3.

Common Accounting Adjustments

in Company Accounts

Trefor McElroy
September/October 2017

Voettekst van presentatie

LEARNING OUTCOMES

You should be able to:

Understand why adjustments are made to some

accounts in the trial balance

Appreciate the accounting conventions

underpinning the adjustments

Understand the role of the Cash Flow Statement

and its linkage with the balance sheet

Identify and understand specific items in the

accounts of companies
 Some common adjustments to the Trial
Balance and Final Accounts
1. Expenses owing
2. Expenses prepaid
3. Depreciation and amortisation
4. Stock valuation
5. Bad debts
6. Capitalisation of expenses e.g R&D
7. Revaluation
8. Goodwill
9. Exceptional and extraordinary items

3
Accounting for expenses owing
e.g sales commission paid during year £5,000 but
£1,000 still owing at end of year

Income statement

Statement Sales commission Statement

of cash expense of financial
flows £6,000 position
at year
Cash £5,000 end

Accrual £1,000
Accounting for expenses prepaid
e.g rent paid during year £20,000, but £4,000 of this is
for next year
Income statement

Statement Statement
Rent payable expense
of cash of financial
£16,000
flows position at
year end
Cash £20,000

Prepaid expense £4,000

More examples
Trial Balance September 30th 2016
Wages €10,000
Travel costs 4,000

On September 30th the accountant finds that the company still owes
€500 in wages.
In addition €300 of travel costs have been paid in advance.

P&L Account extract year ending September 30th 2016

Revenue €*****
Less business expenses:
Wages €10,500
Travel costs 3,700
What are depreciation and amortization? (1)

• Depreciation and amortization represent the cost of assets that are

apportioned to the period:
– Depreciation refers to tangible assets:
e.g. buildings.
– Amortization refers to intangible assets:
e.g. patents, trademarks and licenses.
Profit measurement and the calculation of depreciation

To calculate a depreciation charge for a

period, four factors have to be considered:

The cost (or fair value) of the asset

The useful life of the asset

Residual value (disposal value)

Depreciation methods
Calculating the annual depreciation expense

Cost (fair value)

less

Residual value
equals

Depreciable amount

Year 1 Year 2 Year 3 Year 4

and so on

Depreciati Depreciati Depreciation Depreciation

on on

Asset life (Number of years)

How to calculate depreciation?

• A company purchases a new machine:

– Cost: €100,000
– Useful life: 5 years
– Expected salvage value: €0
– Depreciation method: Straight-line method.

Gross Depreciation Accumulated Net

Amount Depreciation Amount
End of Year 1 €100,000 €20,000 €20,000 €80,000
End of Year 2 €100,000 €20,000 €40,000 €60,000
End of Year 3 €100,000 €20,000 €60,000 €40,000
End of Year 4 €100,000 €20,000 €80,000 €20,000
End of Year 5 €100,000 €20,000 €100,000 €0
Graph of carrying amount against time using
the straight-line method

Carrying amount (£000) 80

60

40

20

0 1 2 3 4
Asset life (years)
 Reducing-balance method

Deriving the fixed percentage

n
P = (1  R/C x 100%)

where:
P = the depreciation percentage
n = the useful life of the asset (in years)
R = the residual value of the asset
C = the cost, or fair value, of the asset
Graph of carrying amount against time using the
reducing-balance method
80
Carrying amount (£000)

60

40

20

0 1 2 3 4
Asset life (years)
Depreciation and amortization and the final accounts

• Depreciation and amortization are both accounting adjustments

made after the trial balance has been produced

Trial balance 30th September 2016

Machinery €10,000
Vehicles 4,000

On September 30th, the accountant depreciates both of these non-

current assets by 10% p.a

The final accounts will be affected in two ways:

1. The depreciation and amortisation amount will be shown as an
expense in the P&L a/c
2. The balance sheet will show the asset values after the depreciation
charge
The final accounts
P&L Account extract year ending September 30th 2016
Revenue €*****
Less business expenses:
Depreciation:
- Machinery €1,000
- Vehicles 400

Balance Sheet as on September 30th 2016

Non-current assets
Tangible
Machinery €9,000
Vehicles 3,600
Profit measurement and inventory costing methods

Common assumptions used are:

First in, first out (FIFO)

Last in, first out (LIFO)

Weighted average cost (AVCO)

FIFO and LIFO treatment of inventories and Cost of Sales
when 9,000 tonnes are sold

