15/02/2024

FINANCIAL ACCOUNTING
TOPIC 08:

YEAR END ADJUSTMENTS

The content of the Topic

1. Adjust account balances for accruals and prepayments.
2. Adjust for an allowance for bad and doubtful debts.
3. Adjust for depreciation (Covered under PPE)

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Adjust account balances for accruals and prepayments.

In the world of business, payments are not necessarily paid or received when due. Expenses and incomes which do
not pertain to a particular year, need adjustments for accruals and pre- payments in order to comply with the
requirements of the matching principle.

1. Accrued expenses (Outstanding expenses) is an expense which is due but has not been paid.
An expense becomes outstanding when the company has taken the benefit, but the related payment has not been
made.
Examples of Outstanding Expenses. Rent past due but not yet paid, Insurance past due but not yet paid,
Accrued expenses appear within the Current Liability section of the Balance Sheet.

Example: Zungu obtained a loan of Tzs 1 million from a bank on 1/1/23 with interest rate of 9%. The dates of interest
payment are 30/06 & 31/12 every year. The financial year ending is on 31/03/23. Calculate the accrual adjustments.

Solution.
Therefore, the amount of interest outstanding which needs to be recognised is 1,000,000 x 9% x 3/12 = Tzs 22,500.
The journal entry made is
Dr Interest on loan (Expense) Tzs 22,500
Cr Interest accrued on term loan (Liability) Tzs 22,500
Being recording of interest accrued on loan

Adjust account balances for accruals and prepayments.

Dr Interest expense account (Year 22 - 23) Cr
Details Tshs Details Tshs
Interest accrued on term loan 22,500 Transferred to P n L 22,500
Note: the interest accrued during 20X2-X3 is transferred to the statement of profit or loss even if there is no payment of
interest.

Dr Interest accrued account (extract) (Year 20X2-X3) Cr

Details Tshs Details Tshs
Interest expense 22,500

Reversal of accrual
In the future period the expense will be due for payment. Thus, the accrual journal entry will be reversed.
At the beginning of the next year, the journal entry is reversed. This is known as reversal of accrual. In the example
considered above, the entry to be made in the next period is:

Dr Interest accrued on term loan (Liability) Tzs22,500

Cr Cash (Payments) Tzs22,500
Being the reversal of entry taken for accrued interest in the last year

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Adjust account balances for accruals and prepayments.

2. Prepaid expenses are future expenses that are paid in advance.
An organizations may make payments at a certain date, which may not coincide with their accounting year, hence,
these expenses would be paid in advance. Due to matching principle the expenses relates to next financial year will be
carried forward.
Example of Prepaid expenses. Rent or insurance.
Prepaid expenses appear within the Current Asset section of the Balance Sheet.

Example: An insurance policy for fire and similar risks is obtained for the year from 1 November 20X3 by paying a
premium of Tshs24 million for the full year in advance. The reporting period is 31 December 20X3.
Solution.
Of the total premium paid of Tshs24 million, the premium subjected up to the end of the reporting period is:
Tshs24 million x (2/12) months = Tshs4 million.

The journal entry made is:

When the payment was made, the accountant would have recorded the following entry:
Dr Insurance expense (Expense) Tshs24 million
Cr Cash (Asset) Tshs24 million
Being payment of insurance premium recorded

Adjust account balances for accruals and prepayments.

Now, at the end of the year, having determined that Tshs20 million is a pre-payment, the following entry is made:
Dr Prepaid insurance (Asset) Tshs20 million
Cr Insurance expense (Expense) Tsh20 million
Being prepaid insurance recorded
Dr Insurance expense account (Year 20X3) Cr
Details Tshs’000 Details Tshs’000
Cash 24,000 Transferred to P n L 4,000
Prepaid insurance 20,000
24,000 24,000
Dr Pre-paid insurance (asset) account (Year 20X3) Cr
Details Tshs’000 Details Tshs’000
Insurance expense 20,000

In the future period the prepaid insurance will be reverse by the amount as the expense will be posted.
In the example considered above, the entry would be:
Dr Insurance expense (Expense) Tshs20 million
Cr Prepaid insurance (Asset) Tshs20 million
Being the entry to transfer prepaid insurance to insurance expense,

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Adjust account balances for accruals and prepayments.

3. Accrued income (outstanding income) Income can also be accrued and needs to be recognised in the financial
year in which it has accrued, whether the actual cash is received or not
Accrued income is revenue that's been earned but has yet to be received.

Example: Moza had business premises that were lying vacant. He rented it out for an agreed rent of Tshs4 million per
month with effect from 1 January 2002. The accounting year ends in 31 December 2002. Moza receives Tshs36 million
on 30 September 2002.

