BAFS Study Notes: Period-end Adjustments

Hey everyone! Welcome to your study guide for one of the most important topics in accounting: Period-end Adjustments. Don't worry if this sounds complicated – it's actually very logical! Think of it like editing a photo before you post it. You take the initial picture (the trial balance), but then you make small adjustments to make sure it's perfect and shows the true situation. That's exactly what we're doing for a business's financial statements.

In this chapter, we'll learn how to make these "edits" to ensure the financial statements are accurate and give a true and fair view of the company's performance and position. Mastering this is key to acing your exams and understanding how accounting really works!


1. The Core Idea: Accrual vs. Cash Accounting

Before we dive into the adjustments, we need to understand the fundamental rule that governs them: the Accrual Concept.

What is Accrual Accounting?

This is the method we use in BAFS. The rule is simple:

• Revenues are recognised when they are earned, not when cash is received.
• Expenses are recognised when they are incurred (used up), not when cash is paid.

Example: You provide tutoring services in December but your client pays you in January. Under accrual accounting, you record that revenue in December (when you earned it).

What is Cash Accounting?

This is simpler but less accurate. It's like managing your own wallet:

• Revenue is recorded only when cash is received.
• Expenses are recorded only when cash is paid.

For preparing proper financial statements, we MUST use Accrual Accounting. This is where the Matching Principle comes in – we must match the expenses incurred in a period with the revenues earned in the same period to calculate the correct profit.

Key Takeaway

Period-end adjustments are the steps we take to convert our day-to-day records into the proper accrual accounting basis, so we can correctly calculate profit.


2. Adjustments for Expenses & Revenues (Prepayments & Accruals)

This is the most common type of adjustment, applying the accrual concept directly.

Accrued Expenses (Expenses Owing)

These are expenses that the business has used/incurred, but hasn't paid for by the end of the accounting period.

Real-World Link: Imagine your company's electricity bill for December arrives in January. You used the electricity in December, so the expense belongs to December, even if you pay later.

Adjusting Entry:
Debit (Dr) The Expense Account (e.g., Electricity Expense)
Credit (Cr) Accrued Expenses (a current liability)

Effect on Financial Statements:
• Income Statement: The expense is increased, so the profit for the period is decreased.
• Statement of Financial Position: A current liability (Accrued Expenses) is created or increased.

Prepaid Expenses (Prepayments)

These are expenses that the business has paid for in advance, but hasn't used up yet.

Real-World Link: Your company pays for a full year of insurance on 1 January. By 31 December, you've used the whole year's worth. But what if you paid it on 1 October? By 31 December, you've only used 3 months, and the other 9 months are an asset – a prepayment!

Adjusting Entry:
Debit (Dr) Prepaid Expenses (a current asset)
Credit (Cr) The Expense Account (e.g., Insurance Expense)

Effect on Financial Statements:
• Income Statement: The expense is decreased, so the profit for the period is increased.
• Statement of Financial Position: A current asset (Prepaid Expenses) is created or increased.

Note: The same logic applies to Accrued Revenues (revenue earned but not yet received) and Revenues Received in Advance (cash received from a customer before the service is provided).


3. Adjustments for Trade Receivables: Bad & Doubtful Debts

Sadly, not all customers who buy on credit will pay us back. We need to account for this to avoid overstating our assets (trade receivables) and profit.

Bad Debts

A bad debt is when we are 100% certain that a specific customer will not pay their debt (e.g., they went bankrupt). We need to write it off completely.

Adjusting Entry (To write off the debt):
Debit (Dr) Bad Debts Expense
Credit (Cr) Trade Receivables (to remove the specific customer's balance)

Allowance for Doubtful Debts

An allowance for doubtful debts is an estimate of how much of our *remaining* trade receivables might not be collected. We aren't sure who won't pay, but based on past experience, we know some won't. This is an application of the Prudence Concept – we don't want to be too optimistic!

This is often calculated using an ageing schedule, which groups debts by how long they've been outstanding. The older the debt, the higher the probability it won't be paid.

Example of an Ageing Schedule Interpretation:
• Debts 0-30 days old: 1% estimated uncollectible
• Debts 31-60 days old: 5% estimated uncollectible
• Debts over 60 days old: 20% estimated uncollectible
You would calculate the allowance by applying these percentages to the amount of receivables in each category.

Adjusting Entry (To create or increase the allowance):
Debit (Dr) Allowance for Doubtful Debts (an expense in the Income Statement)
Credit (Cr) Allowance for Doubtful Debts (a contra-asset account)

How it appears on the Statement of Financial Position:

Current Assets
   Trade Receivables ..................... $$$
   Less: Allowance for Doubtful Debts .. ( $$)
      Net Trade Receivables ........... $$$

Quick Review

• Bad Debt: A confirmed, specific uncollectible amount. It's a fact.
• Allowance for Doubtful Debts: An estimated amount for potential future bad debts. It's an opinion/estimate.


4. Capital vs. Revenue Expenditure

This is a crucial distinction that affects both the Income Statement and the Statement of Financial Position. Getting this wrong can seriously misstate a company's profit!

Capital Expenditure

This is money spent on:

1. Buying non-current assets (e.g., machinery, vehicles, buildings).
2. Improving or upgrading an existing non-current asset to increase its efficiency or lifespan.

Analogy: Buying a new, more powerful engine for a delivery van. This is a capital expenditure. It's recorded as a non-current asset on the Statement of Financial Position.

Revenue Expenditure

This is money spent on:

1. Day-to-day running of the business (e.g., paying salaries, electricity bills).
2. Maintaining an existing non-current asset in its current working condition (e.g., repairs).

Analogy: Buying petrol for the delivery van or paying for its annual oil change. This is a revenue expenditure. It's recorded as an expense in the Income Statement.

