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  • 1. TOPIC 7 PRINCIPLES OF INTERNAL CHECKS
  • 2. In Your Textbook...
    • Roshayani Arshad, et al. (2007), Financial Accounting An Introduction , 2 nd Edition, Malaysia, McGraw Hill .
    • Chapter 7: Adjusting Entries and the Preparation of Financial Statements (pp. 100 – 114)
    • Chapter 12: Receivables (pp. 217 – 230)
  • 3. Learning Objectives
    • At the end of the topic, you should able to:
    • - Distinguish between cash basis and accrual basis.
    • - Explain why adjusting entries are needed.
    • - Identify the major type of adjusting entry.
    • - Prepare a worksheet incorporating the adjusting entries.
  • 4. Underlying Concepts Accounting Period Matching Principle Accrual Concept The need to prepare periodic financial reports. Expense & revenue have to be assigned and matched to periods of time. Revenue reported when earned Expense reported when incurred (used) Cash receipts/payment irrelevant
  • 5. The Accounting Period 1 2 3 4 Annual 1 2 Monthly Quarterly Semiannual 1 2 3 4 5 6 7 8 9 10 11 12 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
  • 6. Matching Principle
    • Sunny Company bought RM24,000 yearly motor vehicle insurance from August 2007 to July 2008. What should the company expense into the income statement from 1 st January to 31 st December 2007 ?
  • 7. 2007 2008 5 months 7 months According Matching Principle: Expenses incurred must match with the accounting period. Since the accounting year ended for Sunny Company was on 31 December, it should record the insurance expenses for only 5 months : RM 24,000 x 5/12 = RM 10,000 1 2 3 4 5 6 7 8 9 10 11 12 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1 2 3 4 5 6 7 8 9 10 11 12 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
  • 8. Accrual Basis vs. Cash Basis Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP
  • 9. Accrual Basis vs. Cash Basis On the cash basis the entire RM2,400 would be recognized as insurance expense in 2006. No insurance expense from this policy would be recognized in 2007 or 2008, periods covered by the policy. RM 2,400 Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Aug
  • 10. RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Aug RM 100 2007 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 RM 100 Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Aug RM 100 2006 Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Aug 2008
  • 11.
    • On the accrual basis RM100 of insurance expense is recognized in 2006, RM1,200 in 2007, and RM1,100 in 2008. The expense is matched with the periods benefited by the insurance coverage.
  • 12. Adjusting Accounts Adjustments An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. Framework for Adjustments Paid (or received) cash before expense (or revenue) recognized Paid (or received) cash after expense (or revenue) recognized Prepaid (Deferred) expenses* Unearned (Deferred) revenues Accrued expense Accrued revenues
  • 13. Adjusting Prepaid (Deferred) Expenses This is the check for my first 6 months’ insurance . Resources paid for prior to receiving the actual benefits. A current asset item .
  • 14. Suria Sdn. Bhd. TRIAL BALANCE as at 31 DECEMBER 2006 $ $
  • 15. Prepaid Insurance
    • Suria Sdn. Bhd. practiced to close the accounts on 31 December for every year. On 1 December 2006, Suria Company paid RM12,000 to cover insurance for December 2006 through May 2007. The accountant recorded the expenditure as Prepaid Insurance on 1 December. What adjustment is required?
    128 2006 Insurance expired for 1 month 31/12(year end ) Example Jan Feb Mar Apr May Jun Jul Sep Oct Nov Dec Aug RM 12,000
  • 16. Adjusting for Prepaid Insurance Expense 31/12 2,000 Prepaid Insurance 31/12 2,000 1/12 12,000 12,000 12,000 31/12 Bal 10,000 31/12 P&L 2,000 Insurance expired for 1 month = Recognized insurance expense for 1 month 1 month = RM12,000 / 6 = RM 2,000
  • 17. Adjusting Unearned (Deferred) Revenues - Cash received in advance of providing products or services. - A current liability item. On 1 October 200 6 , Suria Sdn. Bhd. received cheque RM 20,000 for services to be provide in next five months. Example
  • 18. Adjusting Unearned (Deferred) Revenues 1/1 0 /0 6 31/12/0 6 Year end 28 /0 2 / 07 5 months Services already performed for 3 months Service performed for 3 months = Recognized service revenue for 3 months 3 month = RM20,000 x 3/ 5 = RM 12,000
  • 19. Service revenue 31/12 1 2 ,000 Unearned revenue 1/10 20,000 31/10 1 2 ,000 20,000 20,000 31/12 Bal 8 ,000 31/10 P&L 1 2 ,000
  • 20. Adjusting for Accrued Expenses - Costs incurred in a period that are both unpaid and unrecorded. - A current liability item. T he telephone bill for December 2006 haven’t pay. When should I record it?
