ACC/ACF1100

Introduction to Financial Accounting

Lecture 4:
Balance day adjustments (Part 2)

Dr Chris Adrian - Department of Accounting

Reference:
Required readings: Financial Accounting - Reporting, Analysis and Decision Making (7th
Edition)
Chapter 7: sections 7.7-7.8 (excluding notes receivable)
Chapter 8: sections 8.3-8.4 (straight-line, diminishing-balance, units-of-production methods)
 Week 4
1. Recap from Week 3

2. Balance day adjustments (Part 2)

• Depreciation
• Bad and doubtful debts

3. Continue with case study ‘Donny’s hairdressing business’

2
Recap from Week 3

3
 The Accounting Cycle
Inputs 1 SOURCE DOCUMENTS
During the
2 JOURNALS accounting
period
3 LEDGERS

Processing 4 TRIAL BALANCE

5 ADJUSTING JOURNAL ENTRIES

End of
6 CLOSING JOURNAL ENTRIES accounting
period
7 POST-CLOSING TRIAL BALANCE

Output 8 FINANCIAL STATEMENTS

4
 What Adjusting Entries?
Four main types of adjusting entries are considered today:

Accruals Prepayments

Accrued revenues Prepaid revenues

Revenues (an asset) (a liability)

Accrued expenses Prepaid Expenses

Expenses (a liability) (an asset)
Depreciation

6
 What is Depreciation?
Non-current assets (except land) represent a finite store of future benefit
that the business will utilise or consume over a number of expected years of
benefit. For example, if a machine was purchased 10 years ago, the future
economic benefits are likely to be much less now than when the machine
was originally purchased.
• This consumption of an economic benefit needs to be recognised in the
Income Statement as depreciation expense
• As does the decrease in carrying value in the Balance Sheet (as
accumulated depreciation).
Recorded as an expense via an adjusting entry at balance date

Depreciation is NOT a market valuation process!

IT DOES NOT CHANGE THE MARKET VALUE!

7
 What is Depreciation?

The period of benefit (or useful life) is generally limited, due

to the following:
• expected usage of the asset (‘wear and tear’)

• physical deterioration

• technological obsolescence

• legal or similar limits on the use of the asset

8
 What is Depreciation? (Important Terms)
• There is an Australian Accounting Standard that stipulates the accounting for
Depreciation (AASB116 - PP&E)
• Depreciation is defined in para 6 as “the systematic allocation of the
depreciable amount of an asset over its useful life.”
• Useful life is “the period over which an asset is expected to be available for
use by an entity”
• The depreciable amount is “the cost of an asset, or other amount substituted
for cost, less its residual value”
• Residual value of an asset is “the estimated amount that an entity would
currently obtain from disposal of the asset … at the end of its useful life”
• Carrying amount/carrying value is the amount at which an asset is
recognised after deducting any accumulated deprecation

9
 How do we Account for Depreciation?
Different methods are available.
“The depreciation method used shall reflect the pattern in
which the asset’s future economic benefits are expected to
be consumed by the entity.” (AASB 116, para. 60)

The methods available include:

• Straight-line
• Reducing balance
• Units-of-production
 How do we Account for Depreciation?
Irrespective of the depreciation method chosen the adjusting
entry is:

Date Particulars DR CR

30/6/21 Depreciation expense XX

Accumulated depreciation XX
 What Type of Account is Accumulated
Depreciation?
• Accumulated depreciation is a contra asset (negative asset)
• As asset has a normal Dr balance, a contra asset has a normal Cr balance
• Reflects the amount of depreciation recorded over the life of the asset to date
• There is a separate accumulated depreciation account for each asset class
• It is deducted from the cost of the asset in the balance sheet:
• Example:
Machinery 12,000
less Accumulated depreciation (2,500)
Carrying amount 9,500
• Carrying amount: benefits that have not yet been used up
12
 How do we Calculate Depreciation?

(1) Straight-line Method

• Allocates an equal amount each period for the life of the asset
• Applied to those assets that contribute equally to revenue each period over
their useful life
• E.g., office furniture, buildings

• Depreciation is calculated using the following formula:

Cost – Residual value = depreciation expense p.a.

Useful life

13
 Straight-line Method
Example:
Canyon Industries Ltd purchased a plant & equipment item on 1 July
2019 for $36,000. The equipment has an estimated useful life of five
years and an estimated residual value of $6,000.

