Period-end Adjustments Relating to the Preparation of Financial Statements

Business, Accounting and Financial Studies · Senior Secondary (HKDSE) · 10 min read · Updated: 22 Aug 2026

BAFS Study Notes: Period-end Adjustments

Hey everyone! Welcome to your study guide for one of the most important topics in accounting: Period-end Adjustments. Don't worry if this sounds complicated – it's actually very logical! Think of it like editing a photo before you post it. You take the initial picture (the trial balance), but then you make small adjustments to make sure it's perfect and shows the true situation. That's exactly what we're doing for a business's financial statements.

In this chapter, we'll learn how to make these "edits" to ensure the financial statements are accurate and give a true and fair view of the company's performance and position. Mastering this is key to acing your exams and understanding how accounting really works!

1. The Core Idea: Accrual vs. Cash Accounting

Before we dive into the adjustments, we need to understand the fundamental rule that governs them: the Accrual Concept.

What is Accrual Accounting?

This is the method we use in BAFS. The rule is simple:

• Revenues are recognised when they are earned, not when cash is received.
• Expenses are recognised when they are incurred (used up), not when cash is paid.

Example: You provide tutoring services in December but your client pays you in January. Under accrual accounting, you record that revenue in December (when you earned it).

What is Cash Accounting?

This is simpler but less accurate. It's like managing your own wallet:

• Revenue is recorded only when cash is received.
• Expenses are recorded only when cash is paid.

For preparing proper financial statements, we MUST use Accrual Accounting. This is where the Matching Principle comes in – we must match the expenses incurred in a period with the revenues earned in the same period to calculate the correct profit.

Key Takeaway

Period-end adjustments are the steps we take to convert our day-to-day records into the proper accrual accounting basis, so we can correctly calculate profit.

2. Adjustments for Expenses & Revenues (Prepayments & Accruals)

This is the most common type of adjustment, applying the accrual concept directly.

Accrued Expenses (Expenses Owing)

These are expenses that the business has used/incurred, but hasn't paid for by the end of the accounting period.

Real-World Link: Imagine your company's electricity bill for December arrives in January. You used the electricity in December, so the expense belongs to December, even if you pay later.

Adjusting Entry:
Debit (Dr) The Expense Account (e.g., Electricity Expense)
Credit (Cr) Accrued Expenses (a current liability)

Effect on Financial Statements:
• Income Statement: The expense is increased, so the profit for the period is decreased.
• Statement of Financial Position: A current liability (Accrued Expenses) is created or increased.

Prepaid Expenses (Prepayments)

These are expenses that the business has paid for in advance, but hasn't used up yet.

Real-World Link: Your company pays for a full year of insurance on 1 January. By 31 December, you've used the whole year's worth. But what if you paid it on 1 October? By 31 December, you've only used 3 months, and the other 9 months are an asset – a prepayment!

Adjusting Entry:
Debit (Dr) Prepaid Expenses (a current asset)
Credit (Cr) The Expense Account (e.g., Insurance Expense)

Effect on Financial Statements:
• Income Statement: The expense is decreased, so the profit for the period is increased.
• Statement of Financial Position: A current asset (Prepaid Expenses) is created or increased.

Note: The same logic applies to Accrued Revenues (Dr Accrued Revenues, Cr Revenue) and Revenues Received in Advance (Dr Revenue, Cr Revenues Received in Advance).

3. Adjustments for Trade Receivables: Bad & Doubtful Debts

Sadly, not all customers who buy on credit will pay us back. We need to account for this to avoid overstating our assets (trade receivables) and profit.

Bad Debts

A bad debt is when we are 100% certain that a specific customer will not pay their debt (e.g., they went bankrupt). We need to write it off completely.

Adjusting Entry (To write off the debt):
Debit (Dr) Bad Debts Expense
Credit (Cr) Trade Receivables (to remove the specific customer's balance)

Bad Debts Recovered

If a customer pays after their debt was written off as bad in a previous period:
Debit (Dr) Bank / Cash
Credit (Cr) Bad Debts Recovered (other income in the Income Statement)

Allowance for Doubtful Debts

An allowance for doubtful debts is an estimate of how much of our remaining trade receivables might not be collected. This is an application of the Prudence Concept – we don't want to overstate receivables.

This is often calculated as a percentage of ending trade receivables (after deducting bad debts written off) or by using an ageing schedule.

Adjusting Entries:
• To create or increase the allowance:
Debit (Dr) Bad and Doubtful Debts Expense (or Increase in Allowance for Doubtful Debts)
Credit (Cr) Allowance for Doubtful Debts (contra-asset)
• To decrease the allowance:
Debit (Dr) Allowance for Doubtful Debts (contra-asset)
Credit (Cr) Reduction in Allowance for Doubtful Debts / Profit and Loss (other income)

How it appears on the Statement of Financial Position:

Current Assets
   Trade Receivables ..................... $$\$
   Less: Allowance for Doubtful Debts .. ( $$)
      Net Trade Receivables ........... $$$

Quick Review

• Bad Debt: A confirmed, specific uncollectible amount. It's a fact.
• Allowance for Doubtful Debts: An estimated amount for potential future bad debts. It's an estimate.

