Adjustments and Financial Statements
This domain tests period-end adjustments and their presentation in the statement of profit or loss and statement of financial position. Exam questions require accruals, prepayments, depreciation, closing inventory, irrecoverable debts and allowances, and their effect on profit and assets.
Core rules
- Accrual accounting matches income and expenses to the period, not to cash movement.
- Accrued expense: expense incurred but not paid; liability arises.
- Prepaid expense: paid but not incurred; asset arises.
- Closing inventory is deducted from cost of sales and shown as a current asset.
- Depreciation allocates the depreciable amount over useful life; it is an expense, not a cash payment.
- Financial statements: statement of profit or loss, statement of financial position, statement of changes in equity, statement of cash flows and notes.
Worked example
Insurance of 2,400 is paid on 1 October for 12 months; the year-end is 31 December. Only three months relate to this year: 2,400 x 3/12 = 600 expense. The remaining 1,800 is a prepayment. If the payment was initially debited to insurance expense, adjust: debit prepayment 1,800; credit insurance expense 1,800. Profit increases by 1,800 and current assets include a prepayment of 1,800. If initially recorded as a prepayment, debit insurance expense 600; credit prepayment 600.
Traps
- Charging the full cash payment as this year's expense.
- Treating depreciation as a cash outflow.
- Double-counting closing inventory in cost of sales.
- Ignoring opening accruals and prepayments from the prior year.