CHAPTER 4End of period

adjustments and Depreciation

LEARNING OBJECTIVES

1. Describe the difference between the cash basis and the accrual basis of measuring profit

2. Explain the accounting cycle and the need for end-of-accounting-period adjusting entries

3. Identify and prepare the different types of adjusting entries4. Explain the nature of property, plant and equipment5. Compute the cost of property, plant and equipment6. Discuss the nature of depreciation and determine the amount of

depreciation expense using several different cost allocation methods

2

3

MEASUREMENT OF PROFIT

• Cash Basis– Income is recorded when cash is received– Expenses are recorded when cash is paid

• Accrual Basis– Income recognised when the anticipated inflow of

economic benefit can be reliably measured– Expenses recognised when the consumption of

benefits can be reliably measured

4

TEMPORARY AND PERMANENT ACCOUNTS

• Temporary (Nominal) Accounts– Income Statement Accounts– Reduced to zero balance at the end

of each accounting period (closed)– Reset the business “stopwatch”

• Permanent (Real) Accounts– Balance Sheet Accounts– Ending balances carried forward to next accounting

period

EXPANDED ACCOUNTING CYCLE INCLUDING ADJUSTING ENTRIES

2. Journalise transaction

3. Post to ledger accounts

4. Prepare unadjusted trial balance of general ledger

1. Recognise & record transactions

Source documents

General journal

General ledger

Trial balance (unadjusted)

Continued Next Slide

6

EXPANDED ACCOUNTING CYCLE INCLUDING ADJUSTING ENTRIES

Worksheet

8. Prepare financial statements

6. Post adjusting entries to general ledger

7. Prepare adjusted trial balance

5. Determine adjusting entries and journalise

General journal

General ledger (Accounts Adjusted)

Trial balance (Adjusted)

Financial Statements

7

THE NEED FOR ADJUSTING ENTRIES

• In many cases the period in which cash is paid or received does not coincide with period in which expense and income are recognised

• Therefore, in order for our statements to reflect what has actually happened, some accounts must be adjusted on the last day of the accounting period to correctly recognise income and expenses not reflected in cash receipts or payments

8

CLASSIFICATION OF ADJUSTING ENTRIES

Deferrals(Prepayments)

Prepaid ExpenseCosts/expenses paid before they are consumed

Unearned RevenueRevenues that are collected or received but not yet earned

Accruals(Unrecorded)

Accrued ExpenseExpenses incurred but not yet paid

Accrued RevenueRevenue earned but not yet received

9

THE RULES OF ADJUSTING ENTRIES

• Attempting to account for the “timing difference” between receipt/payment of cash, and recognition of income/expense

• One side of the entry affects an income statement account– That is revenue or expense

• The other side of the entry affects an account reported in the balance sheet– That is asset or liability

• Cash is never adjusted!

ADJUSTING ENTRIESRevenue

Last Year Current Year Next Year

Unearned revenueRevenues collected in

advance, but not yet earnede.g. magazine subscription

received in advance

$$$ Revenue Revenue

Accrued revenueRevenues earned, but not yet

received in cash or enterede.g. interest earned on a bank

term deposit but not paid

$$$

ADJUSTING ENTRIESExpenses

Last Year Current Year Next Year

Prepaid expensesExpenses paid for before they are

consumede.g. Insurance premium paid 12

months in advance

$$$ Expense Expense

Accrued expensesExpenses incurred, but not yet

paid for or enterede.g. wages earned by

employees, but not yet paid

$$$

12

DEFERRALS: PREPAID EXPENSES

• Cash paid before benefits are consumed/expire• Initially recorded as an asset when paid• At the end of the period the amount

consumed/expired is expensed.ASSET ACCOUNTPrepaid Expense

Initial CostDebit

Adjusting EntryCredit

EXPENSE ACCOUNT

Adjusting EntryDebit

Costs consumed or expired

13

EXAMPLE: PREPAID RENT

• On 1 June the following entry was made to record rent covering the a period of 3 months:

General Journal

Jun 5 Prepaid Rent 1 200

GST Outlays 120

Cash at Bank 1 320

(Payment of rent for 3 months)

14

• On 30 June only one month of rent has expired ($1,200 ÷ 3 months = $400)

General Journal

Jun 30 Rent Expense 400

Prepaid Rent 400

(Adjusting entry for rent)

