PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.

Aadhil Hussain

Chapter 5: Accounting Adjustments

Aims of this Chapter:

The aims of this chapter are to:

⮚ Illustrate different methods of inventory valuation and their impact on the financial statements
⮚ Explain the accounting treatment of accruals, prepayments, bad debts and provision for bad
debts
⮚ Increase your understanding of the impact of accounting concepts and periodic measurement,
on the statement of financial position and income statement

Inventory Purchases and Sales

All financial statements are prepared on a periodic basis and as per the accruals and matching concept,
we first need to determine which sales need to be recognized in each period. Sales will be recognized in
the period in which they are earned and then needs to be matched against the expenses that helped
earn those sales.

The expense incurred to earn the sale is known as the cost of sale. Purchases is generally the biggest
component of cost of sales. However, we cannot simply use the purchase figure as the cost of sales, but
need to take into account inventory sold during the period which may have also been owned at the start
of the period and some inventory which may have not been sold at the end of the period.

Hence the purchase figure needs to be adjusted to take account of the change in inventory during the
period to arrive at the cost of sales figure.

The cost of sales figure can be calculated as follows:

Cost of Sales = Opening Inventory + Purchases – Closing Inventory

Closing inventory appears both as current assets in the S o FP and part of cost of sales in the IS. Closing
inventory at the end of the period is inventory that hasn’t been sold and therefore the cost of purchasing
it cannot be included in the cost of sales. Hence why we deduct closing inventory.

The opening inventory on the other hand only appears in the cost of sales in the IS. It is most likely that
all of the opening inventory will be sold during the period and hence included in the cost of sales.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Presentation of the Cost of Sales

The cost of sales is presented on the face of the income statement. The income statement is generally
divided into two sections. The top part is known as the “Trading Account”. It is in this trading account
that the cost of sales is presented. A trading account starts off with Revenue, followed by cost of sales.
The difference between these two amounts is known as the “Gross Profit”.

Below is a snapshot of a trading account:

Revenue (Sales) xxxx

Less: Cost of Sales

Opening Inventory xxx
Purchases xxx
Less: Closing Inventory (xx) (xxx)

Gross Profit xxx

How do you value Closing Inventory?

It’s important to consider two aspects in valuing inventory. First, is the inventory in a condition that can
be sold, and secondly how much did it originally cost.

It’s important to note that inventory is to be valued at cost. But at times inventory can become damaged
or obsolete and thus may not be in a saleable condition. In instances like this, the business may want to
get rid of such inventory, even though it may sell at a price lower than the original cost.

In such cases we need to apply the concept of Prudence. Prudence highlights that we need to make
provision for losses we anticipate. So instead of valuing the inventory at the original cost, we will need
value it the “Net Realisable Value”.

This can be calculated as follows:

Net Realisable Value = Selling Price – Further Selling Costs

However, at some instances the original cost of the goods may be lower than the Net Realisable Value. In
such a scenario the closing inventory will be valued at the original cost.

Hence we could conclude saying:

Inventory should be valued at the Lower of Cost and Net Realisable Value

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Moving into the second aspect, how do we value the original cost of the inventory. There are three
different methods closing inventory could be valued at.

1. First in First out (FIFO)

2. Last in First out (LIFO)

3. Average Cost (AVCO)

Each of the methods will be discussed in detail.

First in First out (FIFO)

In this inventory valuation basis we assume that goods are issued out of the inventory in the order in
which they were delivered into the stores. This is certainly appropriate for many businesses, for example
a retailer selling fresh food.

This basis has its own pros and cons.

Advantages

1. Logical – Reflects the most likely physical flow of goods.

2. Easily Understood

3. Inventory is valued at the latest prices

Disadvantages

1. Issue of goods may be at older prices

2. In instances where there are rising prices, closing inventory value increases, increasing the profit
figure.

3. Cost comparisons from one period to another, or at times within the same period may be difficult.

Last in First Out (LIFO)

In this inventory valuation basis we assume that goods are issued out of the inventory in the reverse
order to which they were delivered into the stores. This is a very uncommon method and only
appropriate for a few businesses. Example: Oil companies may use LIFO.

Advantages

1. Issue of goods are at the latest price

2. In instances where there are rising prices, closing inventory value decreases, decreasing the profit
figure.

Disadvantages

1. Inventory values may become very out of date

2. Cost comparisons from one period to another, or at times within the same period may be difficult.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Average Cost (AVCO)

In this inventory valuation basis we assume that goods issued out of the inventory are all valued at
average price. The average price is calculated every time a new stock arrives.

