CHAPTER 4

ACCOUNTING CONVENTIONS:
ADJUSTMENTS TO THE
FINANCIAL STATEMENTS
LEARNING OBJECTIVES

By the end of this chapter, and having completed the essential reading
and activities, you should be able to:

o Apply the accruals concept to the construction of the statement

of comprehensive income
o Make appropriate adjustments to the statement of financial
position for outstanding balances

INTRODUCTION

In all the previous examples of financial statements (statements of

comprehensive income and statements of financial position) that we
have dealt with so far we have always assumed that all the expenses
were paid exactly when they were due. This is unrealistic. As you are
probably aware, most households and businesses will not pay expenses
at the exact moment they are due (for example, may bills for services
such as electricity will require part payment in advance, while some
payments are made after the electricity has been consumed). This
divergence between the date an expense is due and the date it is paid
will be dealt with in this chapter. This will apply to both expenses that
are incurred by the business and to income received.

The accrual concept is applied in determining how much should appear

in the statement of comprehensive income as an expense or income for
any particular accounting period. All incomes and expenses that are
incurred in a particular period of time should appear in the statement
of comprehensive income of that particular period of time – regardless
of whether they have actually been paid or received by the business. In
other words, even if a bill remains unpaid at the end of the period the
statement of comprehensive income will still show this as a full
expense.

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There are few other accounts that we need to give special attention to
as it is not easy to classify them into the five (5) types of accounts.
These accounts need to be adjusted before we can finally look into final
accounts. These accounts are:

1 Accrues expenses
2 Prepaid expenses
3 Accrued revenues
4 Prepaid revenues
5 Bad debts
6 Provision for bad debts
7 Depreciations

For your purpose, you do not need to know how to open the accounts
for accrued expenses, prepaid expenses, accrued revenues, prepaid
revenues and bad debts. It is enough to know how these accounts will
affect the final accounts. As for provisions for bad debts and
depreciations, it is very important for you to know how to open these
accounts.

ACCRUALS AND PREPAYMENTS

As being mention above, for accruals (expenses and revenues) and

prepayments (expenses and revenues), it is suffice for you to know
what are the effect they have on the final accounts.

EXPENSES ACCRUED
(LIABILITY – since you still owe)
Money you EFFECT ON EFFECT ON
should pay but INCOME STATEMENT
have not paid yet. STATEMENT OF FINANCIAL
POSITION
Increase Increase
expenses Current
ACCRUAL Liabilities
REVENUE ACCRUED
(ASSET – since people still owe you)
Money you EFFECT ON EFFECT ON
should receive INCOME STATEMENT
but not received STATEMENT OF FINANCIAL
yet. POSITION
Increase Increase
revenues Current Assets

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 You received REVENUE PREPAID (LIABILITY – you
money, but still owe services or goods)
still have not
perform the EFFECT ON EFFECT ON
service or INCOME STATEMENT OF
give the STATEMENT FINANCIAL
PREPAYMENT goods yet. POSITION
Decrease Increase
revenues Current
Liabilities
You paid the EXPENSES PREPAID
money but (ASSET – people still owe you
not received services or goods)
the services EFFECT ON EFFECT ON
or goods yet. INCOME STATEMENT OF
STATEMENT FINANCIAL
POSITION
Decrease Increase
expenses Current Assets

BAD DEBTS

Bad debt is the portion of receivables that can no longer be collected,

typically from accounts receivable or loans. Bad debt in accounting is
considered an expense.

Bad debts are normal business risk and it is then a normal business
expense. When a debt is found to be bad, the asset as shown by the
debtor’s account is worthless, and must accordingly be eliminated as
an asset account. This is used only when the debt has been proved to
be a bad debt and is written off.

Thus, bad debts will affect only the Income Statement whereby it will
increase the expenses.

PROVISION OF BAD DEBTS

This is used only for estimates of the amount of the debtors/accounts

receivables at the year end that are likely to finish up as bad debts. Is a
providing for future bad debts.