Key Takeaway

Capital Expenditure = Asset.
Revenue Expenditure = Expense.
Mistakenly treating a capital expenditure as a revenue expense will understate your assets and your profit for the year!


5. Depreciation of Non-Current Assets

Non-current assets (like machines and computers) lose value over time as they are used. Depreciation is the systematic process of allocating the cost of a non-current asset as an expense over its useful life. It's an application of the Matching Principle – we match the cost of the asset against the revenue it helps to generate.

Did you know? Depreciation is a non-cash expense. You don't actually pay cash for "depreciation". The cash was paid when the asset was bought. Depreciation is just an accounting adjustment on paper.

Key Terms to Know

• Cost: The original purchase price of the asset plus any costs to get it ready for use.
• Useful Life: The estimated period of time the business expects to use the asset.
• Residual Value (or Scrap Value): The estimated selling price of the asset at the end of its useful life.

Methods of Depreciation

1. Straight-Line Method

This method spreads the cost evenly over the asset's useful life. The depreciation expense is the same every year.

Formula:

$$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} $$

2. Reducing-Balance Method

This method charges more depreciation in the earlier years and less in the later years. It's based on the idea that assets are more efficient when they are new. Depreciation is calculated on the asset's Net Book Value (NBV).

Formula:

$$ \text{Annual Depreciation} = (\text{Cost} - \text{Accumulated Depreciation}) \times \text{Depreciation Rate \%} $$

Remember: Net Book Value (NBV) = Cost - Accumulated Depreciation

3. Depreciation based on Usage (Units of Production)

This method bases depreciation on how much the asset is used, not on the passage of time. It's great for machinery where usage varies each year.

Step 1: Find the depreciation rate per unit.

$$ \text{Rate per unit} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Units of Production}} $$

Step 2: Calculate the depreciation expense for the year.

$$ \text{Depreciation Expense} = \text{Rate per unit} \times \text{Actual Units Produced in the Year} $$

Recording Depreciation and Disposal

The annual depreciation charge is recorded with this entry:
Debit (Dr) Depreciation Expense (in Income Statement)
Credit (Cr) Accumulated Depreciation (a contra-asset account, reduces the asset's value on the SFP)

Disposal of a Non-Current Asset:
When an asset is sold or traded in, we must remove it from our books and calculate if we made a profit or loss.

Steps to calculate Profit or Loss on Disposal:
1. Calculate the asset's Net Book Value (NBV) on the date of disposal.
NBV = Cost - Accumulated Depreciation up to the date of disposal.
2. Compare the NBV with the disposal proceeds (the cash received or trade-in value).
• If Proceeds > NBV, you have a Profit on Disposal.
• If Proceeds < NBV, you have a Loss on Disposal.


6. Adjustments for Inventory (Stock)

Inventory is a major asset for many businesses. We need to value it correctly at the end of the period.

Valuation Rule: Lower of Cost and Net Realisable Value (NRV)

This is another application of the Prudence Concept. We must value our closing inventory at whichever is lower: its original cost or its Net Realisable Value.

What is NRV? It's the estimated selling price of the inventory minus any costs needed to sell it (like delivery costs or repair costs).

Example: You bought a phone case for $50 (cost). You can now only sell it for $40 (NRV). You must value this inventory item at $40.

Determining the Cost: Weighted Average Cost (AVCO)

When we buy inventory at different prices during the year, which cost do we use for the items left at the end? The AVCO method calculates a weighted average.

Formula:

$$ \text{Weighted Average Cost per unit} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}} $$

You then multiply this average cost by the number of units in closing inventory to find its value.

Goods on Sale or Return

If we have sent goods to a customer on a "sale or return" basis, they are not a real sale until the customer confirms they want to keep them. If the year-end comes and the customer hasn't decided, those goods still belong to us and must be included in our closing inventory (at cost).

Inventory Loss: Normal vs. Abnormal

• Normal Loss: An expected, unavoidable loss due to the nature of the inventory (e.g., evaporation of liquids, a small amount of fruit going bad). The cost of normal loss is simply absorbed into the cost of goods sold.
• Abnormal Loss: An unexpected, avoidable loss (e.g., due to a fire, flood, or theft). This loss is treated as a separate expense in the Income Statement and is NOT included in the cost of goods sold.


7. Summary of Adjusting Entries and Their Effects

Here’s a final cheatsheet to bring it all together. All these adjustments are made to ensure the financial statements are accurate!

Adjustment Type
Journal Entry
Effect on Financial Statements

Accrued Expense
Dr. Expense
Cr. Accrued Expense (Liability)
IS: Expense ↑, Profit ↓
SFP: Current Liabilities ↑

Prepaid Expense
Dr. Prepaid Expense (Asset)
Cr. Expense
IS: Expense ↓, Profit ↑
SFP: Current Assets ↑

Bad Debt Write-off
Dr. Bad Debts Expense
Cr. Trade Receivables
IS: Expense ↑, Profit ↓
SFP: Current Assets (Trade Receivables) ↓

Allowance for Doubtful Debts
Dr. Allowance for Doubtful Debts (Expense)
Cr. Allowance for Doubtful Debts (Contra-Asset)
IS: Expense ↑, Profit ↓
SFP: Net Trade Receivables ↓

Depreciation
Dr. Depreciation Expense
Cr. Accumulated Depreciation
IS: Expense ↑, Profit ↓
SFP: Net Book Value of Non-Current Assets ↓

Inventory Valued below Cost (NRV rule)
(No specific journal entry, but the value is adjusted)
IS: Cost of Goods Sold ↑, Gross Profit ↓
SFP: Current Assets (Inventory) ↓

You've got this! Go through each adjustment one by one, understand the logic, and practice the journal entries. Good luck!