It is calculated as follows: Running Total Costs / Running Total Units

Advantages

1. Logical – All units have the same value

2. Acceptable by the Accounting Standards

Disadvantages

1. Inventory cost may not be the actual cost. It’s merely an average

2. Inventory values may lag behind the current values.

Working out Inventory using Mark-Up and Margin

Goods at times may be valued at selling price. In instances like this, to be in line with the prudence
concept you may need to work out the cost of the goods.

This can be done using the Mark-Up and Margin.

Mark-Up is the percentage added to the cost of the price to derive the selling price. Margin on the other
hand is a percentage of selling price.

Calculation of Mark-Up

Calculation of Margin

Goods sent to customers on sale or return

If a seller sends goods to a customer on a sale or return basis, the goods will continue to belong to the
seller until they are sold on by the buyer. At the end of the supplier’s accounting period, any goods held
on this basis by its customers should be included in the seller’s stock valuation, not in the figure for sales.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Accruals and Prepayments

Expenses such as electricity, heating and lighting costs, are typically incurred before they are paid,
because electricity bills only arrive after the business has used the electricity. These expenses are paid in
arrears. In contrast, expenses such as rent and insurance are usually paid in advance (i.e. these expenses
are prepaid).

Treatment of Accruals

If the business has incurred an expense at the accounting period end, but has not paid for it yet, it must
be included as a liability in the S of FP. Expenses such as electricity which are paid in arrears, and for
which no bill has been received at the accounting year end date, also appear under current liabilities but
are called accruals.

We need to work out what figure should appear in the IS in respect of the charge for the accounting
period in question, and what figure should appear in the S of FP on the accounting year end date. We
need to look at any amounts owing at the start of the accounting period, what was paid during the
accounting period, and what was still owed at the end of the accounting period.

This can be worked out using a “T” Account or even without one.

Treatment of Prepayments

In contrast, some expenses are paid in advance, before they are incurred. If the business has paid an
expense before the accounting period end, but will not receive the benefit until the following accounting
period, there will be an asset in the S of FP. This asset is called a prepayment and appears under current
assets.

We need to look at any amounts prepaid at the start of the accounting period, what was paid during the
accounting period, and what was prepaid at the end of the accounting period and work out what figure
should appear in the IS in respect of the charge for the accounting period in question, and what figure
should appear in the S of FP on the accounting year end date.

This too can be worked out using a “T” Account or even without one.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Bad Debts and Doubtful Debts

There is sometimes a misconception that Bad Debts and Doubtful Debts mean the same thing. However
in accounting these two are quite very different.

A bad debt is recognized when we believe that a receivable is unable or unwilling to pay and that the
business will never be able to recover the money owed. Usually, only specifically identified amounts will
be regarded as bad debts.

A provision for bad or doubtful debts is an estimated reduction in the S of FP value of the asset ‘trade
receivables’. A doubtful debt occurs when we believe that a receivable is unlikely to be able or willing to
pay or on the basis of experience we believe that, 5 per cent of receivables will be unable to pay.

There is either still a chance that the money will be recovered, or we are not sure exactly which
customers are not going to pay us, but we know from experience that a certain percentage are likely to
default.

How does Bad Debts and Doubtful Debts affect the S o FP?

Bad and doubtful debts both reduce the value of receivables on the S & FP. However, they do so in
different ways.

Writing-off a bad debt simply involves deducting the amount of the bad debt from the receivables
balance directly.

However, providing for a doubtful debt involves creating a new balance called the provision for doubtful
debts, or adjusting the value of the provision if one already exists. The provision for doubtful debts
appears as a separate Cr balance on the TB, and is deducted from the receivables figure in the current
assets on the S of FP.

How does Bad Debts and Doubtful Debts affect the IS?

Writing-off a bad debt always creates an expense in the IS for the amount of the debt written off. In
double-entry terms, because there is a Cr to the receivables ‘T’ account, there must be Dr to a IS
expense ‘T’ account.

Creating a new provision for doubtful debts will also create an expense in the IS. This expense can either
be shown separately (as doubtful debt expense) or included with the bad debt expense.

However, if a provision for doubtful debts already existed at the previous accounting year end date, then
adjusting the figure to whatever new provision is required at the current S of FP date may create either
an expense, or an income in the IS (you can think of this ‘income’ as a negative expense). It is only the
change in the provision for doubtful debts which is recognized in the IS, and this change could either be
an increase (in which case there is a cost in the IS) or a decrease (in which case there is an income).

