17 Adjustments

Before you close your books at the end of a year certain adjustments may need to be made in order to reflect a true profit or loss. Most of these adjustments will be made to your expenses. There are many possibilities, but what matters is the reason for an adjustment. Pre-payments An example of a pre-payment adjustment is insurance where the yearly premium covers part of one year and part of the next. Suppose your accounting year runs from July to June the following year, but your buildings insurance runs from January to December. When you enter the expense in January only six months of it will be used for the current year; the other six months worth will pertain to the following year's expenses. We therefore need to split the expense between an 'Insurance Account' (for this year's portion) and another to cover the portion for next year (called 'Pre-paid Insurance' or something similar). Only the portion in the Insurance account will appear in this year's Profit & Loss account. The Pre-paid account will be shown as a current asset in the balance sheet and carried forward to the following year. At the start of the following year we will transfer the Pre- paid account's balance to the Insurance account so it will be included in that year's Profit & Loss as an expense. Figure 17.1 shows the journal entries for the first year. The first transaction credits the bank account and debits the insurance account for the full amount. The second transaction transfers half from insurance to pre- payments. The third transaction closes the Insurance account by transferring it to the Profit & Loss account and the last transaction closes the Profit & Loss account by transferring it to the owner's Capital account.

Figure 17.2 shows the first year's balance sheet.

At the start of the following year the pre-payments account will be entered in the journal as an opening balance and then immediately transferred to the Insurance account (figure 17.3 shows only the relevant journal entries).

The result of this is that the insurance premium paid last year has now been accounted for in full as an expense (albeit over two years). You can apply this example to any expense item which is paid for in one year

but not used up until the following (or later) year. Another example of a pre-payment which may need adjusting is rent paid in advance. It is important to decide if an expense covers more than one year and therefore treat part of it as a pre-payment for the following year otherwise you will be overstating your expenses. Provisions Another adjustment that may need to be made is a Provision. Provisions include items where an expense has been incurred but the supplier has not yet sent an invoice to you. A tyPical example is where you use an accountant to look after your books. The accountant will not be able to work out your bill until the books have been finalised; but the books can't be finalised until the bill is known!, so an estimate is entered instead. This estimate is included as an expense item in the Profit & Loss account; therefore a 'provision' is being made for it. At some point during the following year you will receive the proper invoice. The estimate and final invoice are then subtracted from one another and the difference can be entered as a credit or debit depending on whether the estimate was more or less than the final invoice. We will illustrate this with a simple example: you have sales for year 1 of 10,000 and the accountant estimates that the bill for book-keeping will be 500. Figure 17.4 shows the journal entries and figure 17.5 shows the balance sheet.

The accountant is a creditor of the business because the estimate will not be paid until the final bill is sent. During year 2 you receive the final bill for 550 and decide to pay it. The accountant has under-estimated the bill so a journal entry is made to account for the extra 50 expense (figure 17.6).

One transaction is needed to cover the difference between the estimate and final bill (entered on 1st July) and another to actually pay it (entered on 2nd July). The Profit & Loss account shows a 50 loss (due to the under-estimate of the charges for year 1) and this has been transferred to the Capital account. The Creditors' account has a zero balance because you have now paid the accountant. Figure 17.7 shows the final balance sheet.

