1.0
INTRODUCTION
It was mentioned in
the earlier Note that the only way a business can ascertain its profit and loss
during a given period is to prepare final accounts. These take into account the
goods that were purchased and the goods sold, and the income that came in and
the expenses that went out during the
period.
The relationship between income,
expenses and time is very important. If income was due in a particular period
but payment was not received, the accounts of that period would not reflect the
true financial position unless the accrued income was taken into account. The
same thing applies to expenses. In this note, we are going to examine what are
called 'adjustments'.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• explain the Meaning
of Adjustments in Final Accounts
• give the full list
of adjustment items
• compute relevant
adjustment accounts.
3.0
MAIN CONTENT
3.1
Adjustments in Final Accounts
There are two guiding
principles in the preparation of Final Accounts.
These are:
1) Every Trading
Account and every Profit and Loss Account must be prepared accurately, so that
the correct profit for the period is obtained. This can only be achieved if the
accounts carry every kobo of the losses for the year, and include every kobo of
the profits earned.
2) Every Balance
Sheet must give a 'true and fair view' of the affairs of the business, showing
the assets and the liabilities at their 'true' values.
In order to achieve
these two aims, the accountant must take into account many matters, which
require adjustment. For example the Wages Account may include some wages given
in advance for next year to an employee who has requested an advance of salary
to help him meet some domestic difficulty. This amount must be removed from the
wages bill to be charged to the Trading Account; if it is not removed the
Trading Account for this year will be carrying next year's losses.
Similarly, a
commission earned for selling a piece of property for a client may not have
been paid yet although it is definitely due from the customer. If it is omitted
from the Profit and Loss Account, this year's profits will be understated and
next year's profit will be exaggerated.
A full list of adjustments includes:
1) Payments in
advance by the firm
2) Payments in
advance to the firm
3) Payments accrued
due by the firm
4) Payments accrued
due to the firm
5) Bad debts and
provisions for bad debts
6) Provisions for
discounts
7) Closing stock
adjustments
8) Depreciation of
assets
9) Appreciation of
assets
10) Amortization of
leases
11) Depreciation of
goodwill
3.1.1
Payments in Advance by the Firm
Certain payments are
always made in advance. This includes rents, licensing, trade subscriptions and
insurance. Where the period covered by the payment does not coincide with the
trading year the unexpired portion of such payments must be carried forward to
the following year so that the debit to the Profit and Loss Account would
represent the amount that relates to the accounting period.
The best example is
insurance payments. For, until the first premium is paid, the Insurance Company
will not offer any cover. It follows that whenever we make out the Final
Accounts of the business there is usually some balance of insurance cover due
which has been paid for already but the protection afforded will carry over into
the next year. Consider the Insurance Account shown below.
Insurance
Account L015
1988
N
Jan 1 Motor Vehicle A
(Bank A/C) 175.50
April 1 Motor Vehicle
B (Bank A/C) 66.00
June 30 Motor Vehicle
C (Bank A/C) 156.00
Sept. 30 Fire
Insurance (Bank A/C) 25.00
Clearly the premium
paid on January lst has given cover for a whole year by December 30 and its
protection has been fully enjoyed. The whole of this N175.50 is a loss
chargeable to this year's Profit and Loss Account. The other items are not fully
used. One-quarter of the April Pt payment is still to be enjoyed and it will
give protection until March 31St next year. Half of the June payment and three
quarter of September payment similarly represents unexpired benefits to be
enjoyed in the coming year. It follows that the true charge to the Profit and
Loss Account for insurance this year is as follows:
N
a) The whole of the January
payment 175.00
b) Three-quarters of the April
payment 49.50
c) Half of the June payment 78.00
d) One-quarter of the
September payment 6.25
Charge
to Profit and Loss Account 309.25
The transfer of this
charge to Profit and Loss Account is shown in the Journal entry below:
The
Correct Charge for Insurance for the Year J20
A Nominal Account that has
temporarily become an Asset Account
Fig.
4: The Temporary Asset on the Balance Sheet
Note:
All payments in advance or purchase of such things, as postage stamps,
advertising, brochures and stationery in advance should be carried forward to
the next year.
3.1.2
Payments in Advance to the Firm
If payments can be
made in advance by firms then clearly some other firms will be receiving them
in advance. The insurance premium referred to in the last section will be part
of mass of premium revenue received by the Insurance Companies, much of which
represents a liability for cover in the New Year. Where an insurance company
still owes clients protection in the early months of the year ahead, it will
not be able to treat these sums as revenue income for the year that has passed.
It will instead carry them forward as a liability for the coming year.
