Adjusting Entries

Adjusting entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the period in which they actually are applicable. Adjusting entries are required because normal journal entries are based on actual transactions, and the date on which these transactions occur may not be the date required to fulfill the matching principle of accrual accounting.

Types of Adjusting Entries:

The two major types of adjusting entries are:

·         Accruals: for revenues and expenses that are matched to dates before the transaction has been recorded.

·         Deferrals: for revenues and expenses that are matched to dates after the transaction has been recorded.

1.    Accruals:

Accrued items are those for which the firm has been realizing revenue or expense without yet observing an actual transaction that would result in a journal entry

·        Example:

Some accrued items for which adjusting entries may be made include:

·        Salaries Payable

·        Interest Payable

·        Income Tax Payable

·        Unbilled Revenue

·        Journal Entry:

                                    Salaries Expense……………….. Dr.

                                                Salaries Payable………………… Cr.

2.    Deferrals

Deferred items are those for which the firm has recorded the transaction as a journal entry, but has not yet realized the revenue or expense associated with that journal entry.:

·        Examples:

Some deferred items for which adjusting entries would be made include:

• Prepaid insurance
• Prepaid rent
• Office supplies
• Depreciation
• Unearned revenue

·        Journal Entry:

                                    Prepaid Insurance………………. Dr.

                                                Insurance Expense………………. Cr.

IAS 16: Plant, Property and Equipment

IAS 16 is standard to prescribe the accounting treatment for property, plant and equipment hence users of the financial statements can use information about an entity’s investment in its property, plant and equipment and the changes in such investment.

The principal issues in accounting for property, plant and equipment are the recognition of the assets, the determination of their carrying amounts and the depreciation charges are to be recognized.

·        Property, plant and equipment are tangible

·        Cost of an item of property, plant and equipment shall be recognized as an asset;

·        Cost of property, plant and equipment includes;

(a)   Its purchase price,

(b) Including import duties

(c) Non-refundable purchases taxes, after deducting trade Discounts and rebates.

(d) Cost incurred to bring it to the point of allocation.

·       Measurement after recognition;

Plant, property and equipment can be measured from any one of the following models.

(a) Cost model

(b)  Revaluation model

(a)  Cost Model:

Cost model is that plant, property and equipment shall be carried at its cost less accumulated depreciation and any accumulated impairment losses

(b) Revaluation Model:

Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31]

If an item is revalued, the entire class of assets to which that asset belongs should be revalued. [IAS 16.36]

·       Depreciation:

It  is the systematic allocation of the depreciable amount of an asset over its useful life.

Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.

·        The depreciation charge for each period shall be recognized in profit or loss unless it is included in the carrying amount of another asset.  The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

·        The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

·       Disclosure

For each class of property, plant, and equipment, disclose: [IAS 16.73]

·         basis for measuring carrying amount

·         depreciation method(s) used

·         useful lives or depreciation rates

·         gross carrying amount and accumulated depreciation and impairment losses

STATEMENT OF CASH FLOWS

INTRODUCTION:
        Cash flow is an important consideration for all companies The statement is one of the major financial statements required for companies to provide information to investors, creditors, and other that is in compliance with generally accepted accounting principles 

PURPOSE OF THE STATEMENT:
         The objective of a statement of cash flows is to provide information about the cash receipts and cash payments of a business entity during the accounting period.

Methods of cash flow statement

• Direct Method
• Indirect Method 

Classification of Cash Flow Statement:
Cash flow statement can be divided into three parts;

• Operating activities
• Investing activities 
• financing activities

Operating Activities:

The operating activities section shows the cash effects of revenue and expense transactions.

CASH RECEIPTS

• Collections from customers for sales of goods and services 
• Interest and dividends receives

CASH PAYMENTS

• Payment to suppliers of merchandise and services, Including payments to employees
• Payment of interest
• Payments of income taxes

Investing Activities:

Cash flows relating to investing activities present the cash effects of transactions involving plant assets, intangible assets, and investments .