This assumes of course that the accountant doesn't make a charge for keeping your books for year 2 (otherwise a further provision will be entered for year 2 and so on). A further example of a provision concerns staff wages. If your financial year ends half way through a pay period then provision should be made to cover the portion of the wages due up to the end of the year. This operates in exactly the same way as the previous example. Bad Debts 1 (Real or likely bad debts) If you think a customer is unlikely to pay an invoice or a customer has been declared bankrupt and there is no money left to pay the debt then a bad debts account can be opened to cover it as an expense against the current year's profits. This is known as a direct write- off. When the original invoice was sent, a credit will have been made from the sales account and a debit to the customer's account. To write-off the bad debt, a credit is made to the customer's account, and a debit to an account called 'Bad Debts'. This is then transferred to the Profit & Loss account where it is seen as an expense of the business. The result is that the bad debt has been included in the year's profit & loss figures and closed. The customer's account will also have been closed (assuming it was the only debt from that customer). If a sales ledger and associated control accounts are being used (see chapter 12) then a further journal entry is needed to credit the sales ledger control account and debit the nominal ledger debtors' account. If during the following or later year the debt is recovered from the customer then all we need do is enter the original transaction again in the new set of books, crediting sales and debiting the customer as in a normal credit transaction. (To make it clear we could also include the original invoice number in the reference and add a further comment to explain it). Bad Debts 2 (General reserve for bad debts) Provision can also be made to cover a general estimate of bad debts for the year. This is different from 'direct write-offs' since it cannot be set directly against your tax liability for the year. If after a period of trading you discover that on average 5% (or whatever) of your credit sales are usually written off as bad debts then a bad debts reserve account can be opened in order to give a more accurate indication of your real sales for the year. You will also need a bad debts expense account (as just described in 'Bad Debts 1') in order to keep the general reserve account separate from it. The real bad debts should be subtracted from the estimate to get a more accurate total.

Because we are not dealing with a specific customer you only need to credit the reserve account and debit the profit & loss account (if the estimate is greater than the actual bad debts, and vice-versa if more real bad debts were sustained than the estimate). In subsequent years the bad debts reserve account will only need slight adjustments to keep within the percentage. Keeping a reserve account for bad debts is only of any value if it represents a significant amount of your sales, and even then only if your business suffers from the odd major or minor increase in bad debts. This is because the bad debts expense account already shows the true figures, so all a reserve account will do is even out the estimated profit or loss. An example will help to clarify both types of bad debt account. In the first year you issue 3 invoices totalling 10,000. The first invoice (for 500) is to a customer who is subsequently declared bankrupt with no assets during that year. The second invoice for 9,250 is part-paid during the year. The third invoice, for 250, will not be paid because you have heard that the customer is in financial trouble. You therefore decide to write it off (the first and third invoices represent 'bad debt 1' examples). Due to market research you have also decided that 10% of your sales are unlikely to be paid due to bad debts (this is the 'bad debt 2' example). We will also assume that you are using a sales ledger and control accounts to track the individual customers. Your first entries will therefore be made in the sales book (figure 17.8).

B Smith then pays off 9000 of the 9,250 invoice. This is made in the receivables book (figure 17.9).

We are now in a position to update the control accounts for the sales and nominal ledgers. 1000 more has been invoiced than has been received so we credit the sales ledger control account and debit the nominal ledger debtors control account (this is entered in the journal - figure 17.10).

'A Smith' is then declared bankrupt so we credit the 'A Smith' account (to close it) and debit the bad debts expense account using the sales book. We also decide that 'C Smith' is unlikely to pay up so we do the same thing (figure 17.11).

Further entries are also needed in the journal to update the control

accounts and transfer the sales and bad debts to the Profit & Loss account (figure 17.12).

Figure 17.13 shows the sales ledger.

Figure 17.14 shows the nominal ledger.

We can now show how the bad debts reserve account fits into the Picture: we estimated that 10% of the sales are unlikely to be recovered which represents a value of 1000 in this example. 750 has already been written off therefore a reserve of 250 needs to be set up. This is a straightforward transaction entered in the journal which credits the bad debts reserve account and debits the Profit & Loss account. Figure 17.15 shows the final nominal ledger for year 1.

The bad debts reserve cannot be included as an expense against income tax therefore it must be added back again before the tax liability can be calculated. However, this aspect is not part of the double-entry system so no journal entries are needed (suitable boxes are included in the income tax self-assessment forms for these figures which is why we need to keep the real bad debts separate from the general reserve). Figure 17.16 shows the year 1 balance sheet (we have transferred the profit to the capital account).