Solution.
The rent for the 9 month’s period from 1 January 2002 to 30 September 2002 must be accounted as an income.
Rent for the 3 months from 1 October 2002 to 31 December 2002 had accrued even though it had not actually been
received by Moza amounting of Tshs12 million (Tshs4 million x 3).
The journal entry
1. Dr Cash 36,000
Cr Rent income 36,000
Being rent received

2. Dr Rent receivable (SOFP) 12,000

Cr Rent income (SOPL) 12,000
Being rent receivable recorded

Adjust account balances for accruals and prepayments.

A proforma expense account

Dr Rent (income) account. Cr

Details Tshs’000 Details Tshs’000
Transferred to P n L 48,000 Cash (receipts) 36,000
Income accrued (outstanding) 12,000
48,000 48,000

Dr Rent receivable (asset) account Cr

Details Tshs’000 Details Tshs’000
Rent income 12,000

In the future period (example; next year, month, quarter, and semi), the journal entry is reversed.

Dr Cash (Receipts) Tshs12 million

Cr Rent receivable (SOFP) Tshs12 million
Being the entry to transfer rent receivable account to rent income account,

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Adjust account balances for accruals and prepayments.

4. Income received in advance sometimes income is received in advance. The income related to the current year is to
be recorded as income for the current year. The excess income received needs to be recorded in the same financial
year by reducing the income which is received in advance and shown in the statement of financial position as a
liability.

Income received in advance is a revenue which is due to be received in the near future but has been already received
in the present accounting year.

Example: A firm of lawyers received Tshs10 million on 1 March 20X3 as fees for a case that it was handling and booked
the same as revenue for the period. This amount covered 2 court hearings requiring approximately similar time and
effort. Up to the end of the reporting period on 31 March 20X3, only 1 hearing was complete. The second hearing took
place on 30 April 20X3.

At the reporting date only half of the work was complete and therefore only half of the fees must be accounted.

The journal entry

1. Dr Cash Tshs10 million
Cr Professional fees Tshs10 million
Being cash received

Adjust account balances for accruals and prepayments.

2. Dr Professional fees (SOPL) Tshs5 million
Cr Professional fees received in advance (Prepaid income) (SOFP) Tshs5 million
Being adjustment for fees received in advance recorded

Dr Professional fees (income) account (Year 20X2-X3) Cr

Details Tshs’000 Details Tshs’000
Transferred to SOPL (balancing figure) 5,000 Cash ( receipts) 10,000
Fees received in advance 5,000
10,000 10,000
Dr Professional fees received in advance (liability) account (Year 20X2-X3) Cr
Details Tshs’000 Details Tshs’000
Professional fees 5,000

In the future period (example; next year, month, quarter, and semi), the journal entry is reversed.
Dr Professional fees received in advance (SOFP) Tshs5 million
Cr Professional fees (SOPL) Tshs5 million
Being reversal of fees received in current year, in order to record income in the current year

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Adjust for an allowance for bad and doubtful debts.

Sometimes, despite effort taken to establish the creditworthiness of customers, there are still amounts that are not
recoverable. These amounts are called bad debts or irrecoverable debts.

Bad debts arises as a result of various reasons such as insolvency of a customer, death of a customer, dishonesty e.t.c
A bad debt is a receivable that a customer will not pay, they arise when a company extends too much credit to a
customer that is incapable of paying back the debt, resulting in either a delayed, reduced, or missing payment.

Allowance for bad and doubtful debts.

The management of most companies can reliably estimate the percentage of debts which become bad. They rely
heavily on the past accounting data and other general information to arrive at this percentage.

Prudence dictates that the company must recognise the estimated bad debts as a cost in the statement of profit or
loss. This cost recognised as an allowance for receivables ensures that the profits and the assets of an entity are not
overstated.

However, at this stage, management would not know precisely which accounts have actually become bad. Therefore, it
is not possible or desirable to write off any specific accounts.

An allowance for receivables also known as an allowance for bad debts allows the entity to recognise the cost,
without touching individual receivable accounts. This overall allowance for a certain percentage is known as a general
allowance for receivables.

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Adjust for an allowance for bad and doubtful debts.

The following journal entry is made:
Dr Bad and doubtful debts expense X
Cr Allowance for receivables X
Being an increase in allowance for receivables accounted for
If the new allowance required is less than the existing opening balance, then allowance has to be decreased.

