Notes@HKU by Jax

Preparing trial balances

Trial balance

An accounting report showing the closing balances of all general ledger accounts.

Their purpose is to ensure that the debits and credits are equal - to check for errors and help prepare financial statements.

Example Trial Balance

XYZ Corporation
Trial Balance
For the period ended December 31, 2025
(In millions of dollars)

AccountDebitCredit
Cash$1,000
Common Stock$1,000
Total$2,000$2,000

Posting adjusting entries

Adjusting our Trial Balance

In the account cycle, after preparing an unadjusted trial balance, we make adjustments to respect the Accrual Basis of Accounting for different types of expense and revenues.

This adjustment is necessary when the two sides of a transaction (remember double-sided nature) happens in a different accounting period. (So no adjustments necessary if same period)

A typical transaction

In a transaction there are two parties: a buyer and a seller.

Seller ⇌cashservices\xrightleftharpoons[\text{cash}]{\text{services}} Buyer

In the case of the buyer, the transaction will always be an expense.

In the case of the seller, the transaction will always be revenue.

Categorizing E&R as prepayments / accruals

We need to categorize E&R as either Prepayments or Accruals before making an adjusting entry as part of the analysis.

  • Prepayments: services paid for before received (by buyer), also called Deferrals
  • Accrued: services received before paid for (by buyer)

Hence, there will be 4 titles for the adjusting entries as follows, along with examples:

  • Deferred Expense (A, Dr)
    Example: As a buyer, you drive a car. Your car warranty is for a year, but you pay for it the year prior. The service (car warranty) is paid for before received, hence, this is a prepaid expense.
  • Deferred Revenue (L, Cr)
    Example: As a seller, you sell car warranty. The service (car warranty) is paid for by the customer before it becomes active in the next year, hence, this is a deferred (prepaid) revenue.
  • Accrued Expense (L, Cr)
    Example: As a buyer, you consume water. Water bills are paid every 3 months, but you use water every month and your accounting period is a month. The service (water) is received before paying for by the customer, hence, this is an accrued expense.
  • Accrued Revenue (A, Dr)
    Example: As a seller, you provide water. The service (water) is provided before paying for by the customer, hence, this is an accrued revenue.

What the adjusting entry does

As we recorded our transaction on the cash basis initially, it overstates the corresponding E/R. The purpose of the adjusting entry is to correct this overstatement by converting the transaction to either A/L. This conversion moves the transaction to the permanent accounts, which carries forward to the next period for adjustment again.

To determine if the overstated transaction is A/L:

  • Asset (Dr): Future economic benefit
  • Liability (Cr): Future economic sacrifice

Releasing prepayments and accruals

As we record by the accrual basis, when we consume the / a part of the service, or the payment is made, we need to record the transaction accordingly. If only a part of the service is consumed, calculate the consumed amount by time period.

This moves the transaction back to the temporary accounts.

Example Adjusting Entry (Prepaid Expense)

We make the following adjusting entry for car warranty (example above) that we paid for in the month prior.

DateAccountDebitCredit
Dec 31, 2023Prepaid expense$12
Cash$12

Then each month, we will make the following adjusting entry to recognize the usage of the prepaid expense and release it gradually.

DateAccountDebitCredit
XXX 31, 2024Utility expense$1
Prepaid expense$1
Example Adjusting Entry (Accrued Expense)

We make the following adjusting entry for water bills (example above) in the first and second month. By the history average, we assume each month costs around $1000.

Remember that accrued expense is a liability, as it would be a future economic sacrifice.

DateAccountDebitCredit
Jan 31, 2023Utility expense$1
Accrued expense$1
(Water bills accrued)
Feb 28, 2023Utility expense$1
Accrued expense$1
(Water bills accrued)

We get the receipt for the water bills at the end of the third month. It was $4. We record the utility expense and cash usage accordingly, then release the accrued expense.

DateAccountDebitCredit
Mar 31, 2023Utility expense$4
Cash$4
(Water bills payment)
Mar 31, 2023Accrued expense$2
Utility expense$2
(Release accrued expense)

Depreciation

Recording as adjusting entry

Depreciation

The process of reducing the book value of a tangible fixed asset over time.

Recording depreciation expense

Example:

DateAccountDebitCredit
Dec 31, 2023Depreciation expense12
Accumulated depreciation12

Accumulated depreciation is a contra asset, as it has a normal balance opposite to the asset. We record it like the following in the balance sheet:

Assets
Equipment$100
Accumulated depreciation(12)
Total$88 ←\leftarrow Book value

Depreciation expense is an operating expense, as the depreciation occurs in the course of the business operations.

Depreciation expense

The expense that is recorded each period over the useful life of the asset.