When a provision is 1st made, the amount of this provision is charged

as an expense in the Income Statement for the period in which the
provision is created.

When a provision already exists, but is subsequently increased in size,

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the amount of the increase in provision is charged as an expense in the
Income Statement.

When a provision already exists, but is subsequently reduced in size,

the amount of the decrease in provision is recorded as an item of
‘income’ in the Income Statement.

The Statement of Financial Position must also be adjusted to show the

provision for doubtful debts.

PROVISION FOR DEPRECIATION

Depreciation is the measure of the wearing out, consumption or other

reduction in the useful economic life of a non-current asset. It should
be allocated so as to charge a fair proportion of cost or valuation of the
asset to each accounting period expected to benefit from its use. When
a fixed asset is depreciated, 2 things must be accounted for:

(1) The charge for depreciation is a cost or expense of the accounting

period. For the time being, we shall charge depreciation as an expense
in the Income Statement.

(2) At the same time, the cost of the asset is being written off, and so
the value of the fixed asset in the Statement of Financial Position must
be reduced by the amount of depreciation charged. The balance sheet
value of the fixed asset will be its net book value which is the value net
of depreciation in the books of account of the business.

There are two (2) methods of calculating depreciation:

1 STRAIGHT LINE METHOD – cost is divided by the number of years, to

give the depreciation charge each year.

EXAMPLE 4.1
For example, if a motor lorry was bought for RM30,000 and we thought

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we would keep it for 5 years and then sell it for RM5,000, the
depreciation to be charged would be:

RM30,000 – RM5,000
5 years
= RM5,000

EXAMPLE 4.2
If, after five years, the motor lorry had no disposal value, the charge
depreciation would have been:

RM30,000
5 years
= RM 6,000 per year

2 REDUCING BALANCE METHOD - This method calculates the annual

depreciation charge as a fixed percentage of the net book value of the
asset, as at the end of the previous accounting period. This method is
also known as the diminishing balance method.

EXAMPLE 4.3

Suppose a business purchases a non-current asset at a cost of

RM10,000 with cheque in year 1. The accumulated depreciation after 3
years were RM2,710. The business wishes to use the reducing balance
method to depreciate the asset, and calculates the rate of depreciation
should be 10% of the reducing (net book) value of the asset.

(Cost – Accumulated depreciation) x % of depreciation

= (RM10,000 – RM2,710) x 10%
= RM729

QUESTION 1:

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Kim has drawn up the trial balance at the end of the first year trading,
as shown below:

Kim’s Sports
Trial Balance as at 31 December 2017
Debit RM Credit RM
Capital 10,000
Loan 12,000
Sales 51,000
Purchases 34,500
Electricity 1,920
Insurance 1,750
Telephone 1,500
Sundry expenses 1,650
Drawings 7,200
Accountant’s fees 1,500
Printing machine 5,500
Delivery costs 1,200
Computer 3,500
Bank balance 11,080
Trade receivables 4,100
Trade payables 2,400
75,400 75,400

Additional information:

1) The loan was interest-free for the first six months of the year,
after which time interest was to be paid at the rate of 6% per
annum. No interest was paid during the year.
2) Inventory held at the year-end was valued at RM2,700.
3) Electricity used but not yet paid for as at the year-end
amounted RM480.
4) Insurance had been prepaid by RM351 at the year-end.
5) Depreciation is to be charged on non-current assets as follows:

i) Printing machine: 25% per annum on the straight-line

basis.
ii) Computer: 40% per annum on the reducing-balance
basis.

6) A bad debt of RM820 is also to be written off at the year-end.

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Using the partially completed financial statements to guide you,
prepare the income statement and the Statement of Financial Position
as at that date.

