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Adjustments to financial statements

Many students find it difficult to handle these adjustments properly in an exam. The main
possible adjustments that we have in financial statements are:

 Accruals and prepayments

 Depreciation
 Bad debts and allowances for receivables/provisions for bad debts

The most important point, which must be understood at the outset, is that all these adjustments
have an impact on both the income statement/profit and loss account and the balance sheet. If the
trial balance balances, your answer must balance, and therefore any changes to the trial balance
must balance.

Accruals and prepayments

The income statement/profit and loss account has to include the expenses relating to the period,
whether or not they have been paid. The figures in the trial balance will usually be the amounts
paid in the period, and they need adjusting for outstanding amounts and amounts paid which
relate to other periods to obtain the income statement charge.
Unpaid balances relating to the period should be included in the balance sheet as current
liabilities. If the expense has been paid in advance, the amount prepaid is included in the balance
sheet as a current asset. In the income statement/profit and loss account, the total expense is
needed.

Example
An extract of the trial balance shows:

$
Wages 136 000
Insurance 4 000

Additional information:
At 31 Dec 2019, wages owing amounted to $3 800 and insurance paid in advance was $600

This is presented as follows:

Income statement (extract)
Expenses $
Wages (136 000 + 3800) 139 800
Insurance (4 000 – 600) 3 400

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Balance Sheet (extract)

Current assets $ $
Inventory/stock -
Receivables/debtors -
Prepayments 600
Cash -

Current Liabilities
Trade payables/creditors -
Accruals 3 800

In short, accruals and prepayments are treated twice in financial statements i.e. in the income
statement and balance sheet.
Accruals are added to the expense in the income statement and are treated as current liabilities in
the balance sheet.
Prepayments, on the other hand, are deducted on the expense in the profit and loss and are
treated as current assets in the balance sheet.

Depreciation
Fixed assets like plant and machinery etc. are used in the business for the purpose of production
or providing services. With the passage of time and utilisation, value of such fixed assets
decreases. Value of portion of fixed assets utilized for generating revenue must be charged during
a particular accounting year to ascertain the true cost. This portion of cost of fixed asset allocated
is called depreciation. Depreciation means reduction in value of asset or in the utility due to
passage of time, natural wear and tear, exhaustion of the subject matter.

Causes of depreciation
 Lapse of time
 Natural wear and tear
 Exhaustion of the subject matter
 Obsolescence of technology

Methods of calculating depreciation

1. Straight Line Method

In this method, an equal amount is written off every year during the working life of the asset
to nil or its residual value at the end of its useful life.

𝐶𝑜𝑠𝑡 − 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑣𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
Example
A machine was bought for $18 000 and it is expected to be used for 5 years. Calculate
depreciation charge per year.

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Solution
$18 000 − 0
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
5
= $4 000

Example 2
A business bought a new motor vehicle for $12 000 with an estimated life span of 5 years and
a residual value of $800. Calculate the annual depreciation per annum.

12 000 − 800
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
5
= $2 240

Depreciation can also be calculated as a percentage of cost price

Example
Fixtures and fittings costing $42 500 were bought. Depreciation is to be charged at the rate of
18% 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚. Calculate depreciation to be charged to the income statement

Solution
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = % × 𝐶𝑜𝑠𝑡
= 18% × $42 500
= $7 650

2. Reducing balance method

The reducing balance method of depreciation calculates the annual depreciation charge as a
fixed percentage of the carrying value of the asset, as at the end of the previous accounting
period.
The depreciation is charged at a fixed rate like straight line method. However, unlike
straight line method, the rate percent is not calculated on cost of asset but on the book
value of asset, which in turn is calculated by subtracting depreciation from its cost.

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = % × 𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

𝑵𝒆𝒕 𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 (𝑵𝑩𝑽) = 𝑪𝒐𝒔𝒕 − 𝑨𝒄𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒆𝒅 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏

Accumulated depreciation is the sum of all depreciations of an asset from the ye ar it

was bought to the current year.

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Example
A machine costing $28 000 is bought. It is to be depreciated at the rate of 15% using
the reducing balance method. Calculate the depreciation of the machine of the first 3
years.

Solution
Year 1:
𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 0, 𝑁𝐵𝑉 = $28 000

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 15% × $28 000

= $4 200.

