Accounting - Term 4 - Week 10

Imagine Thandi runs a spaza shop in Soweto. At the end of the year, she wants to know if her business made a profit. But some bills, like Eskom’s electricity, arrive late or are paid in advance. Year-end adjustments help Thandi show the true financial position of her shop by matching income and expenses to the correct period. This ensures her profit calculation is fair and accurate. Without adjustments, her financial statements could mislead her or potential investors. The main rule: record income when earned and expenses when incurred, not just when cash changes hands. Many learners think adjustments only matter for big companies, but even small businesses like Thandi’s need them for honest reporting.

Sipho owns a taxi business in Durban. Sometimes, he pays for insurance upfront for the whole year (prepaid expense), or he still owes his drivers for December’s work (accrued expense). Prepaid expenses are payments made in advance for services not yet received. Accrued expenses are costs that have been incurred but not yet paid. The same logic applies to income: if Sipho receives rent in advance from someone using his office, that’s prepaid income. If he’s earned income but hasn’t received payment yet, that’s accrued income. The adjustment process ensures each item is shown in the correct period. A common mistake is to ignore these items, which can overstate or understate profits.

Lerato buys a delivery bakkie for her catering business in Polokwane. Over time, the bakkie loses value due to wear and tear—this is called depreciation. Depreciation spreads the cost of an asset over its useful life, ensuring expenses match the revenue they help generate. For example, if Lerato’s bakkie cost R120 000 and will last 5 years, she records R24 000 as depreciation each year. This adjustment prevents her profits from looking too high in the year she buys the bakkie. Many learners wrongly think depreciation is money set aside or an actual cash expense—it’s not. It’s an accounting entry to show asset value realistically.

Ahmed runs a cellphone repair shop in Mthatha. At year-end, he must update his Income Statement and Balance Sheet with all adjustments. For example, if he owes R2 000 for rent (accrued expense), he adds this to expenses and shows it as a liability. If he’s paid R1 500 in advance for advertising, he deducts this from expenses and shows it as an asset. Each adjustment affects at least two accounts—this is the double-entry principle. The correct application of adjustments ensures Ahmed’s financial statements are accurate and comply with accounting standards. Forgetting to adjust both accounts is a common error that leads to unbalanced statements.

Step 1: Thandi receives an electricity bill of R1 200 for December, but pays it in January. This is a common situation for small businesses, especially with Eskom bills sometimes arriving late due to load-shedding disruptions. Step 2: Identify the adjustment—this is an accrued expense because the electricity was used in December, even though payment happens next year. Step 3: Add R1 200 to electricity expense in the Income Statement. Reason: the expense belongs to this financial year, since the service was consumed now. Step 4: Show R1 200 as a current liability (accrued expenses) in the Balance Sheet. Reason: Thandi still owes this money to Eskom, so it must be shown as something the business must pay. Step 5: Double-check that both the expense and the liability are increased by the same amount, keeping the accounting equation balanced. Final answer: Electricity expense increases by R1 200; accrued expenses (liability) increases by R1 200. Sanity check: Both sides of the accounting equation increase by the same amount, so the statements remain balanced and accurate.

Step 1: Sipho receives R3 000 in December for a January rental. This is common for taxi owners who rent out their vehicles or office space during the festive season. Step 2: Identify the adjustment—this is prepaid income because the service (vehicle rental) will only be provided next year. Step 3: Deduct R3 000 from rental income in the Income Statement. Reason: income not yet earned should not be included in this year’s profit calculation. Step 4: Show R3 000 as a current liability (prepaid income) in the Balance Sheet. Reason: Sipho owes the service to the customer, so it’s a liability until the service is delivered. Step 5: Check that the deduction from income and the increase in liabilities are both R3 000, maintaining balance. Final answer: Rental income decreases by R3 000; prepaid income (liability) increases by R3 000. Sanity check: The adjustment is reflected in both statements, keeping them balanced and showing the true financial position.

Step 1: Lerato’s bakkie cost R120 000; expected to last 5 years. Many small businesses invest in vehicles, so this is a realistic example. Step 2: Calculate annual depreciation: R120 000 divided by 5 years equals R24 000 per year. Step 3: Add R24 000 to depreciation expense in the Income Statement. Reason: this spreads the cost of the bakkie over its useful life, matching the expense to the revenue it helps generate. Step 4: Deduct R24 000 from the bakkie’s value in the Balance Sheet by increasing accumulated depreciation. Reason: this shows the asset’s reduced value after a year of use. Step 5: Confirm that both the expense and the reduction in asset value are equal, ensuring the double-entry principle is followed. Final answer: Depreciation expense is R24 000; bakkie’s book value decreases by R24 000. Sanity check: The asset’s carrying value matches its age, and the statements remain balanced.

