Chapter 12

Adjustments for accruals and prepayments of expenses, bad debts and depreciation

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  • Created by: Melonball
  • Created on: 23-04-14 13:18

Accrual of expense

An accrual is an amount due in an accounting period which is unpaid at the end of that period.

In the final accounts accrued expenses are:

  • Added to the expense in the trial balance before listing it in the income statement.
  • Shown as a current liability in the year end balance sheet. 

The income statement records expenses that have been incurred in that year which is why we include accrued expenses. The balance sheet also shows liabilities that are due.

With an Accrual of expense, we Add it to the appropriate expense in the income statement.  In the balance sheet it is shown as a separate current liability of 'accruals'. 

Effect on profit- As expenses have increased, the profit decreases. Note: there is no effect on gross profit as expenses come after it in the income statement.

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Prepayment of Expense

A prepayment is a payment made in advance of the accounting period to which it relates.

In the final accounts, prepayments are:

  • Deducted from the expense in the trial balance before listing it in the income statement.
  • Shown as a current asset in the balance sheet.

We need to ensure the income statement records the expense incurred in the year, not the amount paid.

We deduct the prepayment from the expense in the income statement.
In the balance sheet the prepayment is shown as a separate current asset of 'prepayments' 

Effect on profit. - As the expense is decreasing, profit will increase. Again it has no effect on gross profit. 

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Depreciation of Non Current Assets

Depreciation is a measure of the amount of the fall in value of NCA over a period of time.

Things that cause depreciation: wearing through use, using up resources, passage of time etc.

There are 2 methods of depreciation:

  • Straight line
  • reducing balance method.

In unit 1 we are only looking at the straight-line method. Unit 2 is where the reducing balance method is looked at.

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Straight line depreciation

With the straight line method, a fixed percentage is written off the original cost of the asset each year, 

For example 25% will be taken off each year. If the cost of an asset is £2000 then:
£2000 x 25% = £500 per year.
Looking at this, the asset has a useful economic life of 4 years.

The method of calculating straight line depreciation:

Cost of asset - estimated sales proceeds/ scrap value
_____________________________________
 Number of years' expected use of asset 

Example: A machine is expected to have a scrap value of £400. The depreciation amount would be:          £2000 - £400
              ___________   = £400 per year i.e 20% per annum on cost
                  4 years 

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Depreciation in the final accounts

Income statement:    Depreciation is listed among the expenses in the statement. The asset                                        being depreciated will be labelled e.g Depreciation: Machinery 

Balance sheet:         Each NCA will be displayed under three columns: 
                                 Asset at cost   - Provision for Depreciation   = NBV
 So:      Machinery:        £2000           -                £400                 = £1600 

Provision for depreciation: is an estimate of the fall in value of NCA and may comprise depreciation amounts for more than one year

Balance sheet:        Asset at cost   -    Provision for depreciation  = NBV

Year 2
  Machiney:        £2000          -                 £800                  = £1200

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Depreciation: effects

Income statement: There is no effect on gross profit as depreciation is with expenses but it reduces profit for the year.


Balance sheet:
It is a Non- cash expense; depreciation causes no outflow of money. It just reduces the value of an asset.

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Bad debts

A bad debt is a debt owing to a business which it considers will never be paid.

Bad debts in an application of the accounting concept prudence as a conservative (lower) figure is being put in place.

With a bad debt, their account is written off meaning we balance the trade recievables account with the outstanding amount and transfer this amount to the income statement as an expense as we are not going to get paid the money that is owed to us.

Income statement: There is no effect on gross profit. Bad debts written off is included in the expenses. As it is increasing the expense, profit for the year decreases.

Balance sheet: As the trade receivables is the account that owes us money, the bad debts are deducted from trade receivables in the balance sheet as they don't owe us money, they have decreased the asset. 

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Goods for own use

When the owner of a business takes goods for their own use which the business trades: 

  • Deduct the amount from purchases
  • add the amount to the owner's drawings

This means in the income statement we deduct from purchases. This would decrease the cost of sales and increase gross profit.

In the balance sheet under the 'financed by' section in drawings, we would add the amount the owner has taken. Increasing drawings means a decrease in profit. 

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