Premium Received
Account
Fig. 5: Payments
in Advance to the Firm
Balance
Sheet as at 31st December, 1998 
Fig. 6: A Temporary
Liability on the Balance Sheet
3.1.3
Payments Accrued Due by the Firm
At the end of a
financial year there are invariably some payments due, which will not be paid
until the next financial period. These are often called `acruals' that is,
debts which have been collected and are due for payment, for example arrears of
rent, electricity, water and telephone bills due but not yet paid. The
adjustment would be effected by debiting the Appropriated Account and crediting
the Sundry Creditors Account. For example P.S.G. Ltd, which usually closes its
accounts on 31S` March each year, discovers that it has not paid electricity
bills totaling i34246.00 due on 3l st March. In order to reflect this in the
accounts, the following adjustments would be made:
a) Debit the
Electricity Account N246.00 and
b) Credit the Sundry
Creditors Account 246.00
Thus, all the cost of
electricity used during the accounting period would be charged to the account
for the period. Alternatively, the amount outstanding may be carried down in
the Nominal Account as follows:
Illustration 3.1
Electricity
Account
When the outstanding
bill is paid during the following accounting year, it will be debited to the
Electricity Account and will be offset by the balance carried down. So that the
account of each year bear the expenses incurred during that year. The balance
on the electricity account is a liability and would appear as such in the
Balance Sheet.
3.1.4
Payments Accrued Due to the Firm
Just as debts can
collect which are due for payment by the firm, it is also possible for firms to
collect due to the firm. Income due but not yet received or accrued income
includes, rent, fees, interests, dividends due, etc. These payments although
not yet collected should be credited to the appropriate accounts in order to reflect
the correct amount due as income, etc, for the accounting period.
Illustration
4.1
On 31 March, the
books of Shallom Properties Ltd showed that rental income due for March from
sundry tenants totaling N5,000.00 had not been received. The necessary adjustment
would be as follows:
a) Debit the Sundry
Tenants Account N5,000.00 and
b) Credit the Rental
Income due but not yet paid N5,000.00
The Rental Income
Account would be as follows:
Rental Income Account
3.1.5
Bad Debts and Provisions for Bad Debts
It is an established
accounting principle that whilst losses should be anticipated, gains or profits
should not. At the close of any accounting period, therefore, all expected,
anticipated or known losses should be provided for in the accounts. Trading
transactions involve the use of credit facilities. When debtors are unable to
pay their debts, the debts become bad and are of no value to the creditors. As
bad debts occur in the ordinary course of carrying on the business, the loss
must be treated as an expense incurred in running the business.
The procedure is to
debit the Bad Debts Account with the amount of the bad debts and credit the
accounts of the debtors, thus reducing the amount of debtors at the date of
Balance Sheet.
Illustration
5.1
Total debtors of Ben
Ltd. as at 31 March amounts to N200, 000.00 and debts known to be bad were N2,
000.00. The adjustment should be made as follows:
a) Debit Bad Debts
Account N2, 000.00 and
b) Credit the Sundry
Debtors Account N2, 000.00
Bad
Debts Account
This accounting
process is known as Bad Debts written off However, in a situation where bad
debts cannot be written off at once, the accountant shall provide for these bad
debts by setting aside an agreed percentage of the total debtor's figure in a special
account coiled The Provision for Bad Debts Account.
This account
represents some of the owner's profits tucked awn in the
Provision for Bad
Debts Account as profit for the year.
The journal entry and
accounts are shown in Illustration 5.2.
3.1.6
Provision for Discounts
A cash discount is an
allowance given to a customer for the settlement of debt within the agreed
credit terms. As this represents an expense of carrying on a business, it
should be provided in the cash discounts if profits are not to be overstated.
Cash discounts are generally allowed / received on a percentage basis of debts
outstanding. Debts known to be bad and doubtful should be excused in
calculating provision for cash discounts.
For this purpose, a
Discount Account should be opened in the ledger, which will be debited with
discounts allowed and credited with discounts received. The balance of this
account, which will be transferred to the Profit and Loss Account.
Illustration
6.1
For Kupson Ltd., owed
to debtors at March 31 amount to N50,000.00 and total owed to creditors
N35.000.00 A discount of 5% is provided on both debtors and creditors.
LEDGER
Balance Sheet
3.1.7 Closing Stock Adjustments
In real life we
rarely sell everything that we purchase in the trading period. Instead we still
have in stock at the end of the year (or whatever period for which we are
trying to discover the profits) some of the goods purchased.
The issue of closing
stock is of great importance in accounting since without proper and accurate
counting of the remaining stock (stock-taking) at the end of the accounting
period we cannot arrive at a perfect figure for the cost of sales hence, the
proper figure for gross profit will not be known..188
To
discover the gross profits of the business, we must take away from the net
purchases figure any closing stock, which we have not yet sold, and this stock
will become the opening stock for the new period when the time comes to decide
the profits of that period.
4.0
CONCLUSION
Adjustments in Final
Accounts are made in order to reveal the true and fair position of the business
in the Balance Sheet. This means an extra account inserted in the ledger of
section of accounts to make it self-balancing. Items are posted to the
Individual Ledger Accounts in the usual way but when the postings are complete,
the total is posted to the opposite side of the adjustment account.
5.0
SUMMARY
There are various
adjustments items in accounting. Items like payments and receipt, creditors and
debtors discount provisions, bad debts written off and provisions and stock
left at the end of the trading period have to be properly accounted for before
the Final Accounts can be made.
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