The Hong Kong Management Association

HK Hong Kong Polytechnic Joint Diploma A:A

MA in Management Studies tttJ

LECTURE 3 - ADJUSTMENTS TO ACCOUNTS

There are several items which do not occur in the "normal course of business", but
which must be carefully considered at the end of each trading period.

I. Bad Debts

If all the debtors of a firm paid their accounts, no mention of this item would be made.

Unfortunately, however, they do not, qnd many firms incur whal are known as had debts.

For instance, where a debtor is declared a bankrupt, the whole of his debt will not be
settled. Only a part of it is paid, but as far as the Jaw is concerned the debt is wiped out.

The unsettled portion of the debt is of no value, and it must be written off as a loss.

Similarly, if debtors disappear, or if their debts are not worth the trouble of court action,
the debts must be written off.

The debtor's account is Credited with the amount of the bad debt, thus closing the account.

To complete the double entry the Bad Debts Account is Debited.

Thus, all bad debts incurred during the trading period are Debited to a Bad Debts Account.

At the end of the trading period the Bad Debts Account is Credited with the total bad debts
to close the account, here again, the double entry is preserved by Debiting the Profit and
Loss Account with the same amount.

It would be improper to show worthless debts as assets of the firm and this is the
manner in which they are dealt with.
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR !VIANAGERS PAGE - L03 - 2

2. Bank Charges

These are charges made by the firm's bank for working the account of the firm, and are
therefore Debited to the Profit and Loss Account.

Bank Charges are a Financial Expense.

3. Debenture Interest

It is probably known to you that many limited companies borrow money for use in the
business, from persons outside the company.

This is frequently done by means of a Debenture, which is a document setting forth

particulars of the loan. The debenture is issued to the lender as evidence of the debt.

Interest must be paid on these loans, such interest being known as Debenture Interest.

As debenture holders are Creditors of the company, their interest must be paid whether the
company is able to show a profit or not.

Therefore it is an expense and, as such, must be Debited to Prolit and Loss Account.

Note carefully the differences between debenture interest and dividends paid.

The former is interest on an outside loan whilst the latter is merely a distribution of profit.

Jn practice, when debenture interest is paid, Debenture Interest Account is Debited, and
Cash (or Bank) Account Credited, cash being paid out to the debenture holders.

At the end of the trading period, Profit and Loss Account must be Debited and the
Debenture Interest Account Credited to complete the double entry and to close the latter
account.

Debenture Interest is a Financial Expense.

Page - L03 - 2
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 3

4. Depreciation

Plant and machinery, warehouse or factory buildings, patents used in the manufacturing
processes, etc. are used directly in the manufacture of goods or in trading, and, as a result
of this, their value must decrease due, for example, due to wear and tear.

This decrease in value is caused by the manufacture or trading, and must be allowed for
when overhead charges are being Debited to the Manufacturing Account or Profit and Loss
Account.

There are several methods of calculating depreciation.

The most popular method is the "straight line method", i.e. the same amount is charged
as depreciation for each year of the asset's life. The annual depreciation charge can be
calculated by the formula:

Cost-F..slimaled scrap value

Estimated Useful Life

For the moment, however, it will be sufficient for you to know that as a general rule,
Manufacturing Account or Profit and Loss Account is Debited with the depreciation figure
decided upon, and, to complete the double entry, a provision account is Credited.

Example
On I January 19XX a retailer purchased a delivery van for $60,000, with an Estimated
useful life of JO years and no scrap value. His Profit and Loss Account is made up to 31
December 19XX, and he provides $6,000 for depreciation.

MOTOR VAN
Jan I Cash 60,000

DEPRF..CIA TION
Dec 31 Provision for Depreciation 6,000 Dec 31 Profit and Loss Account 6,000

PROVISION FOR DEPRECIATION

Dec 31 Depreciation 6,000

Page - L03 - 3
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 4

EXTRACT FROM PROFIT AND LOSS ACCOUNT

Gross Profit xxx

Depreciation on Motor Van 6,000

EXTRACT FROM BALANCE SHEET AS AT 31DECEMBER19XX

Fixed Assets Cost Depreciation Net Book Value

Motor Van at Cost $60,000 $6,000 $54,000

From the Balance Sheet you will see that the van is valued at $54,000 net book value
because of the provision of depreciation. Each year depreciation will be provided, as the
value of the van will decrease, until the cost of the van is written off.