CASH RECEIPTS

• Cash proceeds form selling investment and plant and intangible assets
• Cash proceeds from collecting principal amounts on loans 

CASH PAYMENTS

•  Payments to acquire investments and plant and intangible assets
• Amounts advanced to borrowers

Financing Activities

Cash flows classified as financing activities include the following items that result from debt and equity financing transactions.

CASH RECEIPTS

• Proceeds from both short term and long term borrowing 
• cash received from owners

CASH PAYMENTS

• Repayment of amounts borrowed 
• Payments to owners such as cash dividends

BANK RECONCILIATION STATEMENT

Definition:
a statement to find out the reasons for disagreement between the bank statement balance and the cash book balance of the bank is called bank reconciliation statement.


Purpose:
The purpose of the bank reconciliation statement is to know whether we have sufficient funds in the bank account to issue the cheques.

Causes of Disagreement Between Bank statement and Cash book:

Deposit in Transit:

The cheques which we have deposited in the bank but not yet have recorded by the bank is a cause of difference between the balance of cash book and bank statement.

Outstanding cheques:

The cheques we have issued but not yet have been presented to bank are also a cause of disagreement between the two balances.

Bank Adjustments:

If the bank have credited or debited the customer account erroneously then it is also a cause of disagreement of balances between cash book and bank statement.

Book Adjustments:

If the customer makes a mistake in cash book while writing the amount or omitting to record the amount then there is a need of bank reconciliation statement.

NSF Cheques:

If there is no amount in the bank account the cheque returns dishonor and these cheques are called NSF cheques. These cheques lead to difference between cash book and bank statement.

Amount Collected by Bank:

If the cash or cheque is directly collected by the bank and customer has no information about it then it is also a reason of disagreement of balances  between cash book and bank statement.

Inventory in IAS 2:

Inventory:

The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets that is ready or will be ready for sale.

Objectives of IAS 2:

Provide guidance about the accounting treatment for inventories. It provides guidance about inventories in following ways

When inventory is purchased, how it should be recorded

When inventory should be recorded as an expense

Scope:

The following 3 types of inventories are included in IAS 2

o   Finished goods

o   Work in process

o   Raw material

The following inventories are not included in IAS 2

o   Work in process arising under construction contracts

o   Financial instruments e.g. shares and bonds

o   Biological assets related to agricultural activity and agricultural produce at the point of harvest e.g. cattle and crops

Fundamental Principle of IAS 2:

Inventories are required to be stated at the lower of cost and net realizable value (NRV).

Measurement of Inventories:

Cost should include all:

• costs of purchase (including taxes, transport, and handling)
• costs of conversion i.e. labour and overhead
• other costs incurred in bringing the inventories to their present location and condition

Note:

In some circumstances borrowing cost is also included in cost of inventory

The following cost is not included in the inventory cost;

·         Abnormal waste

·         Storage costs

·         Administrative FOH unrelated to production

·         Selling costs

·         Foreign exchange differences

·         Interest cost when inventories are purchased with deferred settlement terms

Cost Formulas:

·         Items which are not ordinarily interchangeable should be valued at individual cost basis.

·         For interchangeable items FIFO and Weighted Average Cost methods are used.

Write-Down to Net Realizable Value:

·         NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale.

·         Any write-down to NRV should be recognized as an expense in the period in which the write-down occurs.

·         Any reversal should be recognized in the income statement in the period in which the reversal occurs.

Expense Recognition:

IAS 18 Revenue:

When inventories are sold and revenue is recognized, the carrying amount of those inventories is recognized as an expense.

[IAS 2.34]

Any write-down to NRV and any inventory losses are also recognized as an expense when they occur.

