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Trial Balance to Financial Statements (Stock adjustments (During a…
Trial Balance to Financial Statements
Stock adjustments
During a financial year, it is unlikely that all items purchased for resale will have been sold
The reality is that a business will be left with some items of stock in hand at the end of the financial year
Stock:
Made up of goods purchased for resale. The intention is to resell the stock, so it will normally be kept in the business for a relatively short time
At the end of the financial year, the business has to calculate the gross profit (Sales - cost of sales)
The calculation of cost of sales involves important adjustments for opening and closing stock
Cost of sales = opening stock + purchases - closing stock
The cost of sales can then be compared to the sales for the financial year
The double entry for the purchase of stock: Dr Purchases Cr Bank (or supplier account if stock if purchased on credit)
The transfer of stock to the trading account where stock is an expense: Dr Trading account Cr Purchases account
At the end of the year, the unused stock returns to the stock account from the trading account and the resulting double entry is: Dr Stock account Cr Trading account
The stock transferred from the trading account at the year end is effectively the closing stock at the end of the accounting period, this will be the opening stock at the start of the next accounting period. Therefore the debit to the stock at the end of the period should equal the credit from the stock account at the start of the next account period. The double entry required is: Dr Trading account Cr Stock account
Sometimes stock held can no longer be sold, because of stock obsolescence (becoming out of date), damage, loss or theft. Consequently these items have to be written off
The write off of the redundant stock is achieved by eliminating its value from the closing stock computation. The prevailing principle is that closing stock must be valued at the lower of cost and net realisable value
Net realisable value:
The sales value of stock that an organisation expects to receive when the stock is sold. This may be lesser or greater than the cost of the stock, owing to detonation, obsolescence, or appreciation over time
Adjustments for accruals
An accrual is a cost that has been incurred during the accounting period but which remains unpaid at the end of the period
It is a benefit received during the period that remains unpaid at the end of the period
It is not uncommon to enjoy the benefit from a good or service and make payment for its enjoyment are a later date, eg the use of utilities or telephone services. The suppliers often invoice at the end of the month or quarter
An accrual is always an amount that is owing or unpaid at the end of the accounting period
An unpaid balance on an expense account at the end of the accounting period will result in a credit balance on that expense account
The total expense charged for the year is transferred to the profit and loss account, including the unpaid balance
On the balance sheet, the accrued expense is recorded under the current liabilities
The total expense occurred during the financial year is wholly chargeable to the profit and loss account
The accrued expense is due for payment at the year end and is expected to be paid within one financial year, hence it is a current liability
Adjustments for prepayments
A prepayment is the opposite of an accrual
It is the payment for a good or service in the current accounting period, but will be charged against profit in a later period when the good or service is consumed
A prepayment is the payment for benefit in a period in advance of when the benefit will be received
The advance payment of an expense results in debit balance on that expense account at the end fo the year
Eg rents or tax
The relevant expense figure is decreased by the amount of the prepayment in the profit and loss account
The amount of the prepayment is shown as a current asset on the balance sheet
Debtor adjustments
Every time a business sells goods on credit, it is taking a risk that payment may never be received from the debtor
The realisation concept allows a business to take the profit on credit sales before the cash is received from the debtor
The business is taking a risk in bringing the profit on credit sales into the profit and loss account of the period in which the sale is realised
Bad debts
If a debtor does not pay, the debt is still owed to the business but the business has to recognise the reality of the situation. It would therefore be appropriate to follow the prudence concept and recognise these as bad debts
A debt that is or is considered to be uncollectible and is therefore written off as a charge to the profit and loss account
It would be imprudent if a debt were seen to be not receivable from the debtor and no adjustments were made, as the total debtors' figure appearing under current assets in the balance sheet would be overstated
To provide a more realistic figure of both the financial performance and position of the business, the bad debt should be written off
It is common practice for a business to conduct a regular review of debtors' balances throughout the financial year so that when information is received, ie concerning the bankruptcy of a debtor, the business will accumulate all bad debts to a bad debts expense account during the financial year and then transfer the total to the profit and loss account at the end of the period d
The individual debtors balances are reduced by the individual bad debt written off
Should the debtor subsequently pay the amount owing, the bad debt expense is reversed in the year the payment is received, this results in the business adding back the amount previously written off a bad debt to the profit in that year. When the actual payment is received, the double entry required is: Dr Cash/bank Cr Profit and loss account
Debtors can in general, be grouped into two categories: good debtors and bad debtors
Good debtors are those who settle their debt in full and normally within an agreed time frame, of say 30 days
Those debtors who will not pay their debts are often in dispute with the business, for example about the quality of the goods or services they have received
There are some debtors who cannot or will not pay their debtors, those who cannot pay are usually those who become insolvent and go out of business
If the debtor does not pay, the profit for that period will have been overestimated
Provision for doubtful debts
At any time, there is always a risk that debts will not be collected, which makes it difficult to put an exact value on debtors
A prudent business should make a reasonable estimate of how much of the debts may not be collected
A provision made for debtors that may be uncollectible at the balance sheet date
A provision made for debtors that may be uncollectible at the balance sheet date
Charged as an expense in the profit and loss account and the debtors are shown in the balance sheet with the provision deducted
The double entry for the transfer to the profit and loss account is: Dr Profit and loss account
Cr Provision for doubtful debts
As the provision for doubtful debts is an estate, the actual amount of bad debt is likely to be different from the estimate, so it will be necessary to reassess the level of the provision every year
A business may increase its provision for doubtful debts if it feels there is a greater risk of debtors not meeting their obligations for a variety of reasons. If this arises the double entry is: Dr Profit and Loss Account Cr: Provision for doubtful debts
The actual amount charged to the profit and loss account is the difference between the old provision and new provision, whether its an increase or decrease
A business may reduce its provision for doubtful debts if it feels more confident of its debtors meeting their obligations. If this arises, the new double entry will be: Dr Provision for doubtful debts Cr Profit and loss account
Discounts
Trade discounts
A reduction in selling price given to a customer at the point of sales
Usually for the bulk purchase of items
Known at the time of the transaction and has no impact on the accounting system
For example, a seller may grant a buyer a 10% trade discount on the understanding that the purchaser will buy a certain volume of items
The discount is determined before the buyer completes the transaction and it is the discounted price that is recorded in the double entry system as a standard transaction
Settlement discount
A reduction in an invoice granted to a customer in exchange for early payment
Sellers offer buyers a discount if they pay their invoice in a shorter period than the standard credit term
The incentive to pay an invoice early is a settlement discount
A buyer may get a 5% discount if they settle their invoice in 14 days rather than 30 days
A settlement discount impacts the double entry system when the buyer takes the discount
Discount allowed
The value of the discount that a seller grants to a buyer for early settlement
Discount received
The cash discount a buyer receives from a supplier when they settle their account early