Students should attempt to record the depreciation in the accounts and show the
Balance Sheet position for the year 19Xl and so on.

Depreciation of such assets as office furniture must also be allowed for in the Profit and
Loss Account. Where there is a Manufacturing Account, the depreciation of all assets
which are actually engaged in production, e.g. Plant and Machinery, should be recorded in
it, because such depreciation is a manufacturing expense. The depreciation of other assets
( and, when there is no Manufacturing Account, of all assets ) is shown in the Profit and
Loss Account.

5. Discount

You will remember from your previous knowledge of discount that there are two distinct
accounts, Discounts Received ( INCOME) and Discounts Allowed (EXPENSE).

The former is a Credit balance and the latter is a Debit balance.

At the end of the trading period Discounts Received Account is Debited, and t11e Profit and
Loss Account Credited as items under this heading are benefits received by the firm. Also
at the end of the trading period Discounts Allowed Account is Credited, and the Profit and
Loss Account Debited, as these items are expenses of the firm.

Discounts Allowed are sometimes considered to be a Financial Expense, arising from

the financial policy or allowing discount for prompt payment by debtors. However,
they are more appropriately classified as a Sales Expense, as they relate to Sales.

Page - LOJ - 4
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 5

6. Dividends Paid ( in the case of a limited company only )

This item will appear as Debit balance in the Trial Balance, represents profits which have
been distributed amongst the shareholders of the company.

If no profits have been made, then no dividends will be paid to shareholders.

Is not an expense of the company and is not to be Debited to Profit and Loss Account.

This item must be Debited to the Profit and Loss Appropriation Account.

7. Goodwill

This is an item which often appears as an asset of a business.

The value attached to the probability that old customers will continue to patronise the firm.

Where a company purchases another business, it may give $500,000 for assets which are
agreed as being worth only $450,000. The difference of $50,000 is the value of the
goodwill.

In such circumstances, the company might decide to write off the goodwill over a number
of years, say ten years.

In this case Profit and Loss Appropriation Account would be Debited annually with $5,000
and Goodwill Account Credited, until the latter account ceases to exist.

8. Preliminary Expenses (in the case of a limited company only)

These are expenses incurred at the time a limited company is being floated, and consist
chiefly of stamp duties, ad valorem capital duty, and legal charges, all connected with the
incorporation of the company.

These are not expenses connected with the trading or manufacturing side of the
company and, therefore, must not be Debited in full to the Profit and Loss Account.

In actual practice, this amount is shown on the assets side of the Balance Sheet ( being a
Debit balance) and is written off over a period of from three to five years.

When this is done, the Appropriation Account is Debited with the proportion decided
upon, and Preliminary Expenses Account is Credited.

Page· L03 · 5
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 6

9. Provision for Bad Debts

In addition to writing off bad debts as they occur or when they are known to be bad, a
business should also provide for any losses it may incur in the future as a result of its
present debtors being unable to meet their obligations.

If the business has book debts totalling $500,000 it is not very likely that all those debtors
will pay their accounts in full. Some of the debts may prove to be bad, but this may not be
known for some considerable time.

The amount of the Provision should be determined by a careful examination of the list of
debtors at the Balance Sheet date. If any of these debts are bad, they should be written off.

If any debts are "doubtful" it should be estimated how much the debtor is likely to pay.

The Provision should be the total of such potentially bad amounts, which is created by
Crediting the Provision for Bad Debts Account and Debiting the Bad Debts Account.

The debtor's account will not be written off until it is definitely known that it is bad.

The Provision is formed for the purpose of reducing the value of Sundry Debtors in the
Balance Sheet to an amount which it is expected will be received from them.

It is not an estimate of the bad debts which will arise in the succeeding period.

A moment's reflection will show that the bad debts arising in the next period will result
from Credit sales made within that period as well as from debts outstanding at the
beginning of the period.

It is therefore quite incorrect to Debit bad debts against the "Provision for Bad Debts",
i.e. during the trading period all bad debts incurred are Debited to Bad Debts Account and
the debtor's account Credited.

At the end of the accounting period the required balance on the provision for doubtful
debts accounts is estimated.

The amount required to increase or decrease its balance ( i.e. by Credit or Debit to the
Provision Account), would be matched by Debit or Credit to the Bad Debts Account.