4. Capital vs. Revenue Expenditure

This is a crucial distinction that affects both the Income Statement and the Statement of Financial Position. Getting this wrong can seriously misstate a company's profit!

Capital Expenditure

This is money spent on:

1. Buying non-current assets (e.g., machinery, vehicles, buildings).
2. Improving or upgrading an existing non-current asset to increase its efficiency or lifespan, or initial setup costs (e.g., installation, carriage inwards on assets, legal fees for property purchase).

Analogy: Buying a new, more powerful engine for a delivery van. This is a capital expenditure. It's recorded as a non-current asset on the Statement of Financial Position.

Revenue Expenditure

This is money spent on:

1. Day-to-day running of the business (e.g., paying salaries, electricity bills).
2. Maintaining an existing non-current asset in its current working condition (e.g., repairs, annual insurance, road tax).

Analogy: Buying petrol for the delivery van or paying for its annual oil change. This is a revenue expenditure. It's recorded as an expense in the Income Statement.

Key Takeaway

Capital Expenditure = Asset.
Revenue Expenditure = Expense.
Mistakenly treating a capital expenditure as a revenue expense will understate your assets and your profit for the year!

5. Depreciation and Disposal of Non-Current Assets

Non-current assets lose value over time as they are used. Depreciation is the systematic process of allocating the cost of a non-current asset as an expense over its useful life. It's an application of the Matching Principle – matching the cost of the asset against the revenue it helps to generate.

Did you know? Depreciation is a non-cash expense. You don't actually pay cash for "depreciation". The cash was paid when the asset was bought. Depreciation is just an accounting allocation.

Key Terms to Know

• Cost: The original purchase price of the asset plus any costs to bring it into working condition.
• Useful Life: The estimated period of time the business expects to use the asset.
• Residual Value (or Scrap Value): The estimated selling price of the asset at the end of its useful life.

Methods of Depreciation

1. Straight-Line Method

This method spreads the cost evenly over the asset's useful life. The depreciation expense is the same every year.

Formula:

$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} $

2. Reducing-Balance Method

This method charges more depreciation in the earlier years and less in the later years. Depreciation is calculated on the asset's Net Book Value (NBV).

Formula:

$ \text{Annual Depreciation} = (\text{Cost} - \text{Accumulated Depreciation}) \times \text{Depreciation Rate \%} $

Remember: Net Book Value (NBV) = Cost - Accumulated Depreciation

3. Depreciation based on Usage (Units of Production)

This method bases depreciation on how much the asset is used, not on the passage of time.

Step 1: Find the depreciation rate per unit.

$ \text{Rate per unit} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Units of Production}} $

Step 2: Calculate the depreciation expense for the year.

$ \text{Depreciation Expense} = \text{Rate per unit} \times \text{Actual Units Produced in the Year} $

Recording Depreciation and Disposal

The annual depreciation charge is recorded with this entry:
Debit (Dr) Depreciation Expense (Income Statement)
Credit (Cr) Accumulated Depreciation (contra-asset account on SFP)

Disposal of Non-Current Assets (Cash Sale & Trade-In)

When an asset is sold or traded in for a new asset, we use a Disposal Account to calculate the net gain or loss:

1. Transfer original cost: Dr Disposal Account, Cr Non-Current Asset Account
2. Transfer accumulated depreciation: Dr Accumulated Depreciation Account, Cr Disposal Account
3. Record disposal proceeds / trade-in allowance:
• For cash/cheque sale: Dr Bank / Cash, Cr Disposal Account
• For trade-in allowance on new asset: Dr New Non-Current Asset Account, Cr Disposal Account
4. Close the Disposal Account:
• If credit side > debit side: Dr Disposal Account, Cr Profit on Disposal (Income Statement)
• If debit side > credit side: Dr Loss on Disposal (Income Statement), Cr Disposal Account

6. Adjustments for Inventory (Stock)

Inventory is a major asset for many businesses. We need to value it correctly at the end of the period.

Valuation Rule: Lower of Cost and Net Realisable Value (NRV)

Under the Prudence Concept, closing inventory must be valued at the lower of its historical cost and its Net Realisable Value (NRV).

What is NRV? It is the estimated selling price minus any estimated costs of completion and costs necessary to make the sale.

Example: You bought a phone case for \$50 (cost). Due to market changes, you can now only sell it for \$40 after paying \$2 delivery costs (NRV = \$38). You must value this inventory item at \$38.

Determining Inventory Cost: FIFO and AVCO

When goods are bought at