Calculating depreciation expense

Before calculation, you need to identify some of the following quantities:

  • (C) Cost: The initial cost of the asset.
  • (RV) Residual value: The estimated value of the asset at the end of its useful life.
  • (UL) Useful life: The estimated number of years the asset will be used.
  • (PT_T) Total production: The total number of units the asset will produce over its useful life.
  • (PA_A) Annual production: The number of units the asset will produce in a year.
  • (AD) Accumulated depreciation: The total depreciation expense recorded for the asset up to the current period.

Depreciation estimation methods

MethodFormulaPer period
Straight-lineC−RVUL\frac{C - RV}{UL}Constant amount each period.
Units-of-production(C−RV)×PAPT(C - RV)\times\frac{P_A}{P_T}Based on production level.
Double-declining balance2×C−ADUL2\times\frac{C-AD}{UL}Decreasing amount each period.

For the final year of double-declining balance, the depreciation must set the book value to residual value. Hence, the formula is (C−RV)−AD(C-RV)- AD.

Related: Asset disposal

Amortization

Definite and indefinite life of intangible assets

When an intangible asset is aquired, managers will decide if they have a definite or indefinite life.

  • Definite life: Cost is amortized over it's useful life across account periods.
  • Indefinite life: Cost is not amortized, but tested for impairment annually.

Amortization expense

The value is usually calculated by the straight-line method, similar to depreciation but without RVRV:

Amortization expense=CUL\text{Amortization expense} = \frac{\text{C}}{\text{UL}}

Impairment and impairment loss

Impairment is the reduction of an asset's value.

Impairment loss=Carrying value−Fair value\text{Impairment loss} = \text{Carrying value} - \text{Fair value}

Sales revenue & Bad debt expenses

Net sales revenue

When considering the net sales revenue, we need to recognize some of the following deductions. They are not expenses, but a contra revenue of credit sales revenue.

The following are three common contra accounts of sales revenue. When they occur, we debit the contra revenue account and credit sales revenue.

These discounts should not include the capitalized costs.

Credit card discount

When paying with a credit card, the merchant will be charged a fee by the credit card company. This fee is typically a percentage of the transaction amount.

Sales discounts

Discounts given to customers for early payment, called a early repayment incentive. For the following terms:

2/10,n/30  ⟹  2% discount if paid within 10 days, otherwise net due in 30 days2/10, n/30 \implies \text{2\% discount if paid within 10 days, otherwise net due in 30 days}

Sales returns and allowances

Discounts given to customers for price discounts, or the total sales price of the returned goods.

Presenting in income statement

We simply present as a contra revenue of sales revenue.

Sales revenue$1000
Sales returns and allowances(100)
Sales discounts(50)
Credit card discount(20)
Net sales revenue$830

Bad debts

To keep track of each customer's account receivables, we usually assign an individual account for each customer (a subsidiary account).

Bad debts result from credit customers who will not pay the amount they owe (accounts receivable), regardless of collection efforts. For example, a customer who is bankrupt.

Account: Bad debt expense

An expense account for the amount of money that is not likely to be paid. There are two methods to do so:

Accounting bad debt expenses

Account: Allowance for doubtful accounts

An contra account for the accounts receivable to estimate the amount of money that will not be paid.

Credit sales

Credit sales are sales revenue that debit accounts receivable (credit sales is not an account).

Write-offs & estimating bad debt expense

We record an estimatedbad debt expense at the end of the period of the credit sales as an adjusting entry.

During the next period, we write-off the bad debt expense of the previous period, when we have confirmed that the customer will not pay, by deducting from accounts receivable to allowance for doubtful accounts.

A write-off has no effects on the net income, as it is already recorded as an expense in the previous period.

  • End of period of sales: Allowance (Cr) →\rightarrow Bad debt expense (Dr)
  • Next period write-offs (confirmed bad debts): Accounts receivable (Cr) →\rightarrow Allowance (Dr)

Recoveries

When a customer who has a bad debt previously pays, we simply revert the write-off entry:

DateAccountDebitCredit
Dec 31, 2023Cash12
Allowance for doubtful accounts12

Estimating bad debt expenses

Estimate bad debt by Percentage of sales

Bad debt expense adjustment = Credit sales revenue (minus returns and allowances) ×\times Historial loss rate

Estimate bad debt by Aging method

We estimate the ending balance of the allowance by the age of receivables, and calculate the adjustment by finding the difference between the allowance's current balance (beg. bal. of allowance - write-offs) and the ending balance.

Age of receivableAmountEstimated loss rateEstimated loss
0-30 days$10001%$10
31-60 days$20002%$40
61-90 days$15003%$45
Estimated ending bal. of allowances$95
Balance of allowance($5)
Bad debt expense adjustment$90

Estimate bad debt by Percentage of receivables

Estimated ending balance of allowance == Accounts receivables balance ×\times rate of loss

Presenting in income statement

We present the allowance of doubtful accounts as a contra asset of accounts receivable.

Accounts receivable$1000
Allowance for doubtful accounts(10)
Net realizable value$990
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