Disclosure

• accounting policy for inventories
• Carrying amount, of merchandise, supplies, materials, work in progress, and finished goods.
• carrying amount of any inventories carried at fair value less costs to sell 

Accounting Cycle:

The sequence of accounting procedures used to record, classify and summarize accounting information in financial reports at regular intervals is often termed as "accounting cycle". It includes the following 8 steps;
1. Journal
2. Ledgers
3. Unadjusted Trial Balance
4. Adjusting Entries
5. Adjusted Trial Balance
6. Financial statements
7. Closing Entries
8. After Closing Trial Balance

1. Journal:
Transactions are recorded in chronological order in the journal as both a debit and a credit. Journals may include sales journal, purchases journal and general journal etc.

2. Ledger:
The journal entries are transferred to the appropriate accounts in the ledger. The ledger accounts may be in the form of T-account method or running balance method.

3. Unadjusted Trial Balance:
Unadjusted trial balance is a calculation to verify the sum of the debits is equal to the sum of the credits.

4. Adjusting Entries:
In this step, adjusting entries are passed to match the proper revenue with expense in that period because under accrual accounting system, revenue is recorded when earned and expenses are recorded when incurred.

5. Adjusted Trial Balance:
After making necessary adjustments adjusted trial balance is prepared. Adjusted trial balance is the listing of balances of accounts in order of assets, liabilities, owner's equity, revenue and expenses.

6. Financial Statements:
Financial statements are prepared using the corrected balances from the adjusted trial balance. The financial statements are;
  i.   Income Statement
  ii.  Statement of Retained Earning
  iii.  Balance Sheet
  iv. Cash Flow Statement
  v.  Statement of Changes in Equity

7. Closing Entries:
In this step closing entries are passed to close the balances of temporary accounts e.g. revenue and expenses.

8. After Closing Trial Balance:
After closing trial balance will show only permanent accounts e.g. assets, liabilities, and owner's equity.

Solution of Adjusting Entries - Case 4.1 - Financial and Managerial Accounting

Solution of Adjusting Entries - Case 4.1 - Financial and Managerial Accounting 15e is given blow;

A.  

No adjusting entry is required because the revenue has already been earned prior to December 31^st.

B.  

Adjusting Entry:

Unearned Revenue……….Dr

Revenue Earned ……….Cr

Explanation

3 months revenue was collected in advance on December 1^st and was credited to an Unearned Revenue A/c. At December 31^st an adjusting entry is needed to recognize 1/3 of this amount as revenue.

Effect of Adjusting Entry:

The effect of this adjusting entry will be reduced the liability, increase the revenue earned in this period and thus increase in owner’s equity.

C.  

Adjusting Entry:

Accounts Receivable……….Dr

Revenue Earned……….Cr

Explanation

Adjusting entry is required to record the revenue which we have earned because we have rendered a part of the services to the customer before the billed. Therefore the services we have rendered should be recorded.

Effect of Adjusting Entry:

The effect of the adjusting entry will increase in asset, increase the revenue which lead to increase in owner’s equity.

D.  

No adjusting entry is required because the benefit of insurance policy will start from January 2, 2010 and entry for the payment of unexpired insurance has already been recorded which is

Unexpired Insurance……….Dr

            Cash……………………..Cr

E.  

Adjusting Entry:

Depreciation Expense: Equipment………………Dr

Accumulated Depreciation: Equipment………Cr

Explanation

Equipment is our asset, it was debited to assets account, it is correct. But the adjusting entry is required because the depreciation of asset (equipment) is not recorded.

Effect of Adjusting Entry:

This adjusting entry will increase the expense which leads to decrease in revenue and thus owner’s equity also decreases.

F.   

Adjusting Entry:

Salaries Expense………..Dr

Salaries Payable…….Cr

Explanation

Adjusting entry is required because salaries have been earned by employees and due on January 2, 2010, but not yet have been recorded.

Effect of Adjusting Entry:

This adjusting entry will increase liabilities of business and expenses will be increased which leads to decrease in revenue earned thus owner’s equity also decrease.