Purchases 10,000 tonnes 20,000 tonnes

@ £10 per tonne @ £13 per tonne

9,000 tonnes
FIFO 21,000 tonnes
Cost of sales
(inventories used)
Closing inventories

9,000 tonnes
LIFO 21,000 tonnes
Cost of sales
Closing inventories
(inventories used)
 Cost of Sales - FIFO

FIFO 9,000 units sold are the first 9,000 units bought. The
cost of these were £10 each = total cost £90,000.
Income Statement.
Sales
Less cost of sales 90,000

Balance Sheet
This results in the value of closing stock as a current asset
(1,000 x £10) + (20,000 x £13) = £270,000

18
 Cost of Sales - LIFO

FIFO 9,000 units sold are the last 9,000 units bought. The
cost of these were £13 each = total cost £117,000.
Income Statement.
Sales
Less cost of sales 117,000

Balance Sheet
This results in the value of closing stock as a current asset
(10,000 x £10) + (11,000 x £13) = £243,000

19
 Bad debts written off
If a credit customer’s account is written off (i.e they won’t be paying us).

1. Show the write-off as a business expense in the P&L a/c

2. Remove the account from the total of accounts receivable on the
balance sheet

Example: Trial balance 30th September 2016

Accounts receivable €62,000

On September 30th, it is decided that an account of €1,000 is to be

written off.
The final accounts will be affected in two ways:
3. The bad debt amount will be shown as an expense in the P&L a/c
4. The balance sheet will show the amount of accounts receivable
after the bad debt write-off

20
The final accounts
P&L Account extract year ending September 30th 2016
Revenue €*****
Less business expenses:
Bad debt €1,000

Balance Sheet as on September 30th 2016

Current assets
Accounts receivable €61,000
Bad debts written off

Reduce trade receivables

Increase expenses
How is R&D accounted for? (1)

• There are two accounting methods for R&D:

– Expensing: When incurred, the cost is recognized as an expense
in the income statement.
– Capitalizing and amortizing: When incurred, the cost is
recognized as an intangible asset in the balance sheet. It is then
apportioned as amortization in the income statement during the
useful life of the asset.

There is a potential conflict between matching expenditure with

future income arising (i.e capitalising) and prudence due to any
uncertainty of future expected income (i.e expensing).
How is R&D accounted for? (2)

• In 2010, the company spent €100,000 in R&D to develop an asset

that will generate €20,000 in revenue between 2011 and 2020.
Expensing:

Capitalizing and amortizing:

2010 2011-20 2010 2011-20

Revenue 0 20,000 Revenue 0 20,000

Cost -100,000 0 Amortization 0 -10,000

Profit -100,000 20,000 Profit 0 10,000

Match revenue and expenses

Option to capitalise if all the following are met:
1. there is a clearly defined project
2. expenditure is separately identifiable
3. the project is commercially viable
4. the project is technically feasible
5. project income is expected to outweigh cost
6. resources are available to complete the project.

Under IAS 38 (Intangible Assets) if the (similar to the above)

conditions are met then the company should capitalise the
R&D expenditure.
 Research and development
Example: Trial balance 30th September 2016
R&D €30,000

On September 30th, it is decided that 50% of the R&D spend will be

capitalised and 50% will be written off as an expense.
The final accounts will be affected in two ways:
1. The R&D write-off will be shown as an expense in the P&L a/c
2. The balance sheet will show the amount of R&D that has been
capitalised

26
The final accounts
P&L Account extract year ending September 30th 2016
Revenue €*****
Less business expenses:
R&D €15,000

Balance Sheet as on September 30th 2016

Non-current assets
Intangible
R&D €15,000
Revaluation

• Usually the concept of historic cost is applied, but in relation to non

current assets IAS 16 allows revaluation to its “fair value”.

• Some countries do not allow revaluation – Japan.