Required:
1. Determine the amount of depreciation expense for the financial years
ending 30 June 2020 and 30 June 2021 under the straight-line Method
2. Record the general journal entries to record depreciation for the
financial years ending 30 June 2020 and 30 June 2021
3. Calculate i) the balance of accumulated depreciation account and ii)
the carrying amount of the asset as at 30 June 2021

14
 Straight-line Method
Solution:
30 June 2020:
(Cost – Residual Value)/Useful Life
($36,000 – 6,000) / 5 years = $6,000 p.a.

30 June 2021:
(Cost – Residual Value)/Useful Life
($36,000 – 6,000) / 5 years = $6,000 p.a.

15
 Straight-line Method
Solution:
General journal entry (BDA) 30 June 2020:
Dr. Depreciation exp – Plant & equipment $6,000
Cr. Accumulated depn. – Plant & equipment $6,000

General journal entry (BDA) 30 June 2021:

Dr. Depreciation exp – Plant & equipment $6,000
Cr. Accumulated depn. – Plant & equipment $6,000

16
 Straight-line Method
Solution:
i) Accumulated depreciation account as at 30 June 2021:
$6,000 + $6,000 = $12,000

ii) Carrying amount of the asset as at 30 June 2021:

Cost – accumulated depreciation = $36,000 - $12,000 =
$24,000.

17
 Straight-line Method

Example where we purchase the asset DURING the period:

Canyon Industries Ltd purchased a plant & equipment item
on 1 October 2019 for $36,000. The equipment has an
estimated useful life of five years and an estimated residual
value of $6,000.
Required:
1. Determine the amount of depreciation expense for the financial years
ending 30 June 2020 and 30 June 2021 under the Straight-line
Method
2. Record the general journal entries to record depreciation for the
financial years ending 30 June 2020 and 30 June 2021
18
 Straight-line Method
Solution:
30 June 2020:
(Cost – Residual Value)/Useful Life
($36,000 – 6,000) / 5 years = $6,000 p.a.
But we have only owned it since 1 October
2019 (9 Months): $6,000 x (9/12) = $4,500
30 June 2021:
(Cost – Residual Value)/Useful Life
($36,000 – 6,000) / 5 years = $6,000 p.a.

19
 Straight-line Method
Solution:
General journal entry (BDA) 30 June 2020:
Dr. Depreciation Exp – Plant & equipment $4,500
Cr. Accumulated depn. – Plant & equipment $4,500

General journal entry (BDA) 30 June 2021:

Dr. Depreciation Exp – Plant & equipment $6,000
Cr. Accumulated depn. – Plant & equipment $6,000

20
 How do we Calculate Depreciation?
(2) Diminishing (Reducing) Balance Method
• Allocates a reducing amount of depreciation each period for the life of
the asset

• Applies to those assets that will be used more, or contribute more to

revenue initially, compared to later

• E.g., computers

• Depreciation determined by allocating a set percentage to the

carrying amount of the asset

21
Calculating the Depreciation for the year

(Cost – Accum. Depreciation) * Rate = Depreciation p.a.

22
 Reducing Balance Method
Example:
Canyon Industries Ltd purchased a plant & equipment item
on 1 July 2019 for $36,000. The equipment has an
estimated useful life of five years and an estimated residual
value of $6,000. Assume the reducing balance depreciation
rate per annum is 30%.
Required:
1. Determine the amount of depreciation expense for financial years
2020, 2021, 2022, and 2023 under the Reducing Balance Method

23
 Reducing Balance Method

Solution:
(Cost – Accumulated Depreciation) X Rate
2020:

($36,000 - 0) x 30% = $10,800

2021:
$36,000 – 10,800 = $25,200 x 30% = $7,560
2022: $36,000 – (10,800 + 7,560)= $17,640 x 30% = $5,292
2023: $36,000 – (10,800 + 7,560 + 5,292) = $12,348 x 30% =
$3,704
Note: the residual value is not deducted from the asset cost.

24
 How do we Calculate Depreciation?
(3) Units-of-production method

• Useful life is expressed in terms of the total units of production or the use
expected from the asset
• The amount of depreciation is proportional to the production/activity that took
place during the period
• Depreciation is calculated using the following formula:

Depreciable cost of asset = depreciation cost per unit

Useful life
• Depreciation expense = depreciation cost per unit x yearly units of
production

25
 How do we Calculate Depreciation?
(3) Units-of-production method

• Example from Financial Accounting - Reporting, Analysis and Decision Making

(7th Edition) textbook pp. 425-426
• Cost = $13,000; residual value = $1,000; estimated useful life (in kilometres)
= 100,000
• Depreciation cost per unit = ($13,000-$1,000) / 100,000 = $0.12 per unit
• Depreciation expense

26
Bad and doubtful debts

27
 Bad and Doubtful Debts

Whenever a business sells goods on credit, it is inevitable

that a certain percentage of accounts receivable will turn out
to be uncollectible.

