1. Balance day Adjustment
Topic 4
Balance day Adjustment

2. Introduction What we have learnt so far;
Basic accounting conventions and concepts
The accounting equation
Accounting cycle
Recording transactions in the books of original entry
Balancing off ledger account
Transferring ledger balances to the trial balance
What we want to learn
Posting adjusting entries

3. Learning outcomes By the end of this Topic you should;
Differentiate between accrual and cash accounting
Explain why accrual accounting is superior to cash accounting
Describe accruals and adjust identify adjusting entries
Describe prepayments and adjust identify adjusting entries

4. Recap of some accounting concepts
Matching concept
The accrual concept of recognition of expenses and incomes is referred to as the matching principle.
The matching principle requires revenues to be recognised at the same accounting period for which the cost of generation (expenses) are recorded

5. Recap of some accounting concepts
Time period concept
The continuous life time of the entity can be dividend into distinct periods, usually 12 months.
Time period assumption allows evaluation of performance of a business.
To evaluate performance over a period of time, expenses and incomes for that specific period should be compared to determine whether a profit or loss has been made.

6. Accruals vs Cash Accounting
Cash accounting is an accounting base where revenues and expenses are recorded as and when cash is received and paid respectively
Cash basis has been criticized for its failure to provide a reliable measure of the organisation
Cash basis fails to recognize business activities undertaken on credit and assumes noncash charges.
Preference is given to accrual basis of accounting

7. Accrual basis of accounting
Accrual basis of accounting has gained a worldwide acceptance since;
Follows the matching concept
Recognizes expenses when incurred and revenues when earned
Considers noncash charges incurred in a business such as depreciation expense
Provides a more realistic measure of business activities

8. Balance day adjustments
Passing adjustments at year end helps to ensure that matching concept is not violated
Year end adjustments should be plausible
Caution should be taken against engaging in Creative accounting
Creative accounting occurs when adjustments that are not valid are passed. This is tantamount to fraudulent financial reporting.
Reminder: Accountants should be ethical

9. Balance day adjustments
Using accrual basis of accounting there are two main types of adjustments that will be required as at the reporting date;
Accruals and prepayments
Non cash charges

10. Non cash charges
The reporting entity incurs some expenses which are not paid on cash basis.
Examples
Depreciation charge
Amortization charge
Increae in bad and doubtful debts
Obsolescence of inventories
These adjustments will be the subject of our next topic, Topic 5

11. Accruals and prepayments
Accruals relates to expenses where invoices will not have been received at year end. It also includes unbilled revenues where such is earned at reporting date
Prepayments relate to advance payments and receipts. Where payments for expenses have been made in advance, we need to recognize an asset and where there are receipts before provision of a service, recognize a liability.

12. Accruals
Accrued Revenues — income earned but not received at reporting date and has not been billed. For instance, rental income earned towards end of the year
Recording accrued revenue
Dr Accrued revenue XX
Cr Revenue XX

13. Accruals
Accrued Expenses — Incurred expenses for which invoices are yet to be received from suppliers. An estimate should be made for such expenses and the accounts adjusted accordingly.
Example;
Water bills for periods to year end
Gas bills
Electricity
Post paid telephone bills

14. Accruals Illustration
Assume that a business has a loan of $4,000 that is payable (both interest and principal) in lump sum after 10 years. The loan attracts an annual interest at 10 percent.
At year end the unpaid interest should be recognized as a liability computed as follows;
Principal ($4,000) * Rate (10%) * Time (1 year) = $400
Recording
Dr Interest expense account $400
Cr Accruals $400

15. Prepayments Arise when payments are made in advance Are of two types;
Prepaid expenses
Prepaid revenues / unearned incomes

16. Prepaid expenses Relate to expenses paid before service is enjoyed.
Illustration
Bakari Mohammed Radiators Limited is an enterprise in wholesale trade of motor vehicle accessories and its accounting period ends on 31 December. On 30th June 2010, the company bought an annual insurance policy for its vehicle at a cost of $1,000 and paid the same on 1 July in cash.
At year end a prepaid expense of $500 ($1,000 * 6/12) will be recognized

17. Prepaid expenses
To record a prepaid expense, we debit an asset account, prepayments, and credit the respective expense account
Using our illustration;
Dr Prepaid insurance $500
Cr Expenses $500
Generally prepaid expenses are expected to be utilised in the following financial period and as such as normally classified as a current asset in the balance sheet.

18. Prepaid revenues
Prepayments could also arise when cash is received before a service is offered
Common with professional fees
Revenue is earned when the effort is expended
If not earned, it should be deferred to the period when earning effort is made
Deferred income is treated as a current liability

19. Deferred income
Using cash basis of accounting deferred income overstate income for the period
Under accruals concept, it should be removed by
Dr Revenue XX
Cr Deferred revenue XX
Generally, deferred income for one accounting period will be earned in the subsequent accounting period. Therefore, it is treated as a current liability in the balance sheet.

20. Summary In this lesson we have learnt; How to record accrued expenses
Recording accrued revenues
Recording prepaid expenses
Recording prepaid/unearned income
Posting accruals and prepayments adjustments is important in ensuring that accounting concepts and conventions such as time period and matching are not violated.

21. Summary
The topic covers one leg of adjustments, prepayments and accruals
Topic 5 will cover non cash transactions

22. Questions
Solutions of questions arising from the detailed illustration in Topic 3
Multiple choice questions for Topic 4