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Chapter 13 & 19 profit determination and balance day adjustments clc
Principle of Accounting Chapter 13 &19 Profit determination and Balance-day adjustments BA. in International Business Foreign Trade University
Outline Profit determination Accrual accounting and balance-day adjustments Prepaid expense Adjusting for stocks of materials and supplies Accrued expense Prepaid revenue Accrued revenue
Profit determinationunderlying assumptions Going concern principle: assumes that the business will continue in operation as a going concern for an indefinite period into the future. Reporting period principle: the life of a business is divided into equal periods of time over which the performance of the business can be measured (profit or loss is determined). Matching principle: is used to match the revenue and expense for a particular reporting period to determine a profit or loss figure
Accrual accounting Accrual accounting: A system of accounting in which revenues are recognised when earned and expenses when incurred. Profit is defined as revenue earned less the expenses incurred in earning that revenue. Revenue can be earned in one reporting period while cash can be received in a previous or subsequent period. Expenses can incur in one reporting period while cash payment can be made in a previous or subsequent period.
Balance-day adjustments Adjusting entries: are the entries made in revenue and expense accounts to make them equal to revenue earned and expenses incurred. Adjusting entries are made on the last day of the reporting period (balance day). Closing entries: are used to close off the adjusted revenue and expense accounts to the profit and loss summary account. Closing entries are also made on balance day.
Prepaid expenses Example: On 1 Oct 05, the company paid $480 for a 12-month insurance premium. The question is whether the insurance payment represents an asset or expense? Prepaid expenses are goods & services purchased for future consumption and paid for in advance. Prepaid expenses are assets because they will benefit future accounting periods. As the assets are consumed to generate revenue for a business, a portion of their cost is transferred to expense. The adjusting entries are made to ensure the matching of revenue and cost of the asset written off.
Prepaid expense (cont’d) Using the above example: 1 Oct 05: paid 12-month insurance $480 ($40 per month) 31 Dec 05: Insurance used: 3 months => Insurance expense= 3*40 = $120 Insurance prepaid for 06 (9 months unused) = 9*40 = $360 Accounting entries: 1 Oct 05: Dr Prepaid insurance $480 Cr Cash $480 31 Dec 05: Dr Insurance expense $120 Cr Prepaid insurance $120
Prepaid expense – ledger accounts Prepaid insurance a/cOct 1 Cash at bank $480 Dec 31 Insurance expense $120 Balance $360 $480 $480 Insurance expense a/cDec 31 Prepaid insurance $120 Dec 31 P&L Summary $120
Adjusting for stocks of materials andsupplies Stocks of materials and supplies arise when a service firm purchases materials which it needs in order to provide services to its customers. Examples are office stationery, stocks of petrol, etc. If some of these supplies have been used by the end of a period, adjustments must be made as part of the balance- day process. The cost of supplies used is transferred from an asset account to an expense account on balance day.
Adjusting for stocks of materials andsupplies (cont’d) Example 5 Jan: stationery supplies were purchased for $1,200. 31 Dec: stationery supplies remain on hand is $200 Stationery supplies used during the year = 1,200 – 200=1,000 Adjusting entry for stationery used: Dr Stationery expense $1,000 Cr Stock of stationery $1,000 Closing entry for stationery expense Dr P&L Summary $1,000 Cr Stationery expense $1,000
Adjusting for stocks of materials and supplies – ledger accounts Stock of stationery a/cJan 5 Cash $1,200 Dec 31 Stationery expense $1,000 Balance 200 $1,200 $1,200Jan 1 Balance 200 Stationery expense a/cDec 31 Stock of stationery $1,000 Dec 31 P&L Summary $1,000
Accrued expenses (expenses owing) Accrued expenses: are expenses that have been incurred but not yet paid. Example: A firm incurred $1,000 advertising expense during 2005, in which $200 of advertisement in December is not yet paid. $200 advertising expense is an accrued expense. Adjusting entry for accrued expense Dr Advertising expense $200 Cr Accrued advertising $200
Prepaid revenue Prepaid revenue represents future revenue that has been collected but not yet earned. The prepaid revenue will be realised when some type of service is performed or goods are provided. At the time of collection, prepaid revenue represents a liability to the business because goods or services are owed in return. The adjusting entries are made to ensure the matching of revenue earned and expense incurred to generate revenue.
Prepaid revenue – an example Total bus fares received: $90,000 Bus fares paid in advance for trips in 2006: $10,000 Bus fares revenue earned in 2005 = $90,000 - $10,000 = $80,000 Accounting entries: Jan-Dec: Dr Cash at bank $90,000 Cr Prepaid bus fares revenue $90,000 Dec 31: Dr Prepaid bus fares revenue $80,000 Cr Bus fares revenue $80,000
Prepaid revenue – ledger accounts Prepaid bus fares revenue a/cDec 31 Bus fares revenue $80,000 Jan-Dec Cash at bank $90,000 Balance $10,000 $90,000 $90,000 Jan 1 Balance $10,000 Bus fares revenue a/cDec 31 P&L Summary $80,000 Dec 31 Prepaid bus fares $80,000
Accrued revenue (revenue owing) Accrued revenues: are revenues that have been earned but not yet received. Example: 1 Jul 05, a company deposited $20,000 in a bank account at 10% p.a. payable on 30 Jun 06. Interest earned as of 31 Dec 05 (six months) = $20,000 * 10% * 6/12 = $1,000 Accounting entry: Dr Accrued interest revenue $1,000 Cr Interest revenue $1,000