Principle of Accounting

Chapter 13 &19

Profit determination and Balance-day adjustments

BA. in International BusinessForeign Trade University

Outline

Profit determinationAccrual accounting and balance-day

adjustmentsPrepaid expenseAdjusting for stocks of materials and

suppliesAccrued expensePrepaid revenueAccrued revenue

Profit determination underlying assumptions

Going concern principle: assumes that the business will continue in operation as a going concern for an indefinite period into the future.

Reporting period principle: the life of a business is divided into equal periods of time over which the performance of the business can be measured (profit or loss is determined).

Matching principle: is used to match the revenue and expense for a particular reporting period to determine a profit or loss figure

Accrual accountingAccrual accounting: A system of accounting

in which revenues are recognised when earned and expenses when incurred.

Profit is defined as revenue earned less the expenses incurred in earning that revenue.

Revenue can be earned in one reporting period while cash can be received in a previous or subsequent period.

Expenses can incur in one reporting period while cash payment can be made in a previous or subsequent period.

Balance-day adjustments Adjusting entries: are the entries

made in revenue and expense accounts to make them equal to revenue earned and expenses incurred. Adjusting entries are made on the last day of the reporting period (balance day).

Closing entries: are used to close off the adjusted revenue and expense accounts to the profit and loss summary account. Closing entries are also made on balance day.

Prepaid expensesExample: On 1 Oct 05, the company paid

$480 for a 12-month insurance premium.The question is whether the insurance

payment represents an asset or expense?Prepaid expenses are goods & services

purchased for future consumption and paid for in advance.

Prepaid expenses are assets because they will benefit future accounting periods.

As the assets are consumed to generate revenue for a business, a portion of their cost is transferred to expense.

The adjusting entries are made to ensure the matching of revenue and cost of the asset written off.

Prepaid expense (cont’d)Using the above example:1 Oct 05: paid 12-month insurance $480 ($40

per month)31 Dec 05: Insurance used: 3 months => Insurance

expense= 3*40 = $120Insurance prepaid for 06 (9 months unused) =

9*40 = $360Accounting entries:1 Oct 05: Dr Prepaid insurance $480

Cr Cash $48031 Dec 05: Dr Insurance expense $120

Cr Prepaid insurance $120

Prepaid expense – ledger accountsPrepaid insurance a/c

Insurance expense a/c

Oct 1 Cash at bank $480

$480

Dec 31 Insurance expense $120

Balance $360

$480

Dec 31 Prepaid insurance $120 Dec 31 P&L Summary $120

Adjusting for stocks of materials and suppliesStocks of materials and supplies arise when a

service firm purchases materials which it needs in order to provide services to its customers.

Examples are office stationery, stocks of petrol, etc.

If some of these supplies have been used by the end of a period, adjustments must be made as part of the balance-day process.

The cost of supplies used is transferred from an asset account to an expense account on balance day.

Adjusting for stocks of materials and supplies (cont’d)

Example

5 Jan: stationery supplies were purchased for $1,200.

31 Dec: stationery supplies remain on hand is $200Stationery supplies used during the year = 1,200 –

200=1,000Adjusting entry for stationery used:

Dr Stationery expense $1,000

Cr Stock of stationery $1,000Closing entry for stationery expense

Dr P&L Summary $1,000

Cr Stationery expense $1,000

Adjusting for stocks of materials and supplies – ledger accounts

Stock of stationery a/c

Stationery expense a/c

Dec 31 Stationery expense $1,000

Balance 200 $1,200

Dec 31 Stock of stationery $1,000 Dec 31 P&L Summary $1,000

Jan 5 Cash $1,200

$1,200

Jan 1 Balance 200

Accrued expenses (expenses owing)Accrued expenses: are expenses that have

been incurred but not yet paid.Example: A firm incurred $1,000

advertising expense during 2005, in which $200 of advertisement in December is not yet paid.

$200 advertising expense is an accrued expense.

Adjusting entry for accrued expenseDr Advertising expense $200

Cr Accrued advertising $200

Accrued expenses - ledger accounts Advertising expense a/c

Accrued advertising a/c

Dec 31 P&L Summary 1,000

$1,000

Dec 31 Advertising exp $200

Jan-Dec Cash $800

Dec 31 Accrued advertising $200

$1,000

Prepaid revenuePrepaid revenue represents future revenue

that has been collected but not yet earned.

The prepaid revenue will be realised when some type of service is performed or goods are provided.

At the time of collection, prepaid revenue represents a liability to the business because goods or services are owed in return.

The adjusting entries are made to ensure the matching of revenue earned and expense incurred to generate revenue.

Prepaid revenue – an exampleTotal bus fares received: $90,000Bus fares paid in advance for trips in 2006: $10,000Bus fares revenue earned in 2005

= $90,000 - $10,000 = $80,000Accounting entries:Jan-Dec: Dr Cash at bank $90,000

Cr Prepaid bus fares revenue $90,000Dec 31: Dr Prepaid bus fares revenue $80,000

Cr Bus fares revenue $80,000

Prepaid revenue – ledger accountsPrepaid bus fares revenue a/c

Bus fares revenue a/c

Dec 31 Bus fares revenue $80,000

Balance $10,000

$90,000

Dec 31 P&L Summary $80,000

Jan-Dec Cash at bank $90,000

$90,000

Jan 1 Balance $10,000

Dec 31 Prepaid bus fares $80,000

Accrued revenue (revenue owing)Accrued revenues: are revenues that have

been earned but not yet received.Example:

1 Jul 05, a company deposited $20,000 in a bank account at 10% p.a. payable on 30 Jun 06.Interest earned as of 31 Dec 05 (six months)= $20,000 * 10% * 6/12 = $1,000

Accounting entry:Dr Accrued interest revenue $1,000

Cr Interest revenue $1,000

Accrued revenue – ledger accountsAccrued interest revenue a/c

Interest revenue a/c

Dec 31 Interest revenue $1,000

Dec 31 Accrued interest rev $1,000Dec 31 P&L Summary $1,000

Practice questionsExercise 13.4Exercise 13.6Exercise 13.8Exercise 13.10Exercise 19.1Exercise 19.3Exercise 19.4

HomeworkExercise 13.5Exercise 13.7Exercise 13.9Exercise 13.14Exercise 19.2Exercise 19.5Exercise 19.6