Apply year-end adjustments for accruals, prepayments, depreciation and impairment when preparing financial statements

What this dot point is asking

SEAB wants you to apply the year-end adjustments, accruals, prepayments, depreciation and impairment, that convert a trial balance into a complete set of financial statements. Almost every exam question that asks you to prepare statements buries one or more of these adjustments in the data. The central insight is that the trial balance records cash-based and historical figures, and adjustments are the bridge to accrual-based figures, each one having a dual effect on both the income statement and the statement of financial position.

The answer

The four adjustment families

Each adjustment is recorded with a double entry, so it changes both statements consistently with the accounting equation.

Accruals and prepayments

Expenses must be the amount incurred for the year, not the amount paid:

The same logic, reversed, applies to income earned but not yet received (accrued income) and income received in advance (deferred income).

Depreciation and impairment

Depreciation spreads the cost of a non-current asset over its useful life, charging an expense and increasing accumulated depreciation so the carrying amount falls. Impairment of receivables recognises that some debts may not be collected, creating an allowance that reduces net receivables and charges an expense. Both are applications of matching and prudence: the cost or loss is recognised in the period that benefits or that the loss becomes probable.

Examples in context

Example 1. The rent question that catches everyone. A trial balance shows rent of \24,000$but a note says$\$2\,000$ is still owing for the year. Students who copy \24,000$straight into the income statement understate the expense and overstate profit by$\$2\,000$, and they also miss the \2,000$accrued liability. The correct expense is$\$26\,000$, illustrating why every trailing note must be turned into an adjustment.

Example 2. Depreciation feeding two statements. A delivery firm charges \12,000$depreciation on its fleet. This reduces profit in the income statement and, simultaneously, increases accumulated depreciation so the fleet's carrying amount on the statement of financial position falls by$\$12\,000$. The single adjustment ripples through both statements, which is why depreciation is the classic example of the dual effect at the year end.

Try this

Q1. Insurance paid is \10,000$but$\$2\,000$ is prepaid. State the expense and the balance-sheet item. [2 marks]

• Cue. Expense = 10\,000 - 2\,000 = \8,000$; the$\$2\,000$ prepayment is a current asset.

Q2. A machine costing \40,000$with$\$10\,000$ accumulated depreciation is depreciated at $25\%$ reducing balance. Find this year's charge and the new carrying amount. [3 marks]

• Cue. Carrying amount = 40\,000 - 10\,000 = \30,000$; charge$= 25% \times 30,000 = \$7\,500$; new carrying amount = 30\,000 - 7\,500 = \22,500$.

Q3. Explain how an accrued expense affects both financial statements. [3 marks]

• Cue. It increases the relevant expense in the income statement (reducing profit) and creates a current liability on the statement of financial position, a single double entry touching both.