ADJUSTMENTS Introduction The financial statements prepared by a business should always reflect the correct position of its affairs

at any given time. To achieve this, certain adjustments should be effected so that correct profit/loss is reported in the trading, profit and loss account while the balance sheet items should be shown in such a way that their true and fair view is reflected. Main areas of adjustment include: (a) Fixed Assets-Depreciation and Disposal. (b) Expenses and Revenue-Accruals and prepayments. (c) Bad debts, Bad debts recovered and Provision for doubtful debts. (a) Fixed Assets-Depreciation and Disposal. Fixed assets are those assets of material value that are purchased for use in the business, are not for resale and which have a long life. A fixed asset is acquired for use within a business with a view to earning profits. Its life extends over more than one accounting period, and so it earns profits over more than one period. With the exception of land held on freehold or very long leasehold, every fixed asset eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even buildings do not last forever. When a business acquires a fixed asset, it will have some idea about how long its useful life will be, and it might decide either: to keep on using the fixed asset until it becomes completely worn out, useless and worthless; or to sell off the fixed asset at the end of its useful life, either by selling it as a second-hand item or as scrap. Since a fixed asset has a cost, and a limited useful life, and its value eventually declines, it follows that a charge should be made in the profit and loss account to reflect the use that is made of the asset by the business. This is called depreciation. Definition of depreciation Depreciation is a measure of the decrease in value of a fixed asset through use, time or obsolescence. It is part of the original cost of a fixed asset consumed during its period of use by the business. Depreciation charges should be spread fairly over a fixed assets life, and so allocated to the accounting periods which are expected to benefit (i.e. make profits) from the assets use. Suppose that a business buys a machine for 40 000. Its expected life is 4 years, and at the end of that time it is expected to be worthless. Since the fixed asset is used to make profits for 4 years, it would be reasonable to charge the cost of the asset over those 4 years (perhaps by charging 10 000 per annum) so that at the end of the 4 years the total cost of 40 000 would have been charged against profits. Therefore, depreciation can be described as a means of spreading the cost of a fixed asset over its useful life, and so matching the cost against the full period during which it earns profits for the business. Depreciation charges are an example of the application of the accruals concept to calculate profits. CAUSES OF DEPRECIATION There are four main causes of depreciation which are: (a) Physical deterioration This takes the form of: Wear and tear Fixed assets eventually wear out, some lasting many years whilst others wear out more quickly. Erosion, rust, rot and decay Land may be eroded or wasted away by the action of wind, rain, sun or other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away. Wood will rot eventually. Decay is a process which will be present due to the elements of nature and a lack of proper attention. (b) Economic factors: These may be said to be the reasons for an asset being put out of use even though it is in good physical condition. The two main factors are:

Obsolescence This occurs when an asset becomes out of date due to advanced technology or a change in processes, e.g. in the car industry much of the assembly work is now done by robots. Inadequacy. This arises when an asset is no longer used due to the growth and changes in the size of the business as a result of new regulations. (c) Time This applies to those assets which have legal life fixed in terms of years, e.g. leased property such as buildings. (d) Depletion This involves assets which are of wasting character, perhaps due to the extraction of raw materials from them. Natural resources such as mines, quarries and oil wells come under this heading. METHODS OF CALCULATING DEPRECIATION There are several different methods of depreciation. Of these, the ones you need to know about are: Straight-line method/Fixed instalment method Reducing/Diminishing balance method Revaluation method Straight-line method/Fixed instalment method This is the most commonly used method of all. It is where the total depreciable amount is charged in equal instalments to each accounting period over the expected useful life of the asset. That is, the same amount of depreciable value is deducted from the original cost of the fixed asset every accounting period. Therefore, depreciation remains at an equal amount each year.

Formulas One of the following formulas may be used depending on the content of the question: (i) Annual depreciation = Rate (%) X Cost = X per annum. (ii) Annual depreciation = Cost - Residual value (Disposal value/Scrap value) Expected useful life = X per annum Worked Example: Exercise 26.4A, F.Wood, 10th edition, page 292. (a) Straight line method Given: Cost = 23 000, Trade-in value = 4 000, Expected useful life = 4 years. Annual depreciation = Cost - Residual value Expected useful life = 23 000 4 000 4 = 19 000 4 = 4750 N.B. Residual value means the amount received on disposal of the asset, also referred to as scrap value. Reducing/Diminishing balance method This calculates the annual depreciation charge as a fixed percentage of the net book value (cost accumulated depreciation) of the asset, as at the end of the previous accounting period. Therefore, every year depreciation is at less amount, i.e. depreciation charge falls each year. Formula Every year of use depreciation is calculated as shown below:

First year: Depreciation = Rate x Cost Second year: Depreciation = Rate x [Cost First year depreciation] Third year: Depreciation = Rate x [Cost First year depn Second year depn] and so on. Worked Example: Exercise 26.4A, F.Wood, 10th edition, page 292. (b) Reducing balance method First year: Depreciation = Rate x Cost = 35% x 23000 = 8050 Second year: Depreciation = Rate x [Cost First year depn] = 35% x [23000 8050] = 35% x 14950 = 5232.5 Third year: Depreciation = Rate x [Cost First year depn Second year depn] = 35% x [23000 8050 5232.5] = 35% x 9717.5 = 3401.125 Fourth year: Depreciation=Rate x [Cost 1st year depn 2nd year depn 3rd year depn] = 35% x [23000 8050 5232.5 - 3401.5] = 35% x 6316 = 2210.6 Revaluation method This method is used for calculating depreciation on large quantities of low-cost assets (tools and equipment) such as saws, drills, spanners etc. It would be very difficult to use one of the previously discussed methods of depreciation for such low cost tools and equipment, therefore the revaluation method is used. With this method, the tools and equipment etc. are valued at the beginning of the financial year and any further items purchased during the year for use in the business which are not for resale are added to the initial valuation. After using the tools etc. during the year, they are valued again at the end of the financial year. This figure is then deducted from the initial valuation, plus tools etc. purchased during the year, to find the depreciation to be charged to the profit and loss account. Formula: Depreciation for the year = Opening value + Additions (if any) Closing value. Example: A business has a lot of steel containers. These are not sold but are used by the business. On 1 January 2011 the containers were valued at 3 500 During the year to 31 December containers were purchased costing 1 300 On 31 December 2011 the containers were valued at 3 800 The depreciation is calculated: Opening value + Additions Closing value = 3 500 + 1 300 3800 = 1 000 Assignment: Exercise 26.4A, 26.6A & 26.12.