Adjustments for Financial Reporting

Introduction

In order to give true and fair view of your financial statement there are adjustments required to account for prepaid and accrued expenses and revenue. These adjustments should be dealt with before you proceed to your financial statements.

Objectives

Upon completion of this topic you should be able:
1. Define the terms accrued and prepaid.
2. Make the necessary adjustment to expense and revenue accounts.
3. Account for these adjustments in the financial statements.
4. Understand why it is necessary to adjust expense and revenue accounts for amounts accrued or prepaid.

Making Adjustments

So far we have assumed that all the expense and revenue incurred are for the present financial period. However there are instances where the amounts paid for expense or received for revenue would be for the previous financial period (accrued) or the upcoming financial period (prepaid). When this happens the figure charged to the financial statements for this period need to be adjusted to reflect the accrued or prepaid amounts.

Let’s first look at the entries necessary for accrued and prepaid expenses. Let us assume that two businesses paid rent for the premises $8,000 by cheque per year. For the year 2011 the following occurred

Business A pays $6,500 during the year and owes $1,500 at the end of the year
Rent for the year $8,000
Rent paid $6,500
Rent owed $1,500

Business B pays $9,000 during the year which includes $1,000 prepaid for the following year.
Rent for the year $8,000
Rent paid $9,000
Rent prepaid $1,000

Accrued Expenses (expenses owing)
Remember that expenses are the cost of doing business for example salary, rent, utilities, carriage outwards, discount allowed and interest on money borrowed. From the example above the amount that should be debited to the Profit & loss account for rent should be $8,000 since that is amount that should be used up for this period.

Example 3.2ABusiness A

Rent Account
Date	Details	folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	Bank	CB	6,500	31-Dec	Profit & Loss		8,000
31-Dec	Accrued	c/d	1,500
			8,000				8,000
2012				2012
				01-Jan	Accrued	b/d	1,500

Profit & loss (extract) for year ended 31 December 2011
			$	$
Rent			6,500
Add Rent Accrued			1,500	8,000

Balance Sheet (extract) as at 31 December 2011
Current Liabilities	$
Expenses Accrued	1,500

Prepaid Expenses

Let us now look at Business B and the entries necessary in your records to record prepaid expenses. Remember that the amount that should be debited to the Profit & loss account for rent is $8,000.

Example 3.2 B
Business B

Rent Account
Date	Details	folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	Bank	CB	9,000	31-Dec	Profit & loss		8,000
				31-Dec	Prepaid	c/d	1,000
			9,000				9,000
2012
1-Jan	prepaid	b/d	1,000

Profit & loss (extract) for year ended 31 December 2011
				$	$
	Rent			9,000
	Less Prepaid Rent			1,000	8,000

Balance Sheet (extract) as at 31 December 2011
Current Assets	$
Prepaid Expenses	1,000

Looking at the entries above you will see that prepaid expenses is subtracted in the Profit & loss account and included in the current assets in the balance sheet.

We can now continue by looking at accrued and prepaid revenue. Remember that revenue accounts are those accounts that bring income into the business, for example discount received, interest received, rent received and commission received.
Let us look at two businesses that sublet their premises for $5,000 per year. In 2011 the following occured

Business C received $4200 by cheque for rent in 2011
Rent that should be received for the year $5,000
Rent received $4,200
Rent received owed for the year $ 800

Business D received $6,800 by cheque for rent in 2011
Rent that should be received for the year $5,000
Rent received $6,800
Rent received prepaid for the year $1,800

Accrued Revenue (revenue owing)

From our example the amount that should be credited to the Profit & loss account for rent received is $5,000. Therefore the following entries are required to show the adjustment for revenue owing.
Example 3.2 C
Business C

Rent Received Account
Date	Details	folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	Profit & loss		5,000	31-Dec	Bank	CB	4,200
				31-Dec	Owings	c/d	800
			5,000				5,000
2012
1-Jan	Owings	b/d	800

Profit & loss (extract) for year ended 31 December 2011
	$	$
Gross Profit		xxxx
Add Revenue
Rent Received	4,200
Add Owings	800	5,000

Balance Sheet (extract) as at 31 December 2011
Current Assets	$
Revenue owing	800

Take note that revenue is added to the gross profit in the Profit & loss account and that revenue owing is recorded as a current asset in the balance sheet.

Prepaid Revenue

Observe in the entries below that prepaid revenue is recorded as a current liability in the balance sheet.

Example 3.2 D
Business D

Rent Received Account
Date	Details	folio	Amount	Date	Details	Folio	Amount
2011			$	2011			$
31-Dec	Profit & Loss		5,000	31-Dec	Bank	CB	6,800
31-Dec	Prepaid	c/d	1,800
			6,800				6,800
				2012
				01-Jan	Prepaid	b/d	1,800

Profit & loss (extract) for year ended 31 December 2011
	$	$
Gross Profit		xxxx
Add Revenue
Rent Received	6,800
Less Prepaid	1,800	5,000

Balance Sheet (extract) as at 31 December 2011
Current Liabilities	$
Revenue prepaid	1,800

There is a credit entry in the rent received account above to indicate the cash received for the rent the debit entry is recorded in the cash book since the funds was received by the business.

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Topic Summary

There are number of things to remember from this topic
1. Accounts should be adjusted at the end of each period to account for any prepayments or accruals during the period.
2. Accruals are added in the Profit & loss account while prepayments are subtracted.
3. In the balance sheet prepaid expenses and revenue owing is included in the current assets while expenses owing and revenue prepaid are included in the current liabilities