Study Unit 6: Financial Accounting Adjustments

Key Concepts

  • Adjustments: Necessary changes to accounts to reflect accurate financial positions.
  • Closing: Process of finalizing accounts at the end of a financial period.
  • Prepaid Expenses: Expenses paid in advance that relate to future periods.
  • Accrued Expenses: Expenses incurred but not yet paid at the end of a financial period.
  • Consumable Inventory Adjustments: Adjustments to account for consumable items that are used in business operations but are not for resale.
  • Income Received in Advance: Income received before it has been earned, creating a liability.
  • Credit Losses (Bad Debts): Debts that will not be collected and must be written off as a loss.
  • Settlement Discount: Allowance for reduction in payment as an incentive for early payment.
  • Depreciation: Systematic allocation of the cost of tangible assets over their useful lives.
  • Accumulated Depreciation: Total depreciation expense allocated to an asset over time.
  • Asset Contra Account: An account that offsets the value of an associated asset account (e.g., accumulated depreciation).
  • Carrying Amount: The net value at which an asset is carried on the balance sheet.
  • Pre-adjustment Trial Balance: A trial balance prepared before any adjustments are made.
  • Post-adjustment Trial Balance: A trial balance prepared after adjustments have been made.
  • Post-closing Trial Balance: A trial balance prepared after all nominal accounts have been closed and only balance sheet accounts remain.

Introduction

  • Entities conduct business continuously and need accurate financial information periodically.
  • Financial periods (commonly 12 months) are used to report profit or loss.
  • Accounts may require adjustments for accurate financial statements before final accounts are prepared.

Steps for Year-End Adjustments

  1. Identify accounts that need adjustments.
  2. Determine how accounts are affected and what their correct balances should be.
  3. Calculate the amounts needed for adjustments.
  4. Record adjustments in the general journal and post to ledgers.
  5. Verify that new balances are accurate.

Short-term Adjustments

  • Adjustments necessary for aligning income and expenses for the reporting period, regardless of payment timing.

Prepaid Expenses

  • Definition: Payments for expenses in the current period relating to future periods.
  • Example: An annual insurance premium paid in advance, with only a portion used in the current period.
  • Adjusting Entries:
    • Debit Insurance Expense for the actual expense used (e.g., R400).
    • Credit Prepaid Expenses for the amount prepaid (e.g., R2,000).

Accrued Expenses

  • Definition: Expenses incurred in the current period but unpaid at period end.
  • Example: Outstanding utility bills that need adjustment in accounts.
  • Adjusting Entries:
    • Debit Water and Electricity Expense for actual expenditure (e.g., R3,240).
    • Credit Accrued Expenses for the amount owed (e.g., R360).

Consumable Inventory

  • Definition: Expenses for inventory used in the business, not for resale.
  • Example: Stationery bought, with a physical count determining what remains.
  • Adjusting Entries:
    • Debit Consumables Inventory for amount on hand (e.g., R150).
    • Credit Stationery Expense for actual expense incurred.

Income Received in Advance

  • Definition: Income received for future periods that needs to be recorded.
  • Example: Rental income received in advance for the next month.
  • Adjusting Entries:
    • Debit Rental Income to reflect actual income earned.
    • Credit Income Received in Advance as a liability.

Accrued Income

  • Definition: Income earned but not yet received by end of the financial period.
  • Example: Commission earned but not yet collected.
  • Adjusting Entries:
    • Debit Accrued Income for amounts earned yet unpaid.
    • Credit Commission Income to adjust the earnings.

Credit Losses (Bad Debts)

  • Definition: Debts that are deemed unrecoverable.
  • Adjustment Method: Remove the irrecoverable debts from accounts and record them as expenses.
  • Adjusting Entries:
    • Debit Credit Losses for the unrecoverable amount.
    • Credit Trade Receivables to write off the debt.

Long-term Adjustments (Depreciation)

  • Definition: Allocation of the cost of tangible assets over their useful lives.
  • Example: Machinery depreciation.
  • Adjusting Entries:
    • Debit Depreciation Expense for the period.
    • Credit Accumulated Depreciation for total depreciation.

Trial Balance Preparation

  • Pre-adjustment Trial Balance: Prepared before adjustments to check for errors.
  • Post-adjustment Trial Balance: Prepared after all adjustments to ensure accounts balance.
  • Post-closing Trial Balance: Prepared after all nominal accounts are closed; includes only balance sheet accounts.

Self-Assessment Questions

  • Identify accounts that need adjustment.
  • Record journal entries for short and long-term adjustments.
  • Calculate totals for each adjustment.
  • Prepare trial balances post-adjustment and closing.
  • Show the effects of adjustments in financial statements.