  • 21. Adjusting for Accrued Expenses On 3 January 200 7 , Suria Sdn. Bhd. paid RM 300 for its December telephone bill. Example 1/12/0 6 31/12/0 6 Year end 3/01/0 7 December Bill : RM300 Paid RM300
  • 22. Adjusting for Accrued Expenses Telephone Expense 31/12 300 Telephone payable 31/12 300
  • 23. Adjusting Accrued Revenues - Revenues earned in a period that are both unrecorded and not yet received. - A current asset item. Suria Sdn. Bhd. had RM31,200 of services c ompleted but not yet billed to clients. Let’s make the adjusting entry necessary on 31 December 2006 . Example
  • 24. Adjusting for Accrued Revenues Accounts receivable 31/12 31,200 Service revenue 31/12 31,200
  • 25. Adjusting for Depreciation
    • Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives.
    Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life
  • 26. Adjusting for Depreciation
    • On 1 January 2006, Suria Sdn. Bhd. purchased equipment for RM60,000 cash. The equipment has an estimated useful life of 5 years. Salvage value for the equipment is RM2,000.
    • Let’s record depreciation expense for the year ended 31 December 2006.
    2006 Depreciation Expense = RM6 0 ,000 - RM2,000 5 = RM1 1 , 6 00
  • 27. Adjusting for Depreciation Depreciation Expense 31/12 11,600 Accumulated Depreciation 31/12 11,600
  • 28. Adjusting for Depreciation Equipment is shown net of accumulated depreciation .
  • 29. Source Documents Journal Ledger Trial Balance Adjustments Adjusted Trial Balance Financial Statements Closing Entries The Accounting Cycle
  • 30. Suria Sdn. Bhd. TRIAL BALANCE as at 31 DECEMBER 2006 First, the initial unadjusted amounts are added to the worksheet. $ $
  • 31. Next, Suria’s adjustments are added. Suria Sdn. Bhd. TRIAL BALANCE 31 DECEMBER 2006 Suria Sdn. Bhd. TRIAL BALANCE as at 31 DECEMBER 2006
  • 32. SYKT MAJU TRIAL BALANCE 31 DECEMBER 2006 Finally, the totals are determined. Suria Sdn. Bhd. TRIAL BALANCE as at 31 DECEMBER 2006
  • 33. Lecture Exercise
    • Adjustments:
    • Telephone expense owing was RM30.
    • Commissions revenue received in advance amounted to RM200.
    • RM600 of the insurance not yet expired.
    • Electricity expense owing amounted to RM100.
    • Interest of RM400 was earned but not yet received.
    • RM500 of the rent revenue was not yet earned.
    Show the above adjustments in the journal and ledger . Dr (RM) Cr (RM) Telephone expense 480 Commissions revenue 4,000 Insurance expense 3,000 Electricity expense 2,000 Interest revenue 3,800 Rent revenue 6,500
  • 34. Receivables Bad & Doubtful Debts
  • 35.
    • Accounts Receivable — used for selling merchandise or services on credit, and normally expected to be collected in a relatively short period.
    • Notes Receivable — used to grant credit on the basis of a formal instrument of credit, called a promissory note.
    • Other Receivables — include interest receivable, taxes receivable, and receivables from officers and employees.
    Classification of Receivables
  • 36. Collectability of Debts Experience shows that not all amounts owing from debtors are collected. This uncollected portion is knows as bad debts.
  • 37.
    • Possible reasons may give rise to bad debts:
    • Debtor experiences financial difficulties
    • Debtor cannot be traced
    • Death of a debtor
    Collectability of Debts
  • 38. Writing Off Bad Debts On May 10, D. Ross’ account was determined to be uncollectible. The RM420 balance is written off the books. May 10 Bad Debts Expense 420 00 Accounts Receivable — D. Ross 420 00 To write off an uncollectible account.
  • 39. Writing-off Bad Debts Effect on Profit & Loss Dr Profit & Loss A/C for the year ended 31 Dec 05 Cr Bad debts RM420
  • 40. Recovery of Bad Debts
    • The situation where the debtor (has previously been regarded as bad debts) unexpectedly pays his debt.
  • 41. Recovery of Bad Debts Later, on 1 August 2005, D. Ross unexpectedly turns up to settle his debt. Aug 1 Cash 420 00 Recovery of Bad Debts 420 00 To recover bad debts that were written-off earlier .
  • 42. Recovery of Bad Debts Effect on Profit & Loss Dr Profit & Loss a/c for the year ended 31 Dec 2005 Cr Bad debts $500 Recovery of bad debts $500
  • 43. Provision for Doubtful Debts
    • An ESTIMATE of the amount of the debt that is likely to become bad.
    • Reasons for provisions:
      • To charge as an expense in the profit and loss account for that year an amount representing debts that may never be paid.
      • To show in the balance sheet a debtors figure as close as possible to the true value of debtors.
      • The adherence to the Prudence concept.