The following journal entry is made:

Dr Allowance for receivables X
Cr Bad and doubtful debts expense X
Being a decrease in allowance for receivables accounted for

Example: Goodluck Ltd has total receivables outstanding on 31 March 20X3 of Tshs32 million. It is estimated that 1.5%
of the receivables will not be collected, so therefore it was decided to make an allowance for this. Being the first year
there is no opening balance of allowance for receivables. On 31 March 20X4, the receivables outstanding are Tshs52
million. The allowance is made at the rate of 7%. You are asked to make the accounting entries.
Solution. 1. Journal entry as on 31 March 20X3
Dr Bad and doubtful debt expense Tshs480,000
Cr Allowance for receivable Tshs480,000
Being an allowance made for doubtful debts

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Adjust for an allowance for bad and doubtful debts.

2. In the subsequent year i.e. on 31 March 20X4
Dr Bad and doubtful debt expenseTshs3,160,000
Cr Allowance for receivables Tshs3,160,000
Being the increase in allowance made against doubtful debts

Note Allowance required for the current year = Tshs52 million x 7% = Tshs3,640,000
Less: Existing balance in the allowance account Tshs 480,000
Tshs3,160,000

Presentation in the financial statements.

1. Presentation in statement of profit or loss
a) Bad debts are transferred to the statement of profit or loss as an expense.
b) The increase in the allowance for receivables during the year is transferred to the statement of profit or loss as an
expense.
c) The decrease in the allowance for receivables during the year is transferred to the statement of profit or loss as a
credit in the total bad and doubtful debt expense.
d) If the decrease in the allowance for receivables during the year is greater than the bad debt expense, then the
excess is disclosed as an increase in the expenses.

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Adjust for an allowance for bad and doubtful debts.

Extraction: The following is date pertaining to Alpha Co. and Omega Co. during 20X3 regarding bad debts written off
and change in allowance for receivables:
Excello Tshs’000 Demello Tshs’000
Bad debts written off 70,000 80,000
Change in the allowance for receivables (50,000) (90,000)
Net amount 20,000 (10,000)

The difference between bad debts written off and allowance for receivables is recognised in the following manner:
• Alpha. Tshs20 million: reflect as an expense in the SOPL.
• Omega. (Tshs10 million): reflect as other income in the SOPL or as a reduction in bad debt expense.

2. Presentation in statement of financial position

The closing balance of the allowance for receivables is always reduced from the trade receivables in the statement of
financial position. This reduces the trade receivables to their net realisable value. In real life, the net figure of
receivables may be shown directly in the statement of financial position.
In the examination present it in the following manner:
Tshs’000
Trade Receivables 350,000
Less: Allowance for receivables (20,000)
Net Trade receivables 330,000

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Adjust for an allowance for bad and doubtful debts.

Example: Information provided by Clover Ltd for the last three years is as follows:
Details 31/12/20X1 31/12/20X2 31/12/20X3
Tshs’000 Tshs’000 Tshs’000
Gross profit 32,000 48,000 64,000
Expenses
Irrecoverable debts written off 2,000 1,000 3,000
Salary 2,000 5,000 4,450
Conveyance 1,000 1,100 1,300
Other expenses 1,000 1,500 2,000
Vehicle expenses 2,000 2,330 2,830
Other Information
Receivables as at 31 December 45,000 58,000 42,000

Additional
• Allowance for receivables at 2% on opening balance of receivables
• Being the first year of operation, there were no opening balances for 20X1.
Prepare the statement of profit or loss and show how the receivables will appear in the statement of financial position.

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Adjust for an allowance for bad and doubtful debts.

Answer. Statement of profit or loss for the year.
Details 20X1 20X2 20X3
Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000 Tshs’000
Gross profit 32,000 48,000 64,000
Irrecoverable debts written off 2,000 1,000 3,000
(+) / (-) in Allowance (W1) 900 260 (320)
Salary 2,000 5,000 4,450
Conveyance 1,000 1,100 1,300
Other expenses 1,000 1,500 2,000
Vehicle expenses 2,000 2,330 2,830
Net profit / loss 23,100 36,810 50,740

Extracts from the statement of financial position as at:

31/12/20X1 31/12/20X2 31/12/20X3
Current assets Tshs’000 Tshs’000 Tshs’000
Receivables 45,000 58,000 42,000
Less: Allowance for receivables (900) (1,160) (840)
(W1)
Net receivables 44,100 56,840 41,160

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Adjust for an allowance for bad and doubtful debts.

Workings:
W1 Allowance for receivables
31 December 20X1 Tshs
Allowance required = 2% of x Tshs45 million 900,000
No opening balance of allowances, therefore an allowance should be made for Tshs900,000.

31 December 20X2 Tshs

Allowance required = 2% x Tshs58 million 1,160,000
Less: Balance in allowance account (900,000)
Increase in allowance 260,000

31 December 20X3 Tshs

Allowance required = 2% x Tshs42 million 840,000
Less: Balance in allowance account (1,160,000)
Decrease in allowance (320,000)

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