These bad debts will occur despite the efforts of the credit
department to screen people before credit is allowed.

These debts will eventually

be written off as bad.

28
 Accounting for Bad and Doubtful Debts
There are 2 ways of accounting for bad and doubtful debts:

1. Direct Write-off Method (NOT EXAMINABLE)

• Occurs when debt is bad
• Not a balance day adjustment
• Decision on when to write off – amount is known

2. Allowance method
• Estimate of bad debts (thus doubtful) relating to the accounting period
• Is a balance day adjustment
• Decision on amount to record – based on an estimation

29
 Allowance Method - Preferred Method
An estimate is made at the end of the accounting period of
the accounts receivable expected to be uncollectable.

This amount is recognised as an expense with the following

adjusting entry:

Dr. Doubtful Debts expense

Cr. Allowance for doubtful debts

30
 What Type of Account is Allowance for
Doubtful Debts?
• The Allowance for doubtful debts account is a contra asset (negative
asset)
• As asset has a normal Dr balance, a contra asset has a normal Cr
balance
• It has the effect of decreasing the amount of accounts receivable
shown in the balance sheet:

For Example:
Accounts receivables 10,000
Less Allowance for doubtful debts (1,000)
Net receivables 9,000
31
Allowance Method: What Happens when the
Debt Becomes Bad DURING THE YEAR?
No NEW expense when the debt actually becomes bad.
When a debt becomes bad it is written off:
Dr. Allowance for doubtful debts
Cr. Accounts receivable

• This is not an adjusting entry! It can happen at any time

• The debit is to the Allowance for doubtful debts AND NOT to

Doubtful debts expense as the expense has been previously
recognized

• Effect: Reducing both the allowance for doubtful debts and

accounts receivable
freeze 32
 How do we Estimate Doubtful Debts Expense?
There are 2 ways of estimating doubtful debts expense:
(1) Estimate based on credit sales (NOT EXAMINABLE)

(2) Estimate based on an % of accounts receivable

33
 How do we Estimate Doubtful Debts Expense?
Estimate based on an % of accounts receivable

1. A simple approach is to take a percentage of accounts

receivable (based on past history)

2. A more complex but refined approach is the ageing analysis of

accounts receivable which is based on the assumption that the
longer the accounts receivable is outstanding the more likely it
will become bad

• Both approaches determine the closing balance of Allowance for

doubtful debts AND NOT the amount of the adjusting entry!

34
 Lecture Example 1
The following information is related to the gardening equipment hire business of John
Smith. The balance in the Allowance for Doubtful Debts account on 1 July 2021 was
$29,760 Cr. The bad debts written off during the year amounted to $20,880.
Accounts receivable balance on 30 June 2022 (before taking into account the write-
off) was $651,840, and a 5% of the accounts receivable balance was required as the
closing balance of Allowance for Doubtful Debts. John Smith used the allowance
method to estimate the doubtful debts.
Required:
a. Calculate the doubtful debts expense for the year ending 30 June 2022.
b. Prepare the adjusting entry that needs to be recorded at 30 June 2022.

35
 Lecture Example 1
Step 1 Determine the current balance in the allowance account (after adjusting
for any transactions that affect it e.g. Bad Debts)
Current balance = $29,760 Cr – bad debt $20,880 Dr = $8,880 Cr

Step 2 Determine the balance we want in the allowance account

5% of adjusted accounts receivable = 5% ($651,840 - $20,880) = $31,548 Cr

Step 3 Find the adjustment that will change the current balance (found in Step 1)
to the balance we want (found in Step 2)
$31,548 - $8,880 = $22,668

36
 Lecture Example 1
Date Account Name Debit ($) Credit
($)

30 June Doubtful debts expense 22,668

Allowance for doubtful debts 22,668

37
 Lecture Example 2
Example:
Allowance for doubtful debts has a credit balance of
$7,000 on 1 July 2021.
Past experience provides a percentage of outstanding
debtors expected to become bad (see next slide).

Required:
Prepare the adjusting entry at 30 June 2022 in the
general journal to estimate the doubtful debts expense
for the period.