Year 2:
𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $4 200 𝑁𝐵𝑉 = $28 000 − $4200
= $23 800

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 15% × $23 800

= $3 570

Year 3:
𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $4 200 𝑁𝐵𝑉 = $28 000 − $4200 − $3 570
= $20 230

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 15% × $20 230

= $3 034.50

Treatment of depreciation in financial statements

Depreciation for the year is treated as an expense in the trading and profit and loss
account/income statement. In the balance sheet the depreciation charged reduces the value of
fixed assets so it is added to the accumulated depreciation/provision for depreciation then
subtracted from the cost of the asset to get the net book value of the asset (actual value of the
asset as at that date).

Example
The following is an extract of the trial balance of J & K Ltd for the year ending 31 Dec 2020
$ $
Motor vehicles at cost 200 000
Machinery at cost 150 000
Provision for depreciation: Motor vehicles 80 000
Machinery 32 000

Additional information at 31 Dec 2020

Depreciation to be charged as follows:
 Motor vehicles – 20% on cost
 Machinery – 25% reducing balance method

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Required: Prepare a Trading and profit and loss extract and Balance Sheet extract

Solution

Working for depreciation

𝑀𝑜𝑡𝑜𝑟 𝑣𝑒ℎ𝑖𝑐𝑙𝑒𝑠 = 20% × 200 000 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝 = 80 000 + 40 000
= 40 000 = 120 000

𝑀𝑎𝑐ℎ𝑖𝑛𝑒𝑟𝑦 = 25% × 𝑁𝐵𝑉 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝 = 32 000 + 29 500

= 25% × (150 000 − 32 000) = 61 500
= 29 500

Trading and profit and loss (extract) for the year ended 31 Dec 2020
$ $
Less Expenses
Depreciation: Motor vehicles 40 000
29 500

Balance sheet extract as at 31 Dec 2020

Cost Acc Dpn NBV
Non-current assets $ $ $
Motor vehicles 200 000 120 000 80 000
Machinery 150 000 61 500 88 500
350 000 181 500 168 500

Bad debts and allowances for receivables/provision for bad debts

Bad debts (Irrecoverable debts)

Irrecoverable debts are specific debts owed to a business which it decides are never going to
be paid. They are written off as an expense in the income statement.

Allowances for receivables/provision for bad debts

Allowances for receivables may be specific (an allowance against a particular receivable) or
simply a percentage allowance based on past experience of irrecoverable debts. An increase
in the allowance for receivables is shown as an expense in the income statement.
Trade receivables in the statement of financial position are shown net of any receivables
allowance.
This allowance is set up in order to include a realistic value for receivables/debtors in the
balance sheet, without actually writing off the debt. The balance is left in the
receivables/sales ledger so that collection procedures continue, but the receivables/debtors in
the balance sheet are valued as if the amount is not to be recovered.

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In the Income statement any increase in these allowances from the previous period is treated
as an expense and any decrease as income (added to gross profit).

Example 1
Trial balance extract
$ $
Debtors/Receivables 42 000
Allowance for receivables 600

Additional information
The allowance for receivables is to be adjusted to 2% of receivables.

Required: Prepare the trading and profit and loss account extract and balance sheet

Solution
Working
Allowances for receivables = 2% × $42 000
= $840

Increase in allowances for receivables = 840 − 600

= $240

Trading and profit and loss account (extract)

$ $
Less expenses
Increase in allowances for receivables 240

Balance Sheet (extract)

$ $ $
Current Assets
Stock XXX
Debtors 42 000
Less allowances for receivables 840 41 160
Bank XX

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Example 2
Trial balance extract
$ $
Debtors/Receivables 27 500
Allowance for receivables 1 500

Additional information
The allowance for receivables is to be adjusted to 5% of receivables.

Required: Prepare the trading and profit and loss account extract and balance sheet

Solution
Working
Allowances for receivables = 5% × $27 500
= $1 375

Decrease in allowances for receivables = 1 500 − 1 375

= $125

Trading and profit and loss account (extract)

$ $
Gross Profit XXX
Decrease in allowances for receivables 125
XXX

Balance Sheet (extract)

$ $ $
Current Assets
Stock XXX
Debtors 27 500
Less allowances for receivables 1 375 26 125
Bank XX

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