  • 44. Creating Provision for Doubtful Debts Dec. 31 Doubtful Debts Expense 4 000 00 Provision for Doubtful Debts 4 000 00 On December 31, Cynthia estimates that a total of RM4,000 of the RM105,000 balance in her company’s Accounts Receivable will eventually be uncollectible. Adjusting Entry
  • 45. Creating Provision for Doubtful Debts Dr Profit & Loss a/c for the year ended 31 Dec 2004 Cr $ Doubtful debts 4,000 Balance Sheet as at 31 December 2004 Current Assets : $ $ Accounts Receivable 105,000 Less Provision for Doubtful Debts 4,000 101,000
  • 46. Adjustment to Provision for Doubtful Debts On 31 December 2004, Cynthia’s Trial Balance appears as follows: Sundry debtors 135,000 (dr) Provision for Doubtful Debts 4,000 (cr) Cynthia still maintains 4% of sundry debtors as the Provision for Doubtful Debts.
  • 47.
    • Calculation of provisions
    Adjustment to Provision for Doubtful Debts Provision for Doubtful Debts on 31.12.2005 (4% x $135,000) 5,400 Less : Provision for Doubtful Debts on 1.1.2005 (as per TB) 4,000 Increase in Provision for Doubtful Debts 1,400
  • 48. Only the NET increase amount is being recorded in the entries. Dec. 31 Doubtful Debts Expense 1 400 00 Provision for Doubtful Debts 1 400 00 To increase amount of provision for doubtful debts. Adjustment to Provision for Doubtful Debts
  • 49. Adjustment to Provision for Doubtful Debts Dr Profit & Loss a/c for the year ended 31 Dec 2005 Cr Doubtful debts $1,400 Balance Sheet as at 31 December 2005 Current Assets : $ $ Sundry debtors 135,000 Less Provision for Doubtful Debts 5,400 129,600
  • 50. Adjustment to Provision for Doubtful Debts On 31 December 2005, Cynthia’s Trial Balance appears as follows: Sundry debtors 102,000 (dr) Provision for Doubtful Debts 5,400 (cr) The trader still maintains her policy of allowing 4% of sundry debtors as doubtful debts.
  • 51.
    • Calculation of provision
    Adjustment to Provision for Doubtful Debts Provision for Doubtful Debts on 1.1.2006 (as per Trial Balance) 5,400 Less :Provision for Doubtful Debts on 31.12.2006 (4% x $102,000) 4,080 Decrease in Provision 1,320
  • 52. Only the NET decrease amount is being recorded in the entries. Dec. 31 Provision for Doubtful Debts 1 320 00 Doubtful Debts Expense 1 320 00 To decrease amount of provision for doubtful debts. Adjustment to Provision for Doubtful Debts
  • 53. Adjustment to Provision for Doubtful Debts Dr Profit & Loss a/c for the year ended 31 Dec 2006 Cr Doubtful debts $1,320 Balance Sheet as at 31 December 2006 Current Assets : $ $ Sundry debtors 102,000 Less Provision for Doubtful Debts 4,080 97,920
  • 54.
    • Provision for Doubtful Debts are calculated AFTER all bad debts are written-off.
    • On Balance Day, 31 December 2006. Nathan’s Trial Balance shows the following:
    • $
    • Debtors 10,000(dr)
    • Bad debts 200(dr)
    • Provision for Doubtful Debts 150(cr)
    • On further checking, Nathan discovered that:
    • a bad debt of RM300 has not yet been recorded in the books.
    • He needs to maintain his Provision for Doubtful Debts at 2% of debtors as is his policy.
    When Provision for Doubtful Debt and Bad Debts Exists Simultaneously
  • 55.
    • Procedures to be adopted:
    • Calculate the additional bad debts.
    • Existing debtors less additional bad debts = Net debtors.
    • Net debtors × % of provision for doubtful debts = prov. for doubtful debts amount.
    • Record the provision for doubtful debts.
    When Provision for Doubtful Debt and Bad Debts Exists Simultaneously
  • 56. Example - Calculations Calculation: Net debtors = $10,000 - $300 = $9,700 Provision for Doubtful Debts on 31.12.2006 (2% @ $9,700) $ 194 Less Provision for Doubtful Debts on 1.1.2006 150 Increase in Provision for Doubtful Debts 44
  • 57. The additional bad debts, and the net increase in doubtful debts have to be recorded. Dec. 31 Bad Debts Expense 300 00 Debtors 300 00 Adjustment to Provision for Doubtful Debts Dec. 31 Doubtful Debts Expense 44 00 Provision for Doubtful Debts 44 00
  • 58. Effect on P&L and Balance Sheet Dr Profit & Loss a/c for the year ended 31 Dec 2006 Cr $ Bad debts 500 Doubtful debts 44 Balance Sheet as at 31 December 2006 Current Assets : $ $ Sundry debtors 9,700 Less Provision for Doubtful Debts 194 9,506
  • 59. End of Topic 7