38
 Lecture Example 2

Days Amount Percentage

overdue outstanding bad
1 – 30 days $24,000 1%

31 – 60 days $30,000 3%

61 – 90 days $50,000 10%

91 + days $20,000 20%

 Solution – Steps 1- 3
Step 1 Determine the current balance in the allowance account
(after adjusting for any transactions that affect it e.g. Bad Debts)

Current balance is $7,000 CR

Step 2 Determine the balance we want in the allowance account

1% x $24,000 + 3% x $30,000 + 10% x $50,000 + 20% x $20,000 = $10,140 CR

$10,140 CR is the closing balance WE WANT in the Allowance for doubtful debts

Step 3 Find the adjustment that will change the current balance (found
in Step 1) to the balance we want (found in Step 2)

We want to go from $7,000 CR to $10,140 CR

$10,140 - $7,000 = $3,140 CR which is the adjustment we need to make to the
Allowance
 Solution - Step 4

General Journal
Date Particulars DR CR
30/6/22 Doubtful Debt Expense 3,140
Allowance for Doubtful Debts 3,140
 What Happens when we Recover a Bad
Debt?
In some cases accounts that have been written off may
become recoverable
• For example, administrators declare business can repay “20 cents in the
dollar”

Two step process to record this:

(1) Reinstate the amount outstanding as follows:
Dr. Accounts receivable
Cr. Allowance for Doubtful Debts
(2) Record the receipt of cash from the debtor:
Dr. Cash
Cr. Accounts receivable 42
 What Happens when we Recover a Bad Debt?
Example
A cheque for $500 was received on 1 April 2017 from Smith Pty Ltd as
a partial payment of the $2,000 that was written off.
Required:
What are the general journal entries to record the above?

43
 Summary for Doubtful / Bad Debts
Estimating next year’s doubtful debts (Adjusting the allowance)
Adjusting entries
Dr. Doubtful Debts expense xxx
Cr. Allowance for doubtful debts xxx

Bad Debts written off (Any time during period)

Not adjusting entries
Dr. Allowance for doubtful debts xxx
Cr. Accounts receivable xxx
Donny’s hairdressing business – July transactions

1/7 Donny contributed $20,000 cash to start a hairdressing business

1/7 Donny purchased a hairdressing equipment for $10,000 cash.
1/7 Donny took a five-year bank loan of $40,000 from Bank XYZ.
5/7 Donny provided hairdressing services to his customers for a total of $1,000 cash.
10/7 Donny purchased $6,500 worth of hairdressing supplies on credit.
15/7 Donny received a telephone bill of $250.
21/7 Donny invoiced his clients for a total of $5,000 for the hairdressing services performed.
23/7 Donny paid his telephone bill.
31/7 Donny paid his staff their monthly salary of $1,500..

45
 DONNY’S HAIRDRESSING
Worksheet
As at 31 July 2021
Account names Trial balance Adjustments Adjusted Trial balance Income statement Balance sheet

Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr

Cash 49,250

Accounts 5,000
receivable

Hairdressing 6,500
supplies
Equipment 10,000

Accounts 6,500
payable
Bank loan 40,000

Capital 20,000
Services 6,000
revenue
Telephone 250
expense

Wages expense 1,500

Total 72,500 72,500

Profit or (Loss)

46
Donny’s hairdressing business –
Adjusting entries for the end of July

• Interest rate on the bank loan is 6% p.a. Interest is paid quarterly.

• Depreciation on equipment is calculated using the straight-line method.
Useful life is 5 years. Residual value is $1,000.
• Stocktake shows that the business has $4,500 worth of hairdressing
supplies on hand.
• Donny has completed $1,500 of hairdressing services. He has neither
billed the clients nor received cash

47
Donny’s hairdressing services– Adjusting entries
Date Particulars Debit Credit
31 July Interest expense (6% x 40,000 x 1/12) 200
Interest payable 200

31 July Depreciation expense 150

Accumulated depreciation – equipment 150
(10,000-1,000)/5 x 1/12 5758

31 July Hairdressing supplies expense (6,500 – 4,500) 2,000

Hairdressing supplies 2,000
5243

31 July Accounts receivable 1876

1,500
Service revenue 1,500

48
 DONNY’S HAIRDRESSING
Worksheet
As at 31 July 2021
Account names Trial balance Adjustments Adjusted Trial balance Income Balance sheet
statement

Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr

Cash at Bank 49,250 49,250

Accounts Receivable 5,000 1,500 6,500

Hairdressing Supplies 6,500 2,000 4,500

Equipment 10,000 10,000

Accumulated depreciation 150 150

Accounts Payable 6,500 6,500

Interest Payable 200 200

Bank Loan 40,000 40,000

Capital 20,000 20,000

Service revenue 6,000 1,500 7,500

Telephone expense 250 250

Wages expense 1,500 1,500

Interest expense 200 200

Hairdressing supplies expense 2,000 2,000

Depreciation expense 150 150

Total 72,500 72,500 3,850 3,850 74,350 74,350

49
Our accreditations include:

50