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Bad Debts Recovered

Sometimes, a debt written off in previous years is recovered. When this happens, you:

1. Reinstate the debt by making the following entries:

Dr Debtor’s account
Cr Bad debts recovered account

2. When payment is received from the debtor in settlement of all or part of the debt:
Dr Cash/bank
Cr Debtor’s account

At the end of the financial year, the credit balance in the bad debts recovered account is transferred to
either the bad debts account or direct to the credit side of the profit and loss account. The effect is the
same, since the bad debts account will, in itself, be transferred to the profit and loss account at the end
of the financial year.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

End of Chapter Questions

Quiz 1

A company made a sale of $500,000. The opening inventory stood at $35,000 and the closing inventory
was $55,000. The company made purchases of $300,000 throughout the year.

Calculate the Cost of sales of the company and their gross profit.

Quiz 2

The owner of Plants ‘R’ us is preparing her accounts for the year ended 31 December 20X4. She has
prepared a list of inventory in her shop on accounting year end date, but is unsure how to value the
following items:

Description Quantity Purchase Price Expected Sales Price

Type 1 5 $3.99 $2.99

Type 2 45 $0.40 $0.50

Type 3 3 $24.75 $28.75

*Type 1 has been in the shop for some time and can only be sold at a discounted price.

**Type 3 does need some modification before being sold as it does not look too attractive in the current
state. This will cost the company $5 per unit.

Calculate the cost of each type of inventory and the total inventory.

Quiz 3

M Ltd had the following material transactions during the first week in March. 

    Quantity (units)  Unit cost $ 

Opening balance 1st March  10  2.00 
Receipts 2nd March 70  2.20 
Issues 3rd March  40   
Receipts 4th March  50  2.30 
Issues 5th March  70 

Calculate the value of the inventory under LIFO, FIFO and AVCO

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Quiz 4:

A business had opening inventory of 300 units valued at $4.50 per unit on 1 May. The following receipts
and issues were recorded in May:

2 May Issue 200 units

7 May Receipt 500 units @ $4.80 per unit
13 May Issue 400 units
20 May Receipt 500 units @ $5.00 per unit
28 May Issue 450 units

(a) What is the value of issues during the month using the FIFO method?

A $4,750
B $5,000
C $5,030
D $5,080

(b) What is the value of issues during the month using the LIFO method?

A $4,750
B $5,000
C $5,030
D $5,070

(c) What is the value of closing inventory?

FIFO method LIFO method

A $1,180 $1,250
B $1,250 $1,180
C $1,250 $730
D $1,180 $730

(d) What is the value of closing inventory using the AVCO method?

A $1,180
B $1,232
C $1,250
D $1,282

Quiz 5

1. If the selling price of product A is $800 and the mark-up is 40 per cent, what is the cost price?

2. If the selling price of product B is $600 and the margin is 60 per cent, what is the cost price?

3. If the cost of the product A is $500 and the mark-up is 30 per cent, what is the selling price?

4. If the cost of the product B is $400 and the margin is 40 per cent, what is the selling price?

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Quiz 6

Assume that rent of £4,000 per year is payable at the end of every three months.
Amount Rent due Rent paid
£1,000 31 March 20X5 31 March 20X5
£1,000 30 June 20X5 2 July 20X5
£1,000 30 September 20X5 4 October 20X5
£1,000 31 December 20X5 5 January 20X6

Prepare a rent account for the year ended 31 December 20X5 showing clearly the amount of rent
accrued.

Quiz 7

Insurance for a business is at the rate of £840 a year, starting from 1 January 20X5. The business has
agreed to pay this at the rate of £210 every three months. However, payments were not made at the
correct times. Details were:

Amount Insurance due Insurance paid

£210 31 March 20X5 £210 28 February 20X5
£210 30 June 20X5
£210 30 September 20X5 £420 31 August 20X5
£210 31 December 20X5 £420 18 November 20X5

Prepare the insurance account for the year ended 31 December 20X5.