Kim’s Sports
Income Statement for the year ended 31 December 2017
RM RM

Kim’s Sports
Statement of Financial Position as at 31 December 2017
Cost Acc. Depn. NBV
RM RM RM

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QUESTION 1

The following list of balances has been extracted from the books of
Prema Rama at 30 September 2016:

RM RM
Capital 20,000
Loan account 2,000

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 Drawings 1,750
Freehold premises 8,000
Furniture and fittings 500
Plant and machinery 5,500
Inventory at 1 October 2015 8,000
Cash at bank 650
Provision for doubtful debts 740
Purchases and sales 86,046 124,495
Bad debts 256
Trade receivables and payables 20,280 10,056
Bank charges 120
Rent 2,000
Return inwards and outwards 186 135
Wages and salaries 11,750
Travelling expenses 1,040
Carriage inwards 702
Discount 48 138
General expenses 2,056
Energy costs 2,560
Printing and stationery 6,120
157,564 157,564

Additional information:

1. Inventory at 30 September 2016 is valued at RM7,550.

2. Interest on the loan at 5% per annum has not been paid at 30
September 2016.
3. Rent includes RM250 paid in advance.
4. Plant and machinery is to be depreciated by 10% per annum.
5. Furniture is to be depreciated by 5% per annum.
6. The provision for doubtful debts is to be adjusted to RM1,014.

REQUIRED:

(a) Prepare the Income Statement and the Statement of Financial

Position for Prema Rama as at 30 September 2016.
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Net profit: RM10,735
Balancing Figure SOFP: RM41,141

WEEK 5: TUTORIAL QUESTIONS

QUESTION 1 The trial balance of Mussels as at 31 August 2017 is shown

below:

Mussels
Trial Balance as at 31 August 2017
Debit RM Credit RM
Sales 220,360
Freehold premises 67,500
Plant and equipment 39,000
Fixtures and fittings 15,000
Trade receivables 11,750
Bank balance 4,200
Trade payables 15,100

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 Inventories as at 1 September 2016 7,800
Purchases 92,000
Motor expenses 4,450
Electricity 8,000
Wages 43,600
Bad debts 110
Other business expenses 3,050
Drawings 24,000
Capital 85,000
320,460 320,460

Additional information:
1. No depreciation is to be charged on freehold premises.
2. All depreciation is to be provided on the straight-line basis.
Plant and equipment is to be depreciated at 30% per annum
and fixtures and fittings at 20% per annum.
3. A provision for doubtful debts of 4% of trade receivables is to be
established.
4. Inventories held at 31 August 2017 were valued at RM8,200.
5. Electricity owing at the year-end amounted to RM1,200.
6. Wages due to staff at 31 August 2017 amounted to RM4,800.

Prepare the income statement and statement of financial statement for

Mussels as at 31 August 2017.

Net profit: RM48,380 Balancing Figure SOFP: RM130,480

QUESTION 2
The trial balance was extracted from the records of Mick’s Office
Supplies as at 31 December 2017.

Mick’s Office Supplies

Trial Balance as at 31 December 2017
RM RM
Capital 208,160
Loan 10,000
Inventories at 1 January 2017 27,440
Sales 477,600
Purchases 322,400
Wages 83,630
Advertising 4,400
Electricity 5,050
Insurance 16,080

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 Premises 154,000
Office equipment 27,900
Bank balance 37,700
Trade payables 61,720
Trade receivables 51,880
Drawings 27,000
757,480 757,480

Additional information as at 31 December 2017:

1. The loan carries interest at 10%, and no interest has been paid
during the year.
2. Inventories held were valued at RM38,600.
3. Electricity owing amounted to RM1,200.

Net profit: RM55,000

Balancing Figure SOFP: RM310,080

QUESTION 3

The owner of an electronics store applies for a business loan. The

store’s financial statements reveal large increases in current-year
revenues and income. Analysis shows that these increases are due to a
promotion that let customers to buy now and pay nothing until January
1 of next year. The store recorded these sales as accrued revenue. Does
your analysis raise any concerns?

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