This makes international comparisons using accounting data (e.g.
Return on Capital Employed) at best difficult and at worst
misleading!
The Revaluation Model
• Under the revaluation model, revaluations should be carried out
regularly, so that the carrying amount of an asset does not differ
materially from its fair value at the balance sheet date. [IAS 16.31]
• If an item is revalued, the entire class of assets to which that asset
belongs should be revalued. [IAS 16.36]
• Revalued assets are depreciated in the same way as under the cost
model.
• If a revaluation results in an increase in value, it should be credited to
other comprehensive income and accumulated in equity under the
heading "revaluation surplus" [IAS 16.39]
 Revaluation and the final accounts
Example: Trial balance 30th September 2016
Land €100,000

On September 30th, it is decided that the land should be revalued to €125,000

The final accounts will be affected in two ways, in this case both on the balance sheet:
1. In non-current assets, land will be shown at the new value
2. The increase in value will be added to capital (equity) under the heading
“revaluation reserve”

Balance Sheet as on September 30th 2016

Non-current assets Equity
Tangible
Land €125,000 Revaluation reserve €25,000

This revaluation will not affect the P&L account i.e a revaluation will not increase profit.

30
Goodwill

• Can be internal or external – create it yourself or as a result of a

takeover. Only the latter is recognised in the financial statements.

• Think of the value of an educational establishment – what price

would you be willing to pay and why? Are the key assets all there
and are they fairly reflected on the balance sheet?

• Treatment has now changed – from yearly amortisation over a given

period (40 years) to an annual impairment test.
Goodwill
• Goodwill:
– It is the consequence of acquisitions and takeovers when the
buyer pays a premium for the assets of the target company
relative to their balance sheet figure. You cannot just add it to
the balance sheet to make it look stronger!
– It appears as an intangible, non-current asset on the acquirer’s
balance sheet.
• Each year, goodwill is tested for impairment:
– If the fair market value of goodwill (based upon the net present
value of future expected cash flows arising from the asset) is
lower than its book value:
• The value of goodwill is written down to its fair market
value
• and
• an impairment loss is recorded in the income statement.
Exceptional Items

• Exceptional items are

"... material items which derive from events or transactions that fall
within the ordinary activities of the business and which need to be
disclosed by virtue of their size or incidence if the financial
statements are to give a true and fair view.“
Examples – restructuring, disposals

• Contrast with extraordinary items, which are

"Material items possessing a high degree of abnormality which arise
from events or transactions that fall outside the ordinary activities of
the reporting entity and which are not expected to recur”
Examples – fire and other catastrophic effect

These headings are no longer explicitly used in the P&L a/c

Company Accounts
Standard layout for the statement of cash flows

Cash flows
from operating activities
plus or
minus

Cash flows
from investing activities
plus or
minus

Cash flows
from financing activities
equals

Net increase (or decrease) in

cash and cash equivalents over
the period
 Diagrammatical representation of the statement of
cash flows

Cash and
Operating cash Investing
activities equivalent activities
balances

Financing
activities
 Unilever cash flow
Operating activities
Fiscal year is January-December. All values GBP millions. 2010 2011 2012 2013 2014 5-year trend

 Net Income before Extraordinaries 3.94B 4.01B 3.92B 4.47B 4.44B

Depreciation, Depletion & Amortization 851.09M 892.7M 971.91M 977.6M 907.9M

Depreciation and Depletion 701.95M 727M 799.25M 835.76M 762.89M

Amortization of Intangible Assets 149.13M 165.7M 172.66M 141.84M 145.01M

Deferred Taxes & Investment Tax Credit 0 0 0 0 0

Deferred Taxes - - - - -

Investment Tax Credit 0 0 0 0 0

Other Funds (431.97M) (264.6M) (205.08M) (505.36M) (1.08B)

Funds from Operations 4.36B 4.64B 4.69B 4.94B 4.27B

Extraordinaries 0 0 0 0 0

Changes in Working Capital 144.85M (153.55M) 666.31M 169.87M 6.44M

Receivables (293.98M) (346.15M) 810,601 (778.86M) 66.06M

Accounts Payable 929.94M 382.58M 672.8M 806.04M (21.75M)

Other Assets/Liabilities 0 0 0 0 -

 Net Operating Cash Flow 4.5B 4.49B 5.35B 5.11B 4.28B

 Unilever cash flow statements
Investing activities
2010 2011 2012 2013 2014 5-year trend

 Capital Expenditures (1.56B) (1.82B) (1.93B) (1.84B) (1.81B)

Capital Expenditures (Fixed Assets) (1.4B) (1.59B) (1.6B) (1.52B) (1.52B)

Capital Expenditures (Other Assets) (151.7M) (229.03M) (328.29M) (320.21M) (289.21M)

Net Assets from Acquisitions 0 0 0 0 0

Sale of Fixed Assets & Businesses 97.71M 108.44M 192.11M 119.76M 166.76M

Purchase/Sale of Investments 242.56M (2.34B) 903.01M 535.09M 1.14B

Purchase of Investments (1.15B) (3.69B) (181.57M) (615.78M) (318.21M)

