Presentation on theme: "Chapter 10 Balance Day Adjustments. Revenues & Expenses."— Presentation transcript:
Chapter 10 Balance Day Adjustments
Revenues & Expenses
Note The definitions do not refer to revenues as ‘cash received’, but rather ‘inflows of economic benefits’. The benefit may be cash, but does not have to be; it could be debtors (for a credit sale) or some other asset such as stock (for a stock gain). In the case of discount revenue, the benefit is actually a reduction in an outflow, where no cash flow. Expenses should be recognised when the economic benefit is consumed (or incurred), not when the cash is paid. When we speak of determining profit, we are actually comparing the revenue earned in the current Reporting period against the expenses incurred in the current Reporting period.
Adjusting before closing The assumption we made before closing the ledger (in Chapter 9) was that revenue accounts already showed the amount earned in the current Reporting period, and expense accounts showed the amount incurred in the current Reporting period. Unfortunately, this is not always the case; at balance day (the end of the Reporting period) the accounts may only show the amount received, or the amount paid in that particular period. For example, there may be electricity that has been consumed in the current period (representing a consumption of an economic benefit – an expense) but will not be paid until the next period.
Balance Day Adjustments If at balance day the ledger accounts do not yet show the revenue earned and expenses incurred in the current Reporting period, then a Balance day adjustment (BDA) is necessary. A balance day adjustment is a change made to a revenue or expense account on balance day so that revenue accounts show revenues earned and expense accounts show expenses incurred in a particular Reporting period. Just like closing entries, balance day adjustments apply the Reporting period principle to ensure Relevance in the accounting reports.
Types of BDA’s The balance day adjustments to be covered in this unit refer mainly to expenses (with stock gain being the obvious exception), and include: stock losses and gains (covered in Chapter 8) prepaid expenses depreciation (to be covered in Chapter 11) accrued expenses Other adjustments – relating to revenue accounts – will not be examined until second semester and so are covered in later chapters.) These balance day adjustments must be recorded in the General Journal before being posted to the General Ledger accounts.
You! Review Questions Q’s 1, 2, & 3.
Prepaid Expenses Frequently, an amount will be paid for an expense that is not consumed at the time the payment is made. For instance, when rent or insurance are paid they are usually paid in advance, covering the next month, or perhaps even the forthcoming year. The same could be said for supplies and materials (such as stationery), which are purchased in bulk, but are not used up immediately. These are common payments, but at the time they are paid, should we consider them to be expenses? Consider the definition of an expense – it refers to a consumption or outflow of economic benefits. Yet at the time the amount is paid, how much of the rent, insurance or office supplies has been consumed? The answer is, obviously, none! In fact, each will not be consumed until some time in the future; they are not consumptions of economic benefits, but rather future economic benefits. In other words, they are assets.
Prepaid Expenses When an expense is paid in advance, it should properly be recorded as a current asset called Prepaid expense (in this case, Prepaid Rent, or Prepaid Insurance, or Prepaid Office Supplies). When an expense is prepaid, it must be recorded as such in the journals and ledger accounts. Refer Cash Payments Journal & General Ledger pp Don’t forget GST is treated separately.
Adjusting for the consumption of a prepaid expense Prepaid expenses are recorded as current assets because at the time of payment, none of the amount has been consumed – it is all a future economic benefit. However, by the time balance day arrives (the day on which the ledger is closed and reports are prepared) at least part of this prepaid expense is likely to have been consumed. In other words, part of the asset has become an expense. It is therefore necessary to adjust the ledger accounts so that: the amount consumed (i.e. used up) in the current Reporting period is shown as an expense. the Prepaid expense account only shows the amount remaining (i.e. unused, or to be used up in a future Reporting period).
Adjusting for the consumption of a prepaid expense Calculate the amount consumed/used up/incurred – this is the amount to use in the adjustment. See Figure 10.2 p The General Journal entry debits the Insurance expense account to recognise the expense incurred in the current Reporting period, while the Prepaid insurance account is credited to reduce the current asset by the amount consumed. See also General Ledger entries. Note this adjustment does not change Bank, nor does it affect GST Clearing.
Closing the ledger The expense account is now ready to be closed to the Profit and Loss Summary account. (Remember that all expense accounts are closed in one General Journal entry, with each expense account credited, and one debit to the Profit and Loss Summary account).
You! Review Questions Q 2.
Accrued Expenses Prepaid expenses are paid before they are consumed. However, it is also likely that some expenses will be paid after they are consumed. For example, at balance day there may be wages owing to employees for work that has already been done, or electricity that has been consumed but not paid for. Because this amount has already been incurred – in the language of the definition, consumed in the current Reporting period – it must be recognised as part of the expense amount. In addition, the amount owing should also be recorded as a liability. The amount still owing for an expense that has already been consumed is called an accrued expense.
Accrued Expenses It is therefore necessary to adjust the ledger accounts so that: the extra amount consumed (i.e., used up) in the current Reporting period is added to the expense account a current liability account – Accrued expense – is created to show the amount owing/unpaid (which will be paid in the next Reporting period).
Accrued Expenses See Figure 10.4 p. 224.
Accrued Expenses See also General Ledger entries. Note: The amount used in the adjustment ($300) is not the total expense for the period, it is simply the amount that has been consumed but not yet paid. It is added on to the amount paid to calculate the total expense.
Closing the Ledger As a current liability, the Accrued electricity account will be balanced, but the Electricity expense account will be closed to the Profit and Loss Summary account. Remember, for an item to be recognised as an expense, the definition requires an item to be consumed; payment is not necessary.
Payment of accrued expenses in subsequent periods Sometime in the next Reporting period, the amount owing as an accrued expense will be paid. Therefore, the next time a cheque is written to pay for the expense, we must recognise that while some of the amount paid may represent an expense of the current Reporting period, at least some of the payment relates to the previous Reporting period. In other words, some of the amount paid reduces the liability for accrued expenses.
Payment of accrued expenses in subsequent periods See Figure 10.6 p. 226 incl. General Journal entries..
Note Not all expenses incur GST; when paying a non-GST item (like Wages or Interest expenses) in a subsequent period, it will not be necessary to account for the GST.
Accrued expense vs. Sundry creditor A Sundry creditor occurs when items other than stock are purchased, but the payment has not been made. An accrued expense will be verified not by an invoice, but rather by something like a memo. If an invoice has been received, the transaction is a boring old credit transaction, and the amount owing should be shown as a Sundry creditor. See text for more info if needed.
You! Review Questions Q’s 1, 2, & 4.
THE POST-ADJUSTMENT TRIAL BALANCE The idea of preparing a Trial Balance was introduced in Chapter 3 as part of the ledger recording process. Its function was to check that total debits equal total credits. Technically, this should have been titled a Pre-adjustment Trial Balance, as it prepared before any balance day adjustments have been recorded. However, balance day adjustments change the General Ledger accounts, after the Trial Balance has already been prepared; they increase certain expenses, decrease certain current assets, and increase certain current liabilities. This means it may be useful to prepare a Post-adjustment Trial Balance, to check that even after the balance day adjustments have been made, the total debits equal the total credits.
THE POST-ADJUSTMENT TRIAL BALANCE See Kingston Hardware example incl. Figure 10.4 Post-adjustment Trial Balance on p Do Review Questions 10.4 (all q’s). Read Summary.