Period-end adjustments: prepayment, part-year depreciation and inventory
Millgate Trading has a year end of 31 December 20X4 and its draft figures were prepared by an inexperienced bookkeeper. Insurance in the trial balance is £5,400, being a premium of £4,320 paid on 1 April 20X4 covering the twelve months to 31 March 20X5, plus the prepayment of £1,080 brought forward at 1 January 20X4 that covered January to March 20X4. Office equipment cost £52,000, including equipment bought for £12,000 on 1 October 20X4, and the bookkeeper has charged depreciation of £10,400, being 20% straight line on the full £52,000. Closing inventory was counted at cost at £18,400; this includes 200 units of a discontinued line costing £1,700 whose net realisable value is £400, and goods costing £600 that were invoiced to a customer on 28 December but were still in the warehouse awaiting collection.
1. Calculate the insurance expense for the year and the prepayment to be carried forward, and give the adjustment.
Read the worked answer
Split by period covered:
- Opening prepayment of £1,080 relates to January–March 20X4, so it is an expense of 20X4.
- The £4,320 premium covers 1 April 20X4 to 31 March 20X5: nine months (April–December) fall in 20X4 and three months in 20X5.
Expense for 20X4 = 1,080 + (4,320 × 9/12 = 3,240) = £4,320
Prepayment c/f = 4,320 × 3/12 = £1,080
The trial balance figure of £5,400 is the £4,320 paid plus the £1,080 released from the opening prepayment. So only the closing prepayment is still to be recognised:
Dr Prepayments £1,080 / Cr Insurance £1,080
Effect: expenses fall by £1,080 and profit rises by £1,080; prepayments (current assets) rise by £1,080.
2. Recalculate the depreciation charge and explain the correction and its effect on profit.
Read the worked answer
Policy: 20% straight line on cost, charged from the month of acquisition.
- Equipment held for the whole year: 40,000 × 20% = 8,000
- Equipment bought 1 October 20X4: 12,000 × 20% × 3/12 = 600
- Correct charge = £8,600
The bookkeeper charged 52,000 × 20% = £10,400, so the charge is overstated by £1,800.
Journal: Dr Accumulated depreciation £1,800 / Cr Depreciation expense £1,800
Effect: expenses fall by £1,800, so profit rises by £1,800; the carrying amount of office equipment in the statement of financial position rises by £1,800.
Reasoning: charging a full year on an asset owned for three months breaks the accruals concept - the expense must match the period over which the asset was used. The draft depreciation figure also distorts the comparatives, because next year the same asset will appear to be a full year old.
3. Value closing inventory and explain its effect on gross profit, net profit and the statement of financial position.
Read the worked answer
| Step | £ |
|---|---|
| Inventory per count, at cost | 18,400 |
| Obsolete line written down to NRV: (1,700 − 400) | (1,300) |
| Goods invoiced to a customer, title passed | (600) |
| Closing inventory | 16,500 |
Effect: closing inventory falls by £1,900, so cost of sales rises by £1,900. Gross profit falls by £1,900 and net profit falls by the same £1,900. In the statement of financial position, inventory and capital both fall by £1,900.
Reasoning:
- Inventory is measured at the lower of cost and net realisable value (prudence). The discontinued line will realise only £400 net of selling costs, so carrying it at £1,700 overstates assets and profit.
- The goods invoiced on 28 December are no longer the business's asset even though they are still on the premises; the sale has been made and title has passed. Including them would count the same goods twice - once as inventory and once as a receivable.