Quiz 8

The financial year of T Guiness ended on 31 December 20X6. Show the ledger accounts for the following
items including the balance transferred to the necessary part of the financial statements, also the
balances carried down to 20X7:

(a) Motor expenses: Paid in 20X6 £819; Owing at 31 December 20X6 £94.
(b) Insurance: Paid in 20X6 £840; Prepaid as at 31 December 20X6 £68.
(c) Stationery: Paid during 20X6 £370; Owing as at 31 December 20X5 £110; Owing as at 31 December
20X6 £245.
(d) Business rates: Paid during 20X6 £1,654; Prepaid as at 31 December 20X5 £140; Prepaid as at 31
December 20X6 £120.
(e) Guiness sub-lets part of the premises. He receives £1,400 during the year ended 31 December 20X6.
Harte, the tenant, owed Guiness £175 on 31 December 20X5 and £185 on 31 December 20X6.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Quiz 9

On 5 October 20X1, Bristol Industrial Company Ltd received an electricity bill for $560 for the quarter
ended 30 September 20X1.
Bristol Industrial Company Ltd makes up its accounts to 30 September each year.
On 30 September 20X0, the company owed electricity costs of $420.
During the year, cash payments of $1,620 were made to the electricity company.

Calculate the figure to be presented on the IS 30/9/11.

Quiz 10

Bristol Industrial Company Ltd has a year-end in September each year. Bristol Industrial Company Ltd
paid its annual buildings insurance of £4,000 in advance on 30 June 20X1. The annual insurance paid on
30 June 20X0 was £2,700.

Calculate the amount prepaid at the beginning of the year, the prepayment at the end of the year and
the amount to be charged to the IS.

Quiz 11

The following entry appears in a company’s TB at 30 April 20X8, which is its accounting year end:

Trade receivables 57,200 (Dr)

Receivables of £2,000 are considered to be bad. Five per cent /of the remaining receivables are
considered to be doubtful.

Show the entries that will appear in the financial statements for the year ended 30 April 20X8

Quiz 12

The following entries appear in a company’s TB at 30 April 20X9, which is its accounting year end:

Trade receivables $62,350 (Dr)

Provision for bad and doubtful debts at 1 May 20X8 $2,760 (Cr)

Debts of £2,350 are considered to be bad. Five per cent of the remaining receivables are considered to
be doubtful.

Show the entries that will appear in the financial statements for the year ended 30 April 20X9

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Quiz 13

The following entries appear in a company’s TB at 30 April 20X9, which is its accounting year end:

Trade receivables $62,350 (Dr)

Provision for bad and doubtful debts at 1 May 20X8 $2,760 (Cr)

Debts of £2,350 are considered to be bad. Three per cent of the remaining receivables are considered to
be doubtful.

Show the entries that will appear in the financial statements for the year ended 30 April 20X9

Quiz 14

In a new business during the year ended 31 December 20X7 the following debts are found to be bad,
and are written off on the dates shown:

31 May S Gill & Son £340

30 September H Black Ltd £463
30 November A Thom £156

On 31 December 20X8 the schedule of remaining debtors, amounting in total to £14,420, is examined,
and it is decided to make a provision for doubtful debts of £410.

You are required to show:

(a) The Bad Debts Account, and the Provision for Doubtful Debts Account.
(b) The charge to the Profit and Loss Account.
(c) The relevant extracts from the Balance Sheet as at 31 December 20X8.

Quiz 15

A business which prepares its financial statements annually to 31 December suffered bad debts:

20X7 £420
20X8 £310
20X9 £580

The business had a balance of £400 on the provision for doubtful debts account on 1 January 20X7. At
the end of each year, the business considered which of its debtors appeared doubtful and carried
forward a provision:

20X7 £500
20X8 £600
20X9 £400

Show the entries in the profit and loss account and prepare the provision for doubtful debts account for
each of the three years.

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PRINCIPLES OF ACCOUNTING (AC1025) TUTE-05 By: M.Aadhil Hussain

Quiz 16

J Blane commenced business on 1 January 20X6 and prepares her financial statements to 31 December
every year. For the year ended 31 December 20X6, bad debts written off amounted to £1,400. It was also
found necessary to create a provision for doubtful debts of £2,600.
In 20X7, debts amounting to £2,200 proved bad and were written off. J Sweeny, whose debt of £210 was
written off as bad in 20X6, settled her account in full on 30 November 20X7. As at 31 December 20X7
total debts outstanding were £92,000. It was decided to bring the provision up to 4% of this figure on
that date.
In 20X8, £3,800 debts were written off during the year, and another recovery of £320 was made in
respect of debts written off in 20X6. As at 31 December 20X8, total debts outstanding were £72,000. The
provision for doubtful debts is to be increased to 5% of this figure.

You are required to show for the years 20X6, 20X7 and 20X8, the
(a) Bad Debts Account.
(b) Bad Debts Recovered Account.
(c) Provision for Doubtful Debts Account.
(d) Extract from the Profit and Loss Account.

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