Debits near the door, credits by the window
As this column is targeted at students of the Offshore Diploma, I thought that perhaps it was time to say something about the compulsory accounts question that candidates will encounter in the Diploma 3 examination. In my experience, the majority of people studying this module come to the face-to-face course with a sense of dread, and unless they can be enlightened fairly quickly, will throw away valuable marks in the exam.
Remember that the debit column will consist of both “assets” and “expenses”
Most questions start by setting out the trial balance of a company as at the financial year end. Candidates are then asked to make some year-end adjustments. To move to the next step, it is vital that there is a clear understanding of which items in the trial balance are destined for the profit and loss account (P&L) or the balance sheet (BS). The table below may assist.
A company’s trial balance
Assets - Things owned at the year end
Liabilities - Things owed at the year end
Fixed assets - Real estate, plant and machinery, etc
Long-term liabilities - Bonds, loan capital
Investments - Shares, bonds, deposits, etc
Current liabilities - Creditors
Current assets - Cash at bank, debtors, stock, etc
Share capital and reserves
Expenses incurred during the year - Rents, salaries, fees, bank charge, etc
Income earned during the year - Interest, dividends, rents, royalties, etc
We used to say that debits (on the left) were nearest to the door and credits (on the right) nearest to the window, which is nonsense, of course, as it depends which way you are facing. However, it is important to remember that the debit column will consist of both ‘assets’ (things the company ‘owned’ at the year end, which sit on the BS) and ‘expenses’ (categories of expenditure incurred during the whole year, which will appear in the P&L). Similarly, the credit column will consist of both ‘liabilities’ (things the company ‘owed’ at the year end, which will go on the BS) and ‘income’ (categories of earnings during the whole year, which will appear in the P&L account). The challenge, therefore, is to be certain that you know which is which.
Having got over the first hurdle, the exam question often asks you to make some year-end adjustments that are not yet recorded in the trial balance. One of the requirements of prudent accounting is to ensure that the accounts show a ‘true and fair’ view of the company’s financial situation. The accounts as they stand at the moment (as reflected in the trial balance) may be mathematically correct and complete in that they reflect everything that has passed through the bank accounts and financial records of the company during the year.
However, there may be some expenses incurred (perhaps in the days or weeks prior to the year end) for which no invoice has yet been received. To ignore these costs would be to understate the expenses for the year just ended and overstate the profit by the same amount. Clearly, an adjustment has to be made. Every such year-end adjustment will affect both the P&L and the BS. Thus, if the adjustment was for legal fees of GBP5,000, the double entry to be made would be:
- Debit: legal fees GBP5,000 (increase the charge for the year as shown in the P&L)
- Credit: creditors GBP5,000 (increase the amount which is owed to creditors at the year-end as shown on the BS).
It often happens as the company’s annual insurance premiums have been paid in advance covering a period after the year end. Again, with a view to correctly allocating costs to the right financial year, we have to make an adjustment. Suppose the company’s financial year end is 31 December and we are told that the annual premiums of GBP6,000 are for the year ending 31 May (next year). In this case five-twelfths (GBP2,500) is in respect of the following year and must be excluded. The double entry is therefore:
- Credit: insurance GBP2,500 (reduce the charge for the year as shown in the P&L)
- Debit: debtors and prepayments GBP2,500 (increase the amount owed to the company at the year end, as shown on the BS).
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