustments required to the final accounts for stock, prepayments and accruals

  • Apply the appropriate treatment of non-current (fixed) assets in the Balance Sheet and Income Statement (profit and Loss account)

  • Prepare a Balance Sheet and Income Statement (Profit and Loss account) from a Trial Balance


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End of period Adjustments

There are a number of adjustments required to the final accounts.

These include:

  • Stock (to calculate cost of goods sold – reviewed in previous lecture)

  • Accruals

  • Prepayments

  • Depreciation


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Accruals/matching convention

  • In the previous lecture we saw how the Income Statement (Profit and Loss account) required an adjustment for opening and closing stock. This was to ensure that the cost of goods sold, not purchased, was recognised.

    Opening inventories (stock) x

    Add: Purchases x

    x

    Less: closing inventories (stock) (x)

    Cost of sales x


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Accrued expenses

  • Expenses should also be matched to the revenues that they helped generate. Applying this convention may mean that a particular expense reported in the Profit and Loss Account is not the same as the cash paid in respect of that expense during the period.


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Case study 1

  • Sarah, a sole trader, prepares her accounts to 31st October each year. Her trial balance shows that £350 has been paid for electricity (invoices received for the periods up until 31st August) but meter readings and calculations show that £85 is to be accrued at the end of the year (covering the last two months of the year).


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Accrued expenses- financial year to 31st October

1st November

31st August

31st October

Paid £350 for 10 months

£85 owed for

Last 2 months

12 month accounting period, expense is:

Paid 10 months £350

Owed for 2 months £85

£435


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Case study 1 continued

  • Sarah’s trial balance also shows that £444 has been paid for insurance. This comprises a payment of £60 on 1st November to cover the two months 1st November to 31st December and a further payment of £384 on 1st January to cover the period 1st January to 31st December.


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Prepaid expenses - financial year to 31st October

1st November

31st December

31st October

31st December

Paid £60 for

2 months

Paid £384 for 12 months

For 12 month accounting period, insurance expense is:

Paid 2 Months £60

Paid 12 months £384

Paid 14 months £444

Less: 2 months paid into next

Accounting period (2/12 x £384) (£64)

Insurance expense £380


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The double entry effect is to debit prepaymentand credit insurance expense


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Depreciation

Non current (fixed assets), with the exception of freehold land, do not have an infinite existence; they are eventually “used up” through wear and tear in the process of generating revenue for the business.

The accounting treatment of depreciation is an attempt to measure that portion of the cost of a fixed asset that has been consumed during the period under review.

The depreciation charge is treated as an expense of the period to which it relates.


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To Calculate Depreciation:

We must consider four factors:

  • The historical cost of the asset

  • The useful life of the asset

  • The likely disposal or scrap value

  • Depreciation method

    The two main depreciation methods used are straight-line and reducing balance.


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Depreciation Methods

The straight-line method simply allocates the depreciation evenly over the life of the asset.

Annual depreciation charge = cost - residual value

life

The reducing balance method applies a constant percentage rate of depreciation to the asset each year, so that each year the asset has a Net Book Value (NBV) of, say, X% of the previous year’s value.

Annual depreciation charge = Net Book Value at

start of year x X%


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Example using straight-line

Consider a machine which cost £40,000 and which has an estimated disposal value of £2,250 after a useful life of ten years.

The annual depreciation charge is therefore:

(£40,000 - £2,250) = £3,775

10 years

The annual depreciation expense appearing in the profit and loss account for this fixed asset will be the same for each of the ten years of the asset's life.

£

Cost of machine 40,000

Year 1 depreciation 3,775

Written-down value/Net Book Value 36,225

Year 2 depreciation 3,775

Written-down value/Net Book Value 32,450 

And so on


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How does this appear in the Balance Sheet at the end of the second year?

The accumulated depreciation will be:

£

2 years x £3,775 £7,550

Balance Sheet at end of second year

£

Machine at cost 40,000

Accumulated depreciation

(3,775 + 3,775) 7,550

 Net Book Value/ or Written down value 32,450


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Reducing Balance method second year?