Prepaid RentInitial Entry

1 200Adjusting Entry

400

Rent ExpenseAdjusting Entry

400

Costs expired and allocated to current period

EXAMPLE: PREPAID RENT

15

EXAMPLE: DEPRECIATION

Contra-Asset AccountAccumulated Depreciation

Adjusting EntryCredit

Depreciation ExpenseAdjusting Entry

Debit

Costs consumed and allocatedto current period

Non-Current Asset

Initial CostDebit

Depreciation = Allocation of the historic cost of an asset (less any residual) over the useful life of that asset

16

DEFERRALS: UNEARNED REVENUE

• Cash received in advance for services that are to be preformed in the future

• Initially recorded as liability when received• Recognised as revenue as earned

LIABILITY ACCOUNTUnearned Revenue

Adjusting EntryDebit

Cash Receipt

INCOME ACCOUNT

Adjusting EntryCredit

Revenue earned during the current period

17

EXAMPLE: SUBSCRIPTIONS

• On 8 September a monthly magazine publisher received $264 for a 1 year subscription beginning October

General Journal

Sept 8 Cash at Bank 264

GST Collections 24

Unearned Subscription Revenue 240

(Receipt of subscriptions in advance)

18

• On 31 December 3 months of revenue has been earned (3/12 x $240 = $60)

General Journal

Dec 31 Unearned Subscriptions Revenue 60

Subscriptions Revenue 60

(Adjusting entry for subscriptions earned)

Unearned Subscriptions RevenueAdjusting Entry

60Cash240

Subscriptions RevenueAdjusting Entry

60

Revenue earned during the current period

EXAMPLE: SUBSCRIPTIONS

19

ACCRUALS: ACCRUED EXPENSES

• Expenses that have been consumed but payment has not yet been made

• Expense must be recognised along with a liability for future payment

LIABILITY ACCOUNTExpense Payable

Adjusting EntryCredit

EXPENSE ACCOUNT

Adjusting EntryDebit

Expenses Incurred

20

EXAMPLE: ACCRUED SALARIES

21

• On 30 June an adjusting entry is required to correctly determine June’s expenses

General Journal

Jun 30 Salaries Expense 3 980

Salaries Payable 3 980

(Adjusting entry for salaries payable)

Salaries PayableAdjusting Entry

3 980

Salaries ExpenseAdjusting Entry

3 980

Expenses Incurred

EXAMPLE: ACCRUED SALARIES

22

• The liability is eliminated on 6 July when the next payment is made to employees

General Journal

Jul 6 Salaries Payable 3 980

Salaries Expense 3 420

Cash at Bank 7 400

(Payment of salaries earned 23 June to 6 July)

EXAMPLE: ACCRUED SALARIES

ACCRUALS: ACCRUED REVENUE

• Usually recorded when service is performed – No adjusting entry would be necessary

• Any unrecorded revenue earned needs to be recorded

ASSET ACCOUNTAccounts Receivable

Adjusting EntryDebit

INCOME ACCOUNTRevenue

Adjusting EntryCredit

Revenue earned but not yet received

24

EXAMPLE: MARKET SERVICES

• On 1 June an agreement was signed to provide marketing services for a monthly fee of $800. On 30 June cash is yet to be received and no invoice has been issued

General Journal

Jun 30 Accounts Receivable 800

Marketing Services Revenue 800

(Marketing services fee receivable for June)

25

Now try the 4 journal entries

1. Wages earned by employees but not paid at year-end, $3100.

2. Depreciation on vehicles not recorded, $8000.

3. Rental revenue earned but not collected or recorded, $840. 4. The company requires the first-day rental in advance as a deposit for making a reservation. The deposit is either deducted from the total rental charges or is forfeited. During the last week of December, deposits earned were not recorded as revenue, $550.

26

Solution

1. Wages Expense 3 100Wages Payable 3 100 Wages owing to employees

2. Depreciation Expense - Vehicles 8 000Accum. Depreciation - Vehicles8 000 Depreciation on vehicles

3. Accounts Receivable 840Rental Revenue 840 Rent revenue earned

4. Unearned Rental Revenue 550• Rental Revenue 550• Rent deposits in advance earned

27

WHAT IS PROPERTY, PLANT AND EQUIPMENT?