During year 2 we make credit sales for a further 10,000 and suffer no losses due to bad debts. 9,000 of the sales are duly paid during the year so the bank account will show a balance of 18,000. The debtors' account will increase to 1,250 and the capital account will increase to 19,000 (opening balance of 9,000 plus a new profit of 10,000 with no bad debts or expenses). As you can see, the books balance (assets of 18,000 in the bank plus 1,250 of debtors on one side, and liabilities of 250 reserves plus an equity of 19,000 on the other). If we still estimate that 10% of the credit sales will turn out to be bad debts then we need to increase the reserve by 750 to cover this, so a journal entry is made crediting the reserve and debiting the Profit & Loss account. Figure 17.17 shows the final balance sheet for year 2.

Other Reserves Reserve accounts can be set up for many things in order to show a truer Picture of a business. The important thing to remember is that they have no effect on the tax liability even if they are included in the Profit & Loss account. TyPical examples are reserves for replacing capital items such as vehicles and equipment and reserves to cover legal expenses. Whatever reserves you may want to set up they all use the same logic as the bad debt reserve ie. credit the reserve account and debit the capital, Profit & Loss or any other equity account (in the case of a limited company the debit will be a distribution from the appropriation account - see chapter 15). These accounts are generally used for information only; therefore, if a reserve of 1000 has been set up to replace an asset, then, when the asset is finally bought, a real transaction will be needed (ie. credit the bank and debit the asset's account) and an adjustment will also be needed to correct the reserve account (ie. debit the reserve and credit the relevant equity or capital account). Accruals An example of an adjustment which can occur on both the income and expense side of your books concerns Accruals. If you have some money held in a deposit account, then that money will earn interest. If at the end of the year you have not received a statement for the deposit account then you will need to account for the interest accruing to the end of the year (hence the term 'Accrual'). The same applies if you have borrowed some money. This works in exactly the same way as a provision; ie. you need to make provision for the interest owing, then make an adjustment in the following year to account for any difference. Your final VAT return for the year is an accrual since it probably won't be paid until a month after the year has ended but provision for it will need to be entered before the books are closed. Goodwill A goodwill account can be set up if you decide that a business is worth more than that shown in the equity section of the balance sheet. In other words, if the business was to be sold as a going concern and the equity was say, 10,000 but you actually valued the business (because of its turnover and customer loyalty) at 12,000 then the extra 2000 can be shown on the

balance sheet under a 'goodwill' account. All we need do is make a journal entry crediting your capital account and debiting the goodwill account (ie. we are increasing the assets of the business and also your equity in it). This can also be applied to partnerships, in which case the goodwill aspect can be kept in a separate capital account for each partner. This will help keep track of the goodwill portion of a partner's capital, especially if the portions are not equal. Only a single goodwill asset account needs to be kept in either case. As a simple example, suppose a business was started by two partners with no money and no assets, but for whatever reason they decided that it had a goodwill value of 1000. Furthermore they also decided on a 40/ 60 percentage split of the goodwill between the partners. Figure 17.18 shows the journal, figure 17.19 shows the ledger and figure 17.20 shows the balance sheet.

If you re-value the goodwill at any time then further journal entries can be made to adjust it (eg. if the partners change the portions to 50% each then a journal transaction would be entered to credit partner A 100 and debit partner B the same amount). If the partners eventually have separate capital accounts too, then tyPically the balance sheet would show the total equity with a note pointing to a further document showing the breakdown of each partner's capital. Whatever form this extra document takes is fine since both it and the balance sheet are only reports (they are not a fundamental part of the double-entry system itself). All that matters is that enough accounts are used in the first place to make the reports easier to compile. Suspense Accounts If a trial balance shows a very slight error which can't immediately be accounted for, a single entry can be made in the journal to credit or debit an account called a suspense account in order to force the trial balance to balance. When the error is found, the suspense account can then be debited or credited back to zero, and reversing and correcting entries can be made to amend the mistake. If the trial balance is fine, but one of the balances is not correct (and you don't know why) then a suspense account can be used to debit or credit the offending account - a tyPical example is petty cash: the account shows,

say, a 50 debit balance, but the actual cash within it amounts to 45. In this case you would credit petty cash 5 and debit the suspense account 5. When you discover the reason for the missing 5, you can credit the suspense account and debit the correct account. You can call a suspense account anything you like provided its use is made obvious. Source: Accounting for everyone