Question: Sizwe pays R2 400 for insurance in December, covering December to February. How much is prepaid at year-end? Let’s think: The payment covers 3 months. Only December belongs to this year, so the other two months are prepaid. Worked response: R2 400 divided by 3 months equals R800 per month. January and February (2 months) are prepaid: 2 × R800 = R1 600. This R1 600 is a prepaid expense (asset) at year-end and must be shown as such in the Balance Sheet, while only R800 is recorded as an expense for this year. Now you try: If Sizwe paid R3 000 for a 6-month advertising contract starting in November, what is prepaid at year-end? Answer: R3 000 ÷ 6 = R500 per month. January to April (4 months) are prepaid: 4 × R500 = R2 000.

Question: Lerato repairs a car in December for R2 500. The customer pays in January. What is the adjustment? Let’s think: The income was earned in December but not received, so it must be included in this year’s income. Worked response: Add R2 500 to income in the Income Statement as accrued income. Also, show R2 500 as a current asset in the Balance Sheet, since it is money owed to the business. This ensures that the profit is not understated and the asset is recognised. Now you try: Lerato does a R1 200 job on 31 December, paid in February. What is the accrued income at year-end? Answer: R1 200.

Question: Ahmed’s scooter cost R18 000, expected to last 3 years. What is the annual depreciation? Let’s think: Spread the cost over 3 years to match the expense to the periods benefiting from the asset. Worked response: R18 000 divided by 3 equals R6 000 per year. Add R6 000 to depreciation expense in the Income Statement and deduct R6 000 from the scooter’s value in the Balance Sheet by increasing accumulated depreciation. This adjustment ensures the asset’s value is realistic and profit is not overstated. Now you try: If Ahmed’s new phone for business cost R6 000, expected to last 2 years, what is the annual depreciation? Answer: R3 000.

1. Define accrued expense and give a local example, such as an unpaid water bill in your area. 2. List two types of year-end adjustments and briefly describe them in your own words. 3. State why depreciation is recorded, using a real asset like a delivery scooter or computer. 4. Identify one reason why adjustments are important for small businesses in South Africa. 5. Name one account affected by each of the following: accrued expense, prepaid income, and depreciation.

1. Calculate the prepaid expense if R2 400 is paid for a 4-month insurance policy starting in November. Show your working and explain which months are covered. 2. Record the adjustment for R1 500 rent received in advance for January. Explain how it affects both the Income Statement and Balance Sheet, and why it is necessary. 3. Calculate annual depreciation for equipment costing R30 000 with a useful life of 5 years, and show the entries in both statements. 4. Give an example of accrued income and describe how it would be shown in the financial statements. 5. Explain the double-entry principle using a year-end adjustment example.

1. Prepare the year-end adjustment entries for: (a) R900 electricity bill unpaid, (b) R2 000 advertising paid for next year, (c) R15 000 vehicle with a 3-year useful life. Show the effect on both the Income Statement and Balance Sheet for each adjustment, and explain your reasoning. 2. Explain how missing an adjustment affects the Income Statement and Balance Sheet, using a specific example from a South African business. 3. Analyse why adjustments are important for investors using a South African example, such as a township business seeking funding. 4. Justify the need for depreciation even if the business does not plan to replace the asset. 5. Predict what might happen if a business consistently ignores year-end adjustments over several years.

• Rent paid for next year
• Electricity bill received but not yet paid
• Income received in advance
• Depreciation on equipment

Answer: Electricity bill received but not yet paid

Accrued expenses are costs incurred but not yet paid. Many confuse this with prepaid expenses, but prepaid is paid in advance.

• To save money for asset replacement
• To match asset cost to revenue earned
• To increase cash flow
• To reduce tax payments

Answer: To match asset cost to revenue earned

Depreciation is not a cash saving; it spreads asset cost over its useful life for accurate profit calculation.

• R800
• R1 600
• R2 400
• R0

Answer: R1 600

Only December is in the current year; January and February (2 months) are prepaid: 2 × R800 = R1 600.

• Prepaid income
• Accrued expense
• Depreciation
• Prepaid expense

Answer: Accrued expense

Accrued expenses add to expenses and create a liability. Prepaid items affect assets or income, not both.

• A current asset
• A current liability
• Accumulated depreciation (contra asset)
• An income

Answer: Accumulated depreciation (contra asset)

Depreciation is not a current asset or liability and never income. It is shown as 'accumulated depreciation,' which is a contra asset account. This means it is subtracted from the asset’s original cost to show its reduced book value. Many learners mistakenly think depreciation is an expense only, but in the Balance Sheet, it reduces the asset’s carrying value.