Adjustments and Provisions

Subject: Accounting
Topic: 7
Cambridge Code: 0452 / 0985 / 7707

---

Introduction to Adjustments

Adjustments - Changes made to accounts at the end of an accounting period to ensure that income and expenses are matched to the period in which they were earned or incurred

Why Adjustments Are Needed

1. Accruals Concept - Record income and expenses in correct period
2. Completeness - Ensure all income/expenses for period recorded
3. Accuracy - Show true position of assets and liabilities
4. Matching Principle - Match expenses to revenue they help generate

Types of Adjustments

1. Accruals (expenses due but not paid)
2. Prepayments (payments made in advance)
3. Depreciation (fall in value of fixed assets)
4. Inventory/Stock (opening and closing)
5. Provisions (likely future obligations)
6. Bad debts (debts unlikely to be collected)

---

Accruals (Expenses Owing)

Accrual - An expense incurred during the period but not yet paid in cash

Example: Accrual of Electricity

Period: Year ended 31 December 2024

• Electricity paid during year: $2,400
• Bills received at 31 Dec for Dec: $300 (not yet paid)
• Total electricity expense: $2,400 +$300 = $2,700

Journal Entries

Accrual entry:

Debit	Credit
Electricity Expense	$300
Electricity Payable (Accrual)

In Financial Statements

• Income Statement: Show Electricity Expense of $2,700
• Balance Sheet: Show Electricity Payable of $300 as liability

---

Prepayments (Payments in Advance)

Prepayment - Payment made in advance for goods or services to be received in the next period

Example: Prepaid Rent

Period: Year ended 31 December 2024

• Rent paid during year: $2,400 (6 months ×$400)
• Includes January rent ($400) for next year
• Rent expense this year: $2,400 -$400 = $2,000

Journal Entry

Prepayment entry:

Debit	Credit
Rent Prepayment (Asset)	$400
Rent Expense

In Financial Statements

• Income Statement: Show Rent Expense of $2,000
• Balance Sheet: Show Rent Prepayment of $400 as current asset

---

Depreciation

Depreciation - Systematic reduction in value of fixed assets over their useful life

Why Depreciate

1. Fixed assets lose value over time
2. Expense recognized in income statement
3. Reflects true asset value on balance sheet
4. Matches cost with income generated

Methods of Depreciation

Straight-Line Method (Most common)

$\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life (years)}}$

Example:

• Asset cost: $10,000
• Salvage value: $1,000
• Useful life: 5 years

$\text{Annual Depreciation} = \frac{10,000 - 1,000}{5} = \frac{9,000}{5} = 1,800$

Reducing Balance Method

Depreciation = Fixed percentage of book value each year

Example: 20% of book value

• Year 1: $10,000 × 20$2,000
• Year 2: $8,000 × 20$1,600
• Year 3: $6,400 × 20$1,280

Journal Entry for Depreciation

Debit	Credit
Depreciation Expense	Amount
Accumulated Depreciation (or Provision for Depreciation)

In Financial Statements

Balance Sheet:

Fixed Assets:
  Equipment                    $10,000
  Less: Accumulated Depreciation ($1,800)
  Net Book Value               $8,200

Income Statement:

• Depreciation Expense: $1,800

---

Provisions for Doubtful Debts

Provision for Doubtful Debts - Estimated amount of receivables unlikely to be collected

Why Needed

1. Some customers may not pay
2. Prudence concept
3. Shows realistic value of receivables
4. Matches bad debt expense to sale period

Calculation Methods

Percentage of Receivables

• Estimate 5% of receivables won't be collected
• Receivables: $20,000
• Provision: 20,000 × 5% = $1,000

Aging of Receivables

• Analyze how long debts outstanding
• Apply different percentages based on age

Journal Entry for Provision

If new provision:

Debit	Credit
Bad Debt Expense	Amount
Provision for Doubtful Debts

If adjusting existing provision:

Accounts	Amount
New provision required	$1,500
Existing provision	$800
Additional provision needed	$700

In Financial Statements

Balance Sheet - Assets:

Receivables                  $20,000
Less: Provision for Doubtful Debts ($1,000)
Net Receivables             $19,000

Income Statement:

• Bad Debt Expense (or Provision Increase): shown in expense section

---

Inventory/Stock Adjustment

Opening Stock - Inventory at beginning of period (already in trial balance) Closing Stock - Inventory at end of period (new figure to adjust for)

Journal Entries

To remove opening stock from accounts:

Debit	Credit
Cost of Goods Sold (or Profit & Loss)	Amount
Inventory/Stock

To add closing stock:

Debit	Credit
Inventory/Stock	Amount
Cost of Goods Sold (or Profit & Loss)

In Financial Statements

Balance Sheet:

Current Assets:
  Inventory/Stock            $5,000

Cost of Goods Sold:

Opening Stock               XXX
Plus: Purchases             XXX
Less: Closing Stock        (XXX)
Cost of Goods Sold         XXX

---

Summary of Adjustment Entries

Adjustment	Debit	Credit
Accrual (e.g., Electricity owing)	Expense	Payable
Prepayment (e.g., Rent paid in advance)	Prepayment Asset	Expense
Depreciation	Depreciation Expense	Accumulated Depreciation
Provision - increase	Bad Debt Expense	Provision for Doubtful Debts
Closing Stock	Stock	Cost of Goods Sold
Opening Stock	Cost of Goods Sold	Stock

---

Worked Example

End of Year Adjustments:

1. Electricity owing: $200
2. Insurance paid: $1,200, includes$300 for next year
3. Equipment cost $5,000, depreciate at 20% straight-line
4. Receivables $10,000, provide 5%
5. Closing stock: $3,000

Journal Entries:

1. Electricity Accrual

   • DR Electricity 200 / CR Electricity Payable 200

2. Insurance Prepayment

   • DR Insurance Prepayment 300 / CR Insurance 300

3. Depreciation

   • DR Depreciation 1,000 (5,000 × 20%) / CR Accumulated Depreciation 1,000

4. Provision for Doubtful Debts

   • DR Bad Debt Expense 500 (10,000 × 5%) / CR Provision 500

5. Closing Stock

   • DR Stock 3,000 / CR Cost of Goods Sold 3,000

---

Key Points to Remember

1. Adjustments ensure expenses/income in correct period
2. Accruals for expenses not yet paid
3. Prepayments for expenses paid in advance
4. Depreciation reduces value of fixed assets
5. Provisions estimate potential losses
6. Closing stock added at year-end
7. All adjustments made in final accounts

---

Practice Questions

1. Record adjustment entries for:

   • Rent of $100 owing
   • $200 insurance paid in advance
   • Equipment depreciation of $500
   • Bad debt provision of $400

2. Explain the difference between accruals and prepayments.

3. Calculate depreciation using straight-line method:

   • Cost: $8,000
   • Salvage: $2,000
   • Life: 5 years

---

Revision Tips

• Understand the accruals concept
• Know the definition of each adjustment type
• Practice making adjustment journal entries
• Remember adjustments affect both P&L and Balance Sheet
• Learn how to show adjustments in financial statements