Financial AccountingLecture 4Reporting Financial Performance – adjustmentsReading: McLaney & Atrill Chapter 3Sue Davey-Evans
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
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
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
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.
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).
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
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.
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
The double entry effect is to debit prepaymentand credit insurance expense
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.
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.
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%
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
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
Reducing Balance method 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
Comparison of methods 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
Comparison of methods 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
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
Depreciation 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.
Case study 3The 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
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
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
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
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
What will be the cost of sales? (note 1 to the accounts) £ Opening inventory 0 Purchases 18,263 18,263 Closing inventory (3,400) Cost of sales 14,863