Revise Adjustments to draft financial statements for Cambridge 9706 (1.5.1)

The accruals concept, also known as the matching principle, is a fundamental accounting principle which dictates that revenues earned and the expenses incurred to generate those revenues must be recorded in the same accounting period. This ensures the Statement of Profit or Loss provides a true and fair view of the period's performance. Adjustments are necessary because the timing of cash payments or receipts often does not align with when the economic activity occurs. For example, electricity used in December might not be paid for until January. The accruals concept requires us to 'match' the December electricity cost against December's revenues, regardless of the payment date. This principle underpins adjustments for accruals, prepayments, depreciation, and irrecoverable debts.

Accrued expenses (or accruals) are costs the business has incurred during the period but has not yet paid for. They are recorded as a current liability on the Statement of Financial Position (SOFP) and added to the relevant expense in the Statement of Profit or Loss (SPL). Conversely, prepaid expenses (or prepayments) are costs paid in advance for a benefit to be received in a future period. These are recorded as a current asset on the SOFP, as they represent a future economic benefit. The prepaid portion is deducted from the total amount paid to determine the correct expense for the current period in the SPL. Both adjustments are crucial for accurately reporting profit and the financial position. Opening balances for accruals and prepayments are typically reversed at the start of the new financial period to ensure correct accounting treatment of cash paid during that period.

Depreciation is the systematic allocation of the cost of a tangible non-current asset over its useful economic life. It is an application of the accruals concept, matching the asset's cost against the revenue it helps to generate over several periods. It is not a process of valuation. The two main methods are straight-line (allocating an equal amount each year) and reducing (diminishing) balance (applying a fixed percentage to the net book value). The annual depreciation charge is an expense in the SPL. The cumulative total, known as accumulated depreciation, is shown on the SOFP as a deduction from the asset's cost to arrive at its net book value (NBV).

When a non-current asset is sold or scrapped, it must be removed from the accounts. This involves calculating the profit or loss on disposal. This is a key adjustment. The process involves:

1. Removing the asset's original cost from the non-current asset account.
2. Removing all accumulated depreciation for that asset from the accumulated depreciation account.
3. Recording the cash or other proceeds received from the sale.
4. Calculating the difference between the asset's Net Book Value (NBV) at the time of disposal and the disposal proceeds. A profit on disposal (income) occurs if proceeds exceed NBV; a loss (expense) occurs if proceeds are less than NBV. This profit or loss is reported in the Statement of Profit or Loss.

Businesses that sell on credit face the risk that some customers will not pay. When a specific debt is confirmed as uncollectable, it is written off as an irrecoverable debt. This is an expense in the SPL. Additionally, the principle of prudence requires businesses to anticipate future losses by creating an allowance for irrecoverable debts. This is an estimate of debts that are currently doubtful, but not yet confirmed as irrecoverable. The creation of, or increase in, this allowance is also an expense in the SPL. The allowance is then deducted from trade receivables in the SOFP to show a more realistic value of the amount likely to be collected. Occasionally, a debt previously written off may be paid. This is recorded as income (Irrecoverable Debts Recovered) in the SPL.

According to IAS 2 'Inventories', closing inventory must be valued at the lower of cost and net realisable value (NRV). Cost includes all costs of purchase (purchase price, import duties, transport inwards) and conversion to bring the inventory to its present location and condition. It excludes selling and administrative overheads. NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. This principle prevents businesses from overstating assets and profit. If NRV is lower than cost, an adjustment is made to write down the inventory value. This write-down is treated as an expense and included within 'cost of sales' in the SPL, thereby reducing the gross profit.

Despite a balanced trial balance, errors may still exist in the draft accounts. These must be corrected via journal entries before the final financial statements are prepared. Errors can be classified as those that do not affect the trial balance agreement (e.g., error of original entry, error of principle) and those that do. Errors that cause an imbalance in the trial balance are temporarily posted to a Suspense Account, which is then cleared as the errors are identified and corrected. Correcting errors often affects the reported profit for the period and asset/liability values on the SOFP.