Sale/Maturity of Investments 1.39B 1.35B 1.08B 1.15B 1.46B

Other Uses 0 0 0 0 0

Other Sources 0 0 0 0 0

 Net Investing Cash Flow (1.22B) (4.06B) (834.11M) (1.19B) (504.3M

 Unilever cash flows – financing activities
2010 2011 2012 2013 2014 5-year trend

Cash Dividends Paid - Total (2B) (2.16B) (2.19B) (2.54B) (2.57B)

Common Dividends (1.99B) (2.16B) (2.19B) (2.54B) (2.57B)

Preferred Dividends (5.14M) (2.16B) 0 0 0

Change in Capital Stock (106.28M) 26.03M 38.91M 20.38M (376.21M)

Repurchase of Common & Preferred Stk. (106.28M) 0 0 0 (376.21M)

Sale of Common & Preferred Stock 0 26.03M 38.91M 20.38M 0

Proceeds from Stock Options 0 26.03M 38.91M 20.38M 0

Other Proceeds from Sale of Stock 0 0 0 0 0

Issuance/Reduction of Debt, Net (1.18B) 3.26B (2.44B) 1.07B 153.87M

Change in Current Debt - 1.09B (705.22M) 297.27M 272.29M

Change in Long-Term Debt (1.18B) 2.17B (1.73B) 776.31M (118.42M)

Issuance of Long-Term Debt 34.28M 2.97B 1.17B 3.58B 4.17B

Reduction in Long-Term Debt (1.21B) (800.74M) (2.9B) (2.81B) (4.29B)

Other Funds (252.84M) (342.68M) (369.63M) (2.7B) (969.93M)

Other Uses (252.84M) (342.68M) (369.63M) (2.7B) (969.93M)

Other Sources 0 0 0 0 0

 Net Financing Cash Flow (3.53B) 782.52M (4.96B) (4.14B) (3.76B)

Exchange Rate Effect (126.85M) (333.13M) (178.33M) 71.35M (117.62M)

Miscellaneous Funds 0 0 0 0 0

Net Change in Cash (369.4M) 877.95M (616.87M) (146.94M) (107.95M)

 Free Cash Flow 3.1B 2.89B 3.75B 3.59B 2.75B

Types of share capital

Ordinary shares (equity)

Preference shares
Sources of long-term finance for a typical limited company

Long-term finance

Share Retained Long-term

issues earnings borrowings
• Specified by Companies Acts
• Format
Also, of Accounts
by International Accounting Standard 1
• Law recognises company as a separate legal entity
• Company has to pay corporation tax on profits
• Can pay dividends to shareholders out of distributable
profits
Authorised Share capital - included in the
CapitalofStructure
Memorandum Association
Specifies:
• Total number of shares company can issue and
• The nominal value per share
Issued Share Capital

• Must be issued at or above nominal value

• Cannot be issued at a discount
• Balance sheet shows issued share capital at its nominal value
• If shares are issued at a premium - recorded separately in a
Share Premium Account
• Preference
Ordinary shares
shares
Types
Owners of shares
of company
Voting rights
Limited voting rights
Final profits
Usually receive
belong
fixedto
them
dividend
Last inpriority
Have line if company
over
is woundshareholders
ordinary up if
company wound up
• Debenture – IOU note from company to lender
• Debentures
Quoted company can issue debentures
• These can be sold on stock market
• Normally redeemable
• Normally with a fixed interest rate
• Groups of companies are required to prepare Consolidated Accounts i.e.
Groupinclude
accounts Accounts
results of all group (including subsidiary companies) –
exclude inter-company trading
• Minority (or non-controlling) interest represents the amount of the company
owned by outside investors (i.e not the company shareholders).
• The EAT is then split between that which belongs to the company
shareholders, and that which belongs to the “minority interest”.
• In addition, companies are required to break down these totals into
“segments” to provide more transparency
 Summary

• There are a number of adjustments made to the balances in the trial

balance when drawing up the final accounts
• These adjustments follow various accounting conventions designed
to produce more useful accounting information to stakeholders
• The Cash Flow statement is the third main financial accounting
statement, and links with the balance sheet
• There are a number of items found only in company accounts,
particularly relating to long-term financing and accounting for groups

48