The reducing balance method would require an annual % depreciation rate; let us assume 25%

£

Cost of machine 40,000

Year 1 depreciation (25% x £40,000) 10,000

NBV 30,000

Year 2 depreciation (25% x £30,000) 7,500

NBV 22,500

Year 3 depreciation (25% x £22,500) 5,625

NBV 16,875

Year 4 depreciation (25% x £16,875) 4,219

12,656 


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Comparison of methods second year?

Reducing Straight

Balance Line

£ £

Cost of machine 40,000 40000

Year 1 depreciation 10,000 3,775

NBV 30,000 36,225

Year 2 depreciation 7,500 3,775

NBV 22,500 32,450

Year 3 depreciation 5,625 3,775

NBV 16,875 28,675

Year 4 depreciation 4,219 3,775

NBV 12,656 24,900

Year 5 depreciation 3,164 3,775

NBV 9,492 21,125


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Comparison of methods second year?

Reducing Straight

Balance Line

£ £

Cost of machine 40,000 40000

Year 1 depreciation 10,0003,775

NBV 30,000 36,225

Year 2 depreciation 7,5003,775

NBV 22,500 32,450

Year 3 depreciation 5,6253,775

NBV 16,875 28,675

Year 4 depreciation 4,2193,775

NBV 12,656 24,900

Year 5 depreciation 3,1643,775

NBV 9,492 21,125

Depreciation is higher in the earlier years under the reducing balance method


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Depreciation is higher in the later years under the straight line method

Comparison of methods

Reducing Straight Balance Line

£ £

NBV 9,492 21,125

Year 6 depreciation 2,374 3,775

NBV 7,118 17,350

Year 7 depreciation 1,7803,775

NBV 5,338 13,575

Year 8 depreciation 1,336 3,775

NBV 4,002 9,800

Year 9 depreciation 1,0013,775

NBV 3,001 6,025

Year 10 depreciation 7513,775

NBV 2,250 2,250


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Depreciation line method

It is clear that the pattern of depreciation expense is different year by year for the two methods, the reducing balance method is more applicable to those assets such as motor vehicles that loose most of their value in the first few years.

If a fixed asset is sold for less than its net book value there will be a loss.

If a fixed asset is sold for more than its net book value there will be a profit.


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Case study 3 line methodThe following trial balance has been extracted at the end of Bill’s first year of trading at 31 December 2005.

DR£ CR£

Sales 28,962

Purchases 18,263

Wages and salaries 3,693

Electricity 364

Rent and rates 1,129

Vehicle 7,000

Equipment 1,000

Bank 4,913

Trade receivables (debtors) 2,000

Trade payables (creditors) 1,000

Loan (payable after 12 months) 1,000

Drawings 2,600

Capital 10,000

40,962 40,962


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What will be the total of depreciation shown as an expense in the Profit and Loss account? (notes 2 and 3 to the accounts)

Vehicle – reducing balance basis

£7000 x 25% £1,750

Equipment – straight line basis

(£1000 – 200)/4 years £200

Total depreciation charge in profit and Loss account

£1,950


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What will be the value of non – current (fixed) assets shown in the Balance Sheet?

£

Vehicle – Cost 7,000 Vehicle – depreciation (1,750)

Vehicle – Net Book Value £ 5,250

Equipment – Cost 1,000 Equipment – depreciation (200) Equipment – Net Book Value £800


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What will be the charge for electricity in the Income Statement (Profit and Loss account)? (note 4 to the accounts)

From trial balance + Accrual

£364 + £140 = £504

This will appear in the income Statement (Profit and Loss) as the electricity expense

This will appear in the Balance Sheet under current liabilities as an accrual


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What will be the charge for rent and rates in the Income Statement (Profit and Loss) ? (note 5 to the accounts)

From trial balance - Prepayment

(720 x 3/12)

£1,129 - £180 = £949

This will appear in the Income Statement (Profit and Loss) as the rent and rates expense

This will appear in the Balance Sheet under current assets as a prepayment


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What will be the cost of sales? (note 1 to the accounts) Statement (Profit and Loss) ? (note 5 to the accounts)

£

Opening inventory 0

Purchases 18,263

18,263

Closing inventory (3,400)

Cost of sales 14,863


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