1. Principle of Accounting
Chapter 13 &19
Profit determination and Balance-day
adjustments
BA. in International Business
Foreign Trade University

2. Outline
 Profit determination
 Accrual accounting and balance-day
adjustments
 Prepaid expense
 Adjusting for stocks of materials and
supplies
 Accrued expense
 Prepaid revenue
 Accrued revenue

3. Profit determination
underlying assumptions
 Going concern principle: assumes that the business
will continue in operation as a going concern for an
indefinite period into the future.
 Reporting period principle: the life of a business is
divided into equal periods of time over which the
performance of the business can be measured
(profit or loss is determined).
 Matching principle: is used to match the revenue
and expense for a particular reporting period to
determine a profit or loss figure

4. Accrual accounting
 Accrual accounting: A system of accounting in
which revenues are recognised when earned and
expenses when incurred.
 Profit is defined as revenue earned less the
expenses incurred in earning that revenue.
 Revenue can be earned in one reporting period
while cash can be received in a previous or
subsequent period.
 Expenses can incur in one reporting period while
cash payment can be made in a previous or
subsequent period.

5. Balance-day adjustments
 Adjusting entries: are the entries made in
revenue and expense accounts to make
them equal to revenue earned and
expenses incurred. Adjusting entries are
made on the last day of the reporting
period (balance day).
 Closing entries: are used to close off the
adjusted revenue and expense accounts
to the profit and loss summary account.
Closing entries are also made on balance
day.

6. Prepaid expenses
 Example: On 1 Oct 05, the company paid $480 for a
12-month insurance premium.
 The question is whether the insurance payment
represents an asset or expense?
 Prepaid expenses are goods & services purchased
for future consumption and paid for in advance.
 Prepaid expenses are assets because they will
benefit future accounting periods.
 As the assets are consumed to generate revenue for
a business, a portion of their cost is transferred to
expense.
 The adjusting entries are made to ensure the
matching of revenue and cost of the asset written
off.

7. Prepaid expense (cont’d)
 Using the above example:
1 Oct 05: paid 12-month insurance $480 ($40 per
month)
31 Dec 05:
Insurance used: 3 months => Insurance expense=
3*40 = $120
Insurance prepaid for 06 (9 months unused) = 9*40 =
$360
 Accounting entries:
1 Oct 05: Dr Prepaid insurance $480
Cr Cash $480
31 Dec 05: Dr Insurance expense $120
Cr Prepaid insurance $120

8. Prepaid expense – ledger accounts
Prepaid insurance a/c
Oct 1 Cash at bank $480
Dec 31 Insurance expense $120
Balance $360
$480
$480
Insurance expense a/c
Dec 31 Prepaid insurance $120 Dec 31 P&L Summary $120

9. Adjusting for stocks of materials and
supplies
 Stocks of materials and supplies arise when a service firm
purchases materials which it needs in order to provide
services to its customers.
 Examples are office stationery, stocks of petrol, etc.
 If some of these supplies have been used by the end of a
period, adjustments must be made as part of the balance-
day process.
 The cost of supplies used is transferred from an asset
account to an expense account on balance day.

10. Adjusting for stocks of materials and
supplies (cont’d)
Example
5 Jan: stationery supplies were purchased for $1,200.
31 Dec: stationery supplies remain on hand is $200
Stationery supplies used during the year = 1,200 –
200=1,000
 Adjusting entry for stationery used:
Dr Stationery expense $1,000
Cr Stock of stationery $1,000
 Closing entry for stationery expense
Dr P&L Summary $1,000
Cr Stationery expense $1,000

11. Adjusting for stocks of materials and
supplies – ledger accounts
Stock of stationery a/c
Jan 5 Cash $1,200 Dec 31 Stationery expense $1,000
Balance 200
$1,200
$1,200
Jan 1 Balance 200
Stationery expense a/c
Dec 31 Stock of stationery $1,000 Dec 31 P&L Summary $1,000

12. Accrued expenses (expenses owing)
 Accrued expenses: are expenses that have been
incurred but not yet paid.
 Example: A firm incurred $1,000 advertising
expense during 2005, in which $200 of
advertisement in December is not yet paid.
 $200 advertising expense is an accrued expense.
 Adjusting entry for accrued expense
Dr Advertising expense $200
Cr Accrued advertising $200

13. Accrued expenses - ledger accounts
Advertising expense a/c
Jan-Dec Cash $800
Dec 31 Accrued advertising $200 Dec 31 P&L Summary 1,000
$1,000 $1,000
Accrued advertising a/c
Dec 31 Advertising exp $200

14. Prepaid revenue
 Prepaid revenue represents future revenue that has
been collected but not yet earned.
 The prepaid revenue will be realised when some
type of service is performed or goods are provided.
 At the time of collection, prepaid revenue
represents a liability to the business because goods
or services are owed in return.
 The adjusting entries are made to ensure the
matching of revenue earned and expense incurred
to generate revenue.

15. Prepaid revenue – an example
Total bus fares received: $90,000
Bus fares paid in advance for trips in 2006: $10,000
 Bus fares revenue earned in 2005
= $90,000 - $10,000 = $80,000
 Accounting entries:
Jan-Dec: Dr Cash at bank $90,000
Cr Prepaid bus fares revenue $90,000
Dec 31: Dr Prepaid bus fares revenue $80,000
Cr Bus fares revenue $80,000

16. Prepaid revenue – ledger accounts
Prepaid bus fares revenue a/c
Dec 31 Bus fares revenue $80,000
Jan-Dec Cash at bank $90,000
Balance $10,000
$90,000
$90,000
Jan 1 Balance $10,000
Bus fares revenue a/c
Dec 31 P&L Summary $80,000 Dec 31 Prepaid bus fares $80,000

17. Accrued revenue (revenue owing)
 Accrued revenues: are revenues that have been
earned but not yet received.
 Example:
1 Jul 05, a company deposited $20,000 in a bank
account at 10% p.a. payable on 30 Jun 06.
Interest earned as of 31 Dec 05 (six months)
= $20,000 * 10% * 6/12 = $1,000
 Accounting entry:
Dr Accrued interest revenue $1,000
Cr Interest revenue $1,000

18. Accrued revenue – ledger accounts
Accrued interest revenue a/c
Dec 31 Interest revenue $1,000
Interest revenue a/c
Dec 31 P&L Summary $1,000 Dec 31 Accrued interest rev $1,000

19. Practice questions
 Exercise 13.4
 Exercise 13.6
 Exercise 13.8
 Exercise 13.10
 Exercise 19.1
 Exercise 19.3
 Exercise 19.4

20. Homework
 Exercise 13.5
 Exercise 13.7
 Exercise 13.9
 Exercise 13.14
 Exercise 19.2
 Exercise 19.5
 Exercise 19.6