Provision for Bad Debts is always deducted from the amount of Sundry Debtors in the
Balance Sheet.

Page - L03 - 6
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 7

Example

At I January 19XX the Provision for Bad Debts stands at $4,000.

During the year, Bad Debts are incurred to the extent of $3,670, of which $1,470 is owed
by J Chan and $2,200 is owed by L Lee.

On 31 December l 9XX it is decided to write off the bad debts and to increase the
Provision to be 5 per cent of the Sundry Debtors.

The balance of the Sundry Debtors stands at $100,000.

Show the Accounts for the whole period.

PROVISION F'OR BAD DEBTS

Dec 31 Balance cld 5,000 Jan I Balance b/d 4,000
Bad Debts Increase Provision 1,000

5,000 5,000

BAD DEBTS ACCOUNTS

Dec 31 J Chan 1,470 Dec 31 Profit & Loss Account 4,670
LLee 2,200
Provision Bad Debts 1,000

4,670 4,670

JCHAN
Dec 31 Balance b/d 1,470 Dee 31 Bad Debts Account l,470

LLEE
Dec 31 Balance bid 2,200 Dec 31 Bad Debts Account 2,200

Page - L03 - 7
 AFML-03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L-03 - 8

EXTRACT FROM PROFIT AND LOSS ACCOUNT

Gross Profit xxx

Bad Debts Written Off 3,670
Provision for Bad Debts
New Provision 5,000
Less Old Provision 4,000 1,000

EXTRACT FROM BALANCE SHEET AS AT 31 DECEMBER 19XX

Current Assets
Sundry Debtors 100,000
Less: Provision Bad Debts 5,000 95,000

10. Expenses Paid in Advance

Where a prOjXlrtion of rent has been in advance, this must be allowed for when the Profit
and Loss Account is drawn up.

For instance, if the firm paid $120,000 rent for six months from I November, and the
Profit and Loss Account is made out for the year ended 31 December, it would obviously
be wrong to Debit the Profit and Loss Account with the full amount of $120,000.

Only two months' rent should be Debited, i.e. $40,000 and the other four months' rent,
i.e. $80,000 should be carried forward and shown in the Balance Sheet as an asset,

"Rent paid in advance".

Remarks also apply - premiums paid in advance on insurance policies, and to rates.

Example
In illustration of this point we have set out the Rent Account and Profit and Loss Account
as they would appear for the above case:

RENT ACCOUNT
Dec 31 Cash (Six months rent) 120,000 Dec 31 Profit & Loss Account
( 2 Months Rent) 40,000
Balance c/d ( 4 Months Rent) 80,000

120,000 120,000

Jan 1 Balance bid ( 4 Months Rent) 80,000

The Rent Account could be closed off by Debiting the Prepaid Rent Account with $80,000.

Page - L-03 - 8
 AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 9

EXTRACT FROM PROF1T AND WSS ACCOUNT

Gross Profit xxx

Rent 40,000

The balance of $80,000 being a Debit balance, is naturally shown on the right-hand side of
the Balance Sheet under current assets.

EXTRACT FROM BALANCE SHEET AS AT 31DECEMBER19XX

Current Assets
Prepayments - Rent 80,000

Then, in the following trading period, it will be included in the amount which will be
Debited to Profit and Loss Account as rent.

Where rents are received, the above process is reversed, of course.

11. Expenses Paid in Arrears

On the other hand, it is quite conceivable that many firms, at the end of the trading period,
have incurred expenses which have not yet been paid.

For instance, where rent is not payable in advance, a proportion of the rent for the period
may be owing when the Profit and Loss Account is drawn up.

How is this to be accounted for ?

Obviously, Profit and Loss Account will be Debited with rent already paid, and it must
also be Debited with the proportion of the rent which is due hut unpaid.

Having Debited Profit and Loss Account with the latter proportion, we must Credit Rent
Account with it.

The Rent Account will then show a Credit balance and, as such, must appear as a liability
on the Balance Sheet - it is debt owing by the business.

Then, when this proportion of rent owing is paid, cash will be Credited and Rent Account
Debited, thus offsetting the Credit balance already shown in the latter account.

Page - L03 - 9
AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 10

Example

Rent of premises $24,000 per year.

