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Adjusting Entries

  • Depreciation

    Depreciation is the process of making a regular allocation of the cost of an asset spread over its entire estimated useful life to expense. All assets except land have a limited useful life and eventually lose their productive capacity due to wear and tear, obsolescence, rust, etc. What is left is their scrap value which may be nil or even negative when they are disposed of. Salvage value is also known as scrap value or residual value.

    The useful life of an asset is its estimated productive life when it is expected to generate revenues, and it may be the number of years it is productive, the high production of units or if it is a vehicle, its high mileage.

    Each time a depreciation amount is written off as an expense item, it is assumed that an equivalent portion of the cost of the asset is used up, and this has to match the income that is received from the use of the asset. Thus, the portion of the cost of the asset that is used up is transferred to the income statement from the balance sheet.

    Charging depreciation is not meant to estimate the asset’s market value which is the price a buyer is willing to pay.  An asset’s market value is rarely equal to its net book value. Net book value is the asset’s total cost less the accumulated depreciation. The book value is the same as scrap value at the end of the asset’s useful life. But it is possible that the market value of an asset is increasing while it is being depreciated.

    Using the double-entry system, whenever a depreciation amount is debited to the income statement, the same amount is credited to the accumulated depreciation. This accumulated depreciation is recorded in an account called a contra-asset account. By keeping a separate contra-asset account enables it to show the total depreciation accumulated to date from the date the asset was acquired.

    If depreciation is not calculated for inclusion in the accounting records, it will understate expenses and therefore overstate the net income. The book values of the assets will be overstated too. But it does not reduce the cash balance of a firm.  This then is why depreciation expense is sometimes referred to as a noncash expense. The cash balance is however reduced when the asset is acquired.

    A separate accumulated depreciation account enables the fixed asset to be shown at cost on the financial statements. The cost of the asset is the price paid for it including those expenses incurred in making it functional such as transportation and installation costs, etc. Each asset except land has its own accumulated depreciation account. On the balance sheet, accumulated depreciation is a credit balance shown as a subtraction from the debit asset balance to give its net book value. Once an asset is fully depreciated, no further deduction is made for depreciation even though it could continue to be productive.

    At the end of each accounting period, the depreciation account is closed and its balance is written off to the profit and loss account. In the next period, a new depreciation account is opened. The balance in the accumulated depreciation account is carried over to the next accounting period and increases as further depreciation is added to it.

    A general journal is used to write off yearly or monthly depreciation charges depending on how often the financial statements are prepared. The depreciation expense account is debited with the depreciated amount and this same amount is credited to the accumulated depreciation. Journal entries can be prepared as of the last day of each month or year as follow.

    The accumulated depreciation account in the ledger is shown just below its asset account.

    On the balance sheet, the net book value of the asset is shown by deducting the accumulated depreciation from the asset:

    Plant and Machinery                    60,000 
    Less: Accumulated Depreciation  24,000 36,000

    To determine the depreciation expense for an asset, these three factors are usually considered: its cost, its useful life and its expected salvage value. Salvage value is the value that is a firm expects to receive when the asset is sold at the end of its useful life. If no salvage value is expected, the entire cost is charged to depreciation over the estimated useful life of the asset.

    Sometimes, after making an estimate of the useful life of an asset and charging depreciation for a few years, a firm may revise the useful life to a shorter period due to some reason. This change in the estimated useful life affects the future depreciation rate but not the deprecation charged in the past. The depreciation charged in the past cannot be changed.

    There are five different depreciation methods:

  • Provisions
  • Bad Debts
  • Other Adjustments


  • Valuation of Inventory/Stock

    The Valuation of Inventory/Stock

    Net realizable value
    The net realizable value of stock is its saleable value less all the selling expenses. Selling expenses are those expenses that are incurred directly in the selling of goods such as marketing expenses, and sales commissions, travelling and lodging expenses of salespersons.

    If the cost of stock is higher than its net realizable value, it’s the net realizable value that should be taken in when preparing the final accounts. The underlying reason for this is that stock should not be over-valued. Over-valued stock will show an inflated profit. To ensure that stock is recorded at its net realizable value, any decrease in the value of stock due to obsolescence, damage, rust, rot, deterioration, etc must be considered as soon as it is detected.