• Any asset with physical substance that is expected to be used over more than 1 year

• Because future economic benefit of property, plant and equipment will be received over 2 or more accounting periods

• Depreciable amount must be allocated in a systematic manner over useful life to measure depreciation

28

DETERMINING COST OF PROPERTY, PLANT AND EQUIPMENT

• Must be accounted for at cost– The amount of cash or the fair value of other

consideration given to acquire an asset• Cost includes

• Purchase price• Any directly attributable costs such as transport,

installation, testing the equipment• Also initial costs of insurance and registration (car)• Estimate of costs of dismantling, removing and restoring

29

EXAMPLE – DETERMINING COST OF PROPERTY, PLANT AND EQUIPMENT

List price of the machine $22 000

Less: Trade discount (10% x $22 000) - 2 200

19 800

Less: GST (1/11) - 1 800

Purchase price 18 000

Freight inwards (net of GST) + 820

Installations costs (net of GST) + 675

Cost of machine $19 495

In this example the buyer has been given various amounts for the purchase of the machine. Eg the RRP (list price), his special discount (trade discount), and ALWAYS eliminate the GST if it is included in the machine cost.

30

SUBSEQUENT COSTS

How do we treat costs incurred after we have purchased or used the asset?– Repairs to the asset are expensed– Maintenance costs are expensed– Improvement costs can be capitalised-an asset– Modification costs can be capitalised- an asset

• When making the decision we need to consider the impact on useful life/future economic benefits of the asset

31

DEPRECIATION

• Nature of depreciation– Expected usage– Expected wear and tear– Technical and commercial obsolescence– Legal or similar limits

• Cost needs to be apportioned over expected useful life

32

Depreciation Factors in computing depreciation

33

Depreciation methods

1. Straight-line method• Allocates and equal amount of

depreciation to each full accounting period in asset’s useful life

Annual depreciation = depreciable amount*useful life

* Depreciable amount is cost less residual value

34

EXAMPLE – STRAIGHT-LINE METHOD

– On 1 July, assume a machine has a cost of $33 000 (net of GST), a residual value of $3000, and a useful life of 4 years.

Annual Depreciation =Depreciable amount

Useful life

=$33 000 - $3 000

4 years= $7 500 p.a.

General Journal

Jun 30 Depreciation Expense 7 500

Accumulated Depreciation – Machine 7 500

(Depreciation expense for the year)

35

Depreciation methods continued

2. Diminishing-balance method• Results in decreasing depreciation charge

over the useful life of the asset• Asset more productive in its earlier years

and earns more revenue

n = useful life in yearsr = residual value (in $)c = original cost or gross revalued amt (in $)

c

rn1Rate

36

EXAMPLE – DIMINISHING-BALANCE METHOD– On 1 July, assume a machine has a cost of

$33 000 (net of GST), a residual value of $3000, and a useful life of 4 years.

= 1 -

Year

Carrying amount at beginning of

the year Rate

Annual depreciation

expense

Carrying amount at end of year

1 $33 000 x 45% $14 850 18 150

2 18 150 x 45% 8 168 9 982

3 9 982 x 45% 4 492 5 490

4 5 490 x 45% 2 490 3 000

37

Depreciation methods continued

3. Sum-of-years digits• Different way of applying diminishing

value method• Depreciation each period is determined by

multiplying the residual amount by successively smaller fractions

38

EXAMPLE – SUM-OF-YEARS-DIGITS METHOD– On 1 July, assume a machine has a cost of

$33 000 (net of GST), a residual value of $3000, and a useful life of 4 years.

Sum−of −years −digits  = 1+2+3+4 = 10

YearDepreciable

amount Fraction

Annual depreciation

expense

Total accumulated depreciation

Carrying amount

1 $30 000 x 4/10 $12 000 $12 000 $21 0002 30 000 x 3/10 9 000 21 000 12 0003 30 000 x 2/10 6 000 27 000 6 0004 30 000 x 1/10 3 000 30 000 3 000

39

Depreciation methods continued

4. Units-of-production method• Determines fixed amount of depreciation

per unit of output• Annual depreciation is depreciable

amount divided by the production capacity or useful life in units

Depreciation per = depreciable amountoperating hr operating hours

40

EXAMPLE – UNITS-OF-PRODUCTION METHOD– On 1 July, assume a machine has a cost of

$33 000 (net of GST), a residual value of $3000, and a useful life of 15 000 hours.

Annual Depreciation =Depreciable amount

Operating hours

=$33 000 - $3 000

15 000 hours= $2 per hour

41

DEPRECIATION ISSUES

• All methods will show the same total depreciation expense over life of the asset

• However each method will show different annual charges

• The method used should reflect the nature of the underlying asset

• Residual values and useful lives should be reviewed every few years

• Depreciation is an estimate and does not equal cash!