What you'll learn
Year-end adjustments are the entries that convert a set of cash-based records into accruals-based financial statements. Without them the trial balance shows what was paid and received; with them it shows what was earned and consumed. Every adjustment in this topic — accruals, prepayments, depreciation, allowances for doubtful debts and closing inventory — exists for the same reason: the matching concept requires the expenses of a period to be set against the revenue of that period, whatever the cash happened to do.
Each adjustment has the same shape. One side goes to the income statement and changes profit; the other side goes to the statement of financial position and creates or changes an asset or a liability. If you can state both sides of every adjustment, you can handle any question in this area, because the arithmetic is rarely hard and the marks are for knowing where the two halves land.
By the end of this topic you should be able to calculate and record accruals and prepayments for expenses and for income, apply both the straight line and the reducing balance methods of depreciation, account for the disposal of a non-current asset, create and adjust an allowance for doubtful debts, and explain why each of these adjustments is required.
Key terms and definitions
Accrued expense — an expense consumed in the period but not yet paid. An expense in the income statement and a current liability in the statement of financial position.
Prepaid expense — an amount paid in the period that relates to a future period. Deducted from the expense and shown as a current asset.
Accrued income — income earned but not yet received. Added to income and shown as a current asset.
Income received in advance — income received that relates to a future period. Deducted from income and shown as a current liability.
Depreciation — the systematic allocation of the depreciable amount of a non-current asset over its useful life.
Depreciable amount — cost less residual value.
Carrying amount — cost less accumulated depreciation.
Bad debt — a receivable known to be irrecoverable, written off to expenses.
Allowance for doubtful debts — an estimate of receivables that may not be collected, deducted from receivables in the statement of financial position.
Core concepts
Accruals and prepayments on expenses
The rule is that the income statement carries the amount consumed, not the amount paid.
If rent of $60,000 a year is payable and only $45,000 has been paid by the year end, the income statement shows $60,000 and a $15,000 accrual appears among current liabilities. If insurance of $36,000 has been paid but $9,000 of it covers next year, the income statement shows $27,000 and a $9,000 prepayment appears among current assets.
The most reliable method is a three-line calculation: take the amount paid in the year, add any accrual at the year end, deduct any accrual brought forward from last year, deduct any prepayment at the year end, add any prepayment brought forward. Opening balances are easy to miss and are exactly where examiners hide the second mark.
Accruals and prepayments on income
Income follows the mirror image. Rent receivable earned but not yet collected is added to income and shown as a current asset; rent collected in advance is deducted from income and shown as a current liability.
Candidates who have learned the expense rule often apply it unchanged to income and put a receipt in advance among assets because cash came in. It is a liability: the business has been paid for something it has not yet provided.
Why depreciation is charged
Depreciation is not a fund set aside to replace the asset, and it is not an attempt to record the asset's market value. It is an allocation of cost. A truck bought for $180,000 and used for six years costs the business $180,000 less whatever it is eventually sold for, and that cost belongs across the six years that benefited from it, not to the year it was bought.
Three concepts justify it. Going concern says the asset will be used rather than sold. Periodicity forces a figure for each year. Matching decides how much of the cost belongs to each year.
Straight line and reducing balance
The straight line method charges an equal amount each year: (cost − residual value) ÷ useful life. It suits assets that give up their value evenly — buildings, fixtures, a fifteen-year lease.
The reducing balance method applies a fixed percentage to the carrying amount, so the charge is heaviest in the early years. It suits assets that lose value fastest when new and cost more to run as they age — vehicles, computers, plant. The combined charge for depreciation plus repairs is then more even across the asset's life, which is the usual argument for choosing it.
Whichever is chosen, consistency requires it to be applied in the same way each year, and any change must be justified and disclosed.
Disposal of a non-current asset
Open a disposal account. Debit it with the cost of the asset and credit the asset account. Credit the disposal account with the accumulated depreciation to date and debit the accumulated depreciation account. Credit it with the proceeds and debit cash or the receivable.
The balance on the disposal account is the profit or loss on disposal, which goes to the income statement. A profit on disposal means depreciation charged over the asset's life was more than the value actually lost; a loss means it was less. Neither is an error — both are the consequence of estimating a useful life and a residual value in advance.
Bad debts and the allowance for doubtful debts
A bad debt is a specific receivable known to be irrecoverable. Debit bad debts expense, credit the customer's account — the debt leaves the ledger.
An allowance for doubtful debts is an estimate covering receivables generally. The customer's account is untouched, because the business still expects to pursue the money. Only the movement in the allowance is charged to the income statement: if the allowance needs to rise from $8,000 to $11,000, the charge is $3,000, not $11,000. If it needs to fall, the reduction is credited as income.
Both entries are applications of prudence, but note the difference in evidence. A bad debt is a known fact; an allowance is an estimate, and prudence justifies making it while neutrality forbids inflating it.
Worked examples
Example 1 — Accrued and prepaid expenses (6 marks)
A business pays rent quarterly in arrears at $18,000 per quarter. During the year ended 31 December it paid four instalments totalling $72,000, of which one related to the last quarter of the previous year. The instalment for the final quarter of this year is unpaid.
Amount paid in the year: $72,000. Deduct the opening accrual settled this year: $18,000. Add the closing accrual for the unpaid final quarter: $18,000.
Charge to the income statement = $72,000 − $18,000 + $18,000 = $72,000, which equals four quarters at $18,000 as it should.
Statement of financial position: accrued rent $18,000 under current liabilities.
The figures coincide here because one quarter came in and one went out. Examiners often set the opening and closing amounts differently precisely so that the shortcut of "four quarters" gives the wrong answer.