    For example, a fire caused considerable damage to manufactured goods worth $150,000 stored within a warehouse, and the sale value of the undamaged goods is now put at $40,000. The $40,000 must be accepted as the realistic value and recorded using the following journalized entry.

    Date Accounts Folio Debit Credit
    $ $
    20XX
    Sep 30 Inventory Loss 110,000
    Inventory 110,000
    (Revised value of inventory)

    Any other expense accounts may be used for the inventory loss. Some choose to


    Lower of cost or market value
    Sometimes the market value of inventory has dropped below its purchase price. Here, the lower of cost or market value rule is applied to revalue the goods in stock.

    For example, a large consignment of 200 computer games was purchased at $100 per unit. After 120 of these games were sold, the price for each unit dropped to $80. The unsold 80 units in store have now a lower value of $6,400 and not $8,000 as it would be if the price had not dropped. The loss of $1,600 is journalized in the following entry.

    Date Accounts Folio Debit Credit



    $ $
    20XX
    Oct 30 Inventory Loss 16,000
    Inventory 16,000
    (Revised value of inventory)

    Valuation methods
    Let’s assume that a company deals with one type of goods as the following table shows. The goods are bought in batches at different times and at different prices. At the end of the financial year, the 30 units left in stock have to be valued. Since the units are bought at different prices, it means the closing stock of goods has to be calculated at the prices they are bought. But not many companies know whether to use the earlier or the later purchase price. The price of the earlier batch is lower that the later batch.

    Goods purchases Goods sold
    Date Units Unit Cost Amount Date Units Unit Cost Amount
    $ $
    20XX 20XX
    Mar 30 15 450 Apr 23 20 460
    Jul 50 20 1,000 Aug 22 25 550
    Nov 70 25 1,750 Oct 30 30 900
    Dec 45 30 1,350
    3,200 3,260

    The stock valuation needn’t be based on the price the items were bought. In other words, the valuation does not have to be done based on only one price or cost. Stock can be calculated with different amounts. There is a variety of inventory valuation methods that are being used, a few of which are explained here:

  • Bank Reconciliation

    Bank reconciliation is the process of reconciling cash book to bank statement by comparing the entries in the bank account in the cash book and on the bank statement. Every company has one or more bank accounts, and receives a bank statement for each account it has. The bank statement is a copy of the company’s account as kept at the bank. The statement shows a list of all financial transactions that take place over a period of time, usually a month using the account.

    Entries on the debit side of the company’s cash book appear on the credit side of the bank statement, and items on the credit side in the cash book are recorded on the debit side on the bank statement. This is because the cash account is a debit account in the company’s books. To the bank, the company’s account is a creditor’s account. A cash deposit is debited in the cash book as it increases the asset of cash while a payment is credited as it reduces the cash balance. From the bank’s point of view, a cash deposit into the company’s account is an increase in the creditor’s balance and so it’s credited. A cheque issued by the company is debited in the account by the bank as it decreases the credit balance which is the amount owed by the bank.

    The cash balance shown on the bank statement must equal the bank balance in the company’s cash book. If all the transactions were recorded in the cash book and on the bank account within the same period, then surely the balances would agree. But they rarely do. A bank reconciliation statement is therefore prepared to reconcile the two by identifying the causes of the difference.

    The items that usually cause the difference are deposited cheques that are still not credited, and cheques issued but not yet presented to the bank, and service and other miscellaneous bank charges that are not known and so not recorded in the cash book until the bank statement is received. Sometimes, other unanticipated entries on the bank statement or omission of an entry in the cash book can cause the difference between the two balances

    Items that are recorded in the cash books often do not appear on the bank statement. Deposits made into the bank account and cheques issued are usually recorded in the cash book without delay. But they are done close to the end of the month giving the bank insufficient time to record them in the same month. They thus appear on the following month’s bank statement.

    Bank reconciliation is necessary to confirm that the closing cash balance is correct for it to appear on the company’s financial statements. It is a necessary process of managing a company’s cash resources.

  • Control Accounts
  • Errors Not Affecting Trial Balance
  • Cost of Goods Sold
  • Capital and Revenue Expenditure
  • Suspense Account - more than one error

    DEF

  • Single Entry
  • Incomplete Records
  • Incomplete Records - Losses
  • Trial Balance
  • Disposal of an asset