Week 5 Student

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MIT565702

LECTURE 5

ADJUSTING ENTRIES (2)

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Homework – This WeekWorksheet

Complete the following worksheet for Property Developers Ltd for the MONTH of June 2012 in light of the following adjusting entries:

Depreciation on the motor vehicles is $3,000 per annum;

$900 of insurance has been consumed during the month;

Office stationery on hand as at June 30, 2012 was costed at $350. (This is included in “Office Stationery Expense”);

Wages of $900 are owed on June 30, 2012; and

Commission revenue owed to Property Developers Ltd on June 30, but not recorded, was $1100.

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Account Unadjusted Trial Balance

Adjustments Adjusted Trial Balance

Income Statement Balance Sheet

Title Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit

Cash at Bank 13500

Prepaid Insurance 1200

Debtors 22000

Vehicles 18000

Acc Dep of Vehles 4000

Land & Buildings 80000

Creditors 12000

Capital

Sales 126000

Sales Returns 1000

Commission Rev 4000

Supplies Expense 45000

Wages 19000

Rates 500

Office Stat. Exp 3700

Sales &Dist Exp 9800

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Required Exercise P5.9

Date Particulars DR

$

CR

$

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Required Exercise P5.9Date Particulars DR CR

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Questions from other Required Exercises?

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Lecture Objectives

At the completion of this lecture you should be able to:– Understand what is a bad debt;– Estimate bad debts expense and prepare adjusting entries

accordingly;– Prepare journal entries to write off a bad debt and to

reinstate a bad debt recovered;– Understand what is depreciation;– Apply the most appropriate depreciation method in

calculating depreciation; and– Prepare adjusting entries to record depreciation expense

under the alternative methods

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Why do we have Adjusting Entries?

• Recall, we have adjusting entries because of:

• Accrual accounting• Recognise revenue when earned and expenses when incurred

• Accounting period assumption• Life of a business divided into accounting periods• An accurate profit figure for that period is required

• Extends to the following adjusting entries:

• Bad and doubtful debts; and

• Depreciation

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What are Bad Debts?

• When selling goods on credit, a certain percentage of debtors will fail to pay their debts • Eventually they will be written off as bad

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How do we Account for Bad Debts?

(1) Direct Write-off Method• When obvious a debtor will not pay their debt it is declared

bad and written off as an expense:

• Not an adjusting entry!!• Inconsistent with the matching principle

• Some bad debts occur in an accounting period later than the credit sale

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Example – Matching Principle

20121 June Credit sale of $100 to M James30 June Statement of account sent to M James30 June The end of the accounting period1 Aug M James should have settled his account with the

business but has failed to do so31 Aug A reminder letter is sent asking

payment within the next thirty days30 Sept A letter threatening court action is

sent to M. James20 Oct The account is declared bad

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• Revenue recognised in June, but bad debt is not expensed until October (in the next accounting period)

• Effect is a profit distortion for each accounting period (no proper matching)

• Need to look into the future and foresee future bad debts

1 June 30 June 20 Oct

Credit Sale End of accounting period

Account declared bad

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How do we Account for Bad Debts?

(2) Allowance Method• Estimate made at the end of the accounting period of

the accounts receivable expected to be uncollectable • Recognised as an expense with the following adjusting

entry:

Preferred method in Australia

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What Type of Account is Allowance for Doubtful Debts?

• Allowance for doubtful debts account is a contra asset (negative asset)

• Decreases the amount of accounts receivable shown in the balance sheet

• For example:

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How do we Estimate Bad Debts Expense?

(1) Estimate based on credit sales– Percentage of sales made in the period is estimated to be

bad E.g., 1% of credit sales

– Is the amount of the adjusting entry (irrespective of Allowance for doubtful debts balance)

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Student Task

Example

Past experience has shown that bad debts over recent years average 2% of credit sales

Credit sales for the current financial year (2012) were $468,000

Required

Prepare the adjusting entry at 30 June 2012 to estimate the bad and doubtful debts

(Spend 5 minutes doing this)

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Workings

General Journal

Date Particulars DR CR

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How do we Estimate Bad and Doubtful Debts Expense?

(2) Estimate based on an aged analysis of accounts receivable– Assumes that the longer the accounts receivable is

outstanding the more likely it will become bad– Determines the closing balance of Allowance for

doubtful debts AND NOT the amount of the adjusting entry!

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Student Task

Example

Allowance for doubtful debts has a CR balance of $3,500 on 30 June 2011

Past experience provides a percentage of outstanding debtors expected to become bad (see next slide)

Required

Prepare the adjusting entry at 30 June 2012 to estimate the bad and doubtful debts


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Student Task

Days overdue Amount outstanding

Percentage bad

0 days $50,000 0%

1 – 30 days $12,000 1%

31 – 60 days $15,000 3%

61 – 90 days $25,000 10%

91 + days $10,000 20%

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Workings

General Journal


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What Happens when the Debt Becomes Bad?