Example 2 — Straight line depreciation (4 marks)
Machinery cost $240,000, has an estimated residual value of $30,000 and a useful life of seven years.
Depreciable amount = $240,000 − $30,000 = $210,000. Annual charge = $210,000 ÷ 7 = $30,000.
After three years: accumulated depreciation = 3 × $30,000 = $90,000; carrying amount = $240,000 − $90,000 = $150,000.
Example 3 — Reducing balance depreciation (5 marks)
A delivery van cost $180,000 and is depreciated at 25% on the reducing balance.
Year 1: $180,000 × 25% = $45,000. Carrying amount $180,000 − $45,000 = $135,000. Year 2: $135,000 × 25% = $33,750. Carrying amount $135,000 − $33,750 = $101,250. Year 3: $101,250 × 25% = $25,312.50. Carrying amount $101,250 − $25,312.50 = $75,937.50.
Total charged over three years = $45,000 + $33,750 + $25,312.50 = $104,062.50. Straight line over a six-year life with no residual value would have charged $180,000 ÷ 6 = $30,000 a year, or $90,000 over the same three years. The reducing balance front-loads the cost; over the whole life it does not reduce it.
Example 4 — Disposal of a non-current asset (5 marks)
The van in Example 3 is sold at the end of year 3 for $82,000.
Carrying amount at disposal = $75,937.50. Proceeds = $82,000. Profit on disposal = $82,000 − $75,937.50 = $6,062.50, credited to the income statement.
Disposal account: debit cost $180,000; credit accumulated depreciation $104,062.50; credit proceeds $82,000. The credits total $186,062.50 against a debit of $180,000, leaving a $6,062.50 credit balance — the profit.
Example 5 — Movement in the allowance for doubtful debts (5 marks)
Receivables at 31 December are $260,000 before adjustment. A debt of $10,000 is to be written off, and an allowance of 4% is to be carried on the remainder. The allowance brought forward was $7,200.
Receivables after the write-off = $260,000 − $10,000 = $250,000. Allowance required = 4% × $250,000 = $10,000. Increase in allowance = $10,000 − $7,200 = $2,800.
Income statement: bad debts written off $10,000, plus increase in allowance $2,800 — a total charge of $12,800. Statement of financial position: receivables $250,000 less allowance $10,000 = $240,000.
The single commonest error here is charging the whole $10,000 allowance rather than the $2,800 movement, which overstates the expense by $7,200.
Common mistakes and how to avoid them
Ignoring opening accruals and prepayments. Last year's closing balance is this year's opening balance and must be reversed out of the charge.
Treating income received in advance as an asset. It is a liability — money held for a service not yet given.
Charging the full allowance for doubtful debts instead of the movement. Only the increase or decrease goes to the income statement.
Applying the reducing balance percentage to cost every year. It applies to the carrying amount, which falls each year.
Deducting residual value under reducing balance. Residual value is deducted under straight line only; reducing balance applies the rate to the carrying amount as it stands.
Forgetting to remove the disposed asset's accumulated depreciation. Leaving it behind overstates accumulated depreciation and understates the profit or loss on disposal.
Making the adjustment in one statement only. Every adjustment has an income statement side and a position statement side.
How this links to your Internal Assessment
Adjustments are where an Internal Assessment shows whether the records were genuinely kept or reconstructed at the end. Identify the accruals and prepayments that actually exist in the business you have chosen — the unpaid electricity bill at the year end, the insurance premium paid in advance — and show the working, not just the final figure.
Depreciation gives you a defensible judgement to make and justify. State the method you have chosen for each class of asset and say why: straight line for the premises fixtures because they give up value evenly, reducing balance for the delivery vehicle because it loses most value in its first two years. A justified choice earns more than a correct calculation with no reasoning attached.
If the business has receivables, comment on their recoverability. An allowance based on the actual ageing of the debts, with the ageing shown, is far stronger evidence of analysis than a flat percentage applied because the textbook used one.
Exam technique for year-end adjustments
Adjustments appear in almost every Paper 02 preparation question and are also examined directly. Read the adjustments note before you touch the trial balance, and tick each adjustment off as you deal with both of its sides.
Set out workings as labelled notes — W1 rent, W2 depreciation, W3 allowance — because mark schemes award method marks for the working even when the final figure is wrong. A depreciation calculation that shows cost, residual value, life and the resulting charge will pick up marks that a bare number cannot.
Mind the command words. Calculate the depreciation charge means show the arithmetic. Explain why depreciation is charged means give the matching and going concern argument, not the method. Distinguish between a bad debt and an allowance for doubtful debts wants the contrast drawn explicitly — known versus estimated, ledger removed versus ledger untouched.
Where a question asks you to justify a choice of method, commit to one and give a reason grounded in how the asset loses value. An answer that lists both methods without choosing earns the knowledge marks and forfeits the judgement marks.
Quick revision summary
- Every adjustment has two sides: one changes profit, one changes an asset or a liability.
- Accrued expense: add to the expense, show as a current liability. Prepaid expense: deduct from the expense, show as a current asset.
- Accrued income: add to income, current asset. Income in advance: deduct from income, current liability.
- Always reverse the opening accrual or prepayment before adding the closing one.
- Straight line charge = (cost − residual value) ÷ useful life; the same amount every year.
- Reducing balance charge = percentage × carrying amount; heaviest in the early years, and residual value is not deducted.
- Carrying amount = cost − accumulated depreciation.
- Disposal account: debit cost, credit accumulated depreciation, credit proceeds; the balance is the profit or loss on disposal.
- Bad debt: known and specific, removed from the ledger. Allowance: estimated and general, ledger untouched.
- Only the movement in the allowance is charged or credited to the income statement.
- Receivables appear in the statement of financial position net of the allowance.