Rent paid up to 31 October 19XX $20,000

The Profit and Loss Account is made out for the year ended 3 t December l 9XX

The entries in the ledger would appear as follows:

RENT ACCOUNT
Dec 31 Cash 20,000 Dec 31 Profit and Loss Account 24,000
Balance c/d
( Two months rent )
( due but unpaid ) 4,000

24,000 24,000

Jan I Balance bid 4,000

(2 Months Rent)

The Rent Account could be closed off by Debiting the Prepaid Rent Account with $4,000.

EXTRACT FROM PROFIT AND LOSS ACCOUNT

Gross Profit xxx

Rent 24,000

The balance of $4,000 being a Credit balance, is naturally shown on the Left-hand side of
the Balance Sheet under current liabilities.

EXTRACT FROM BALANCE SHEET AS AT 31 DECEMBER 19XX

Cnrreul Liabilities
Expense Creditor - Rent 4,000

Page - L03 - 10
AFML.03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L.03 - 11

Where debenture interest is payable, the full year's interest must be allowed for.

A trap is often set in an examination, as follows:

In the Trial Balance given in the question,

1. Debenture Interest Account may be shown as $2,250 (Dr. Balance).

2. Also in the Trial Balance will appear an item, say 6 per cent Debentures $50,000 ( Cr. )
This is the loan itself.

Now the interest on $50,000 6 per cent Debentures is $3,000 so we must provide for an
extra $750 for debenture interest for the year.

Evidently three months' interest is unpaid at the Balance Sheet date.

JOURNAL Dr Cr.
Debenture Interest 750
Debenture Holders 750
Being three months interest accrued due

Always look out for traps of this nature - but be careful that you do not discover them
where they do not exist !

12. Royalties

These are amounts paid by mining or quarrying firms, to landlords, in exchange for the
privilege of extracting coal, stone, chalk, etc. from the land owned by the landlord.

These payments differ from rent in that they are based upon the quantity of coal, stone,
etc. which is mined or quarried.

Also manufacturers may pay royalties to designers or inventors for the use of special
designs or technology.

This being the case, royalties are a real trading or manufacturing expense of the firm and
are therefore Debited to Manufacturing Account ( which may be called Production
Account, if the business is mining rather than manufacturing).

Page • L03 - 11
AFML03.DOC JLW 2/11/90 ACCOUNTING FOR MANAGERS PAGE - L03 - 12

ALLOCATION OR APPROPRIATION OF NET PROFIT

The net profit of a business for any period is the excess of its income ( gains and profits )
over its expenses and losses. It is quite easily ascertained by deducting the total of the
Debit items in the Profit and Loss Account from the total of the Credit items.

To make the two sides of the Profit and Loss Account agree, the amount of the net profit is
then entered on the Debit side. The converse is true for a net loss. The excess of expenses
and losses over income is entered on the Credit side of the Profit and Loss Account.

The question now arises - in what way is the Debit to the Profit and Loss Account for net
profit ( or Credit for net loss ) to be represented by double entry in the books of the
business?

Limited Company

With a limited company, the net profit shown in the Profit and Loss Account is carried
down to the Credit side of the second half of the Profit and Loss Account. This second
half of the Profit and Loss Account is known as the Profit and Loss Appropriation
Account, or simply Appropriation Account. A limited company distributes its profits by
means of dividends on the shares of its capital held by the shareholders.

Thus, where a company declares a dividend of IO per cent on its ordinary share capital of
$1,000,000 (divided into 1,000,000 shares of $1 nominal value), the holder of each $1
share will receive 10 cents, i.e. 10 per cent of $1.

Such a dividend would be Debited to the Appropriation Account. together with all
dividends paid on the other classes of shares.

Profits Tax is also Debited to the Appropriation Account.

Directors Fees are Debited to the Profit and Loss Account.

When these various items have been Debited to the Appropriation Account, the whole of
the profit may not have been used. The balance remaining is carried forward to the
Appropriation Account of the next trading period, when it will appear on the Credit side
under the amount of the net profit brought down from the Profit and Loss Account.

When a company makes a very large profit. the directors will often deem it prudent lo
place a proportion of such profit on one. side, instead of distributing it amongst the
shareholders. An account is opened Lo which such sums wi II be Credited, the
Appropriation Account being Debited. This account is known as a Reserve Account. A
Reserve Account contains appropriation from net profits, accumulating year by year. The
Articles usually give the directors power to make such reserves as they choose, being
recommending dividends.

Page - 1..03 - 12