• No NEW expense when the debt actually becomes bad• It is written off:

• This is not an adjusting entry!• DR to Allowance for doubtful debts AND NOT to Bad debts expense

• Expense already recognised• Net accounts receivable balance remains the same before and after

the write off

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Student Task

Example

Accounts receivable is $112,000 on 30 June 2012

Allowance for doubtful debts has a CR balance of $5,070 on 30 June 2012

Amount of $2,000 owing from Smith Pty Ltd is uncollectable and written off as bad on 1 March 2013Assume no other entries occurred in relation to accounts receivable for the year

RequiredPrepare the general journal entry to write off the bad debt; andPrepare a balance sheet extract showing net receivables as at 30 June 2012 and 1 March 2013


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Workings

General Journal


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Workings

Balance Sheet extract as at 30 June 2012

Balance Sheet extract as at 1 March 2013

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Change in Allowance

Allowance for doubtful debts may also be increased after bad debts have been written off– Restores balance to estimate of ‘future’ bad debts – Prevents possible DR balance in Allowance for doubtful

debts

Allowance for doubtful debts may be increased (or decreased) upon a re-assessment of credit risk– Adjust to reflect likelihood of debts becoming bad

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Student Task

Example

After the previous bad debt write off, management re-assesses the percentage of outstanding debtors expected to become bad (see next slide)

Required

Prepare the adjusting entry at 30 June 2013 to estimate the bad and doubtful debtsPrepare a balance sheet extract showing net receivables as at 30 June 2013


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Student Task

Days overdue Amount outstanding

Percentage bad

0 days $50,000 0%

1 – 30 days $12,000 1%

31 – 60 days $15,000 3%

61 – 90 days $25,000 10%

91 + days $8,000 50%

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Workings

General Journal


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Workings

Balance Sheet extract as at 30 June 2013

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What Happens when we Recover a Bad Debt?

• Accounts that have been written off may become recoverable– E.g., administrators declare business can repay “20 cents in the

dollar”• Two step process:

(1) Reinstate the amount outstanding as follows:

(2) Record the receipt of cash from the debtor:

– Bad debts expense is not affected at all!

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Student Task

Example

A cheque for $500 was received on 1 August 2013 from Smith Pty Ltd as a partial payment of the $2,000 that was written off

Required

What are the general journal entries to record the above?

Prepare a balance sheet extract showing net receivables as at 1 August 2013


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Workings

General Journal


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Workings

Balance Sheet extract as at 1 August 2013

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Student Task

Have a go at practice problem 2 (pg 71) and we will discuss it in 15 minutes time. Only do the journal

entries.

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Workings


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WorkingsDate Particulars DR CR

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What is Depreciation?

Non-current assets contribute to revenue over more than one year

Subject to wear and tear, so they contribute to revenue over a finite number of years

– What about land? Depreciation allocates the cost of an asset over the years of which the

asset contributes to revenue

– Recorded as an expense via an adjusting entry at balance date

– Consistent with the matching principle

Depreciation is NOT a valuation process

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How do we Account for Depreciation?

Different methods available to match the cost of using the asset with the revenue generated

Method chosen should reflect the pattern of use of the asset The methods available include:

– Straight-line

– Reducing balance

– Units of production

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How do we Account for Depreciation?

Irrespective of the depreciation method chosen the adjusting entry is:


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What Type of Account is Accumulated Depreciation?

• Accumulated depreciation is a contra asset (negative asset)• Is the amount of depreciation recorded over the life of the asset

to date• Is deducted from the cost of the asset in the balance sheet:• E.g.,

* This amount is known as the book value, written down value, carrying amount, or unallocated cost

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How do we Calculate Depreciation?

(1) Straight-line Method Allocates an equal amount each period for the life of the asset Applied to those assets that contribute equally to revenue each

period over their useful life – E.g, Office furniture

Depreciation calculated using the following formula:

What do these terms mean?

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Student Task

ExampleAn entity purchased an asset on 1 July 2010 at a cost of $40,000. The asset will have a life of 5 years at which time it will be sold for $5,000

RequiredPrepare the adjusting entry in the general journal to record depreciation under the straight-line method at 30 June 2011 and 30 June 2012


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Workings

General Journal


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(2) Reducing Balance Method Allocates a reducing amount each period for the life of the asset Applied to those assets that contribute more to revenue in the

early stages of their lives

– E.g., Computers; Machinery Depreciation determined by allocating a set percentage to the

book value of the asset Depreciation calculated using the following formula:

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Student Task

ExampleUsing the same facts as the previous example, assume a depreciation rate of 30%

RequiredPrepare the adjusting entry in the general journal to record depreciation under the reducing balance method at 30 June 2011 and 30 June 2012


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Workings

General Journal


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$

Years

Reducing balance

Straight-line

Comparing the Methods:Depreciation Expense

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Straight-line

Reducingbalance

$

Years

Comparing the Methods:Book Value

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(3) Units-of-production Method Relates depreciation to use rather than to time Appropriate where use of the asset varies from period to

period and usage can be defined– E.g., Motor Vehicle (kilometres); Photocopier (hours)

Depreciation calculated using the following formula:

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Student TaskStudent TaskExample

A photocopier was purchased on 1 July 2010 for $30,000. It is estimated to have a useful life of 150,000 hours at which time it will have a scrap value of $0. The photocopier was used for 4,000 hours in Year 1 and 5,000 hours in Year 2.

RequiredPrepare the adjusting entry in the general journal to record depreciation under the units of production method at 30 June 2011 and 30 June 2012


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Workings

General Journal


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Lecture Outcomes

You should now be able to:– Understand what is a bad debt;– Estimate bad debts expense and prepare adjusting entries

accordingly;– Prepare journal entries to write off a bad debt and to

reinstate a bad debt recovered;– Understand what is depreciation;– Apply the most appropriate depreciation method in

calculating depreciation; and– Prepare adjusting entries to record depreciation expense

under the alternative methods

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Next Class

We will continue to look at depreciation related issues including:– What is included in the cost of an asset?– When do we start depreciating?– How do we revalue an asset?– What happens when we sell an asset?

Emphasis will also be placed on the closing and reversing process

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Homework!

Required Exercises D5.15, P5.24, P5.28; P5.29; P9.11 (ignore taxes)

Textbook reading: Chapter 4 (page 168-169) & Chapter 9 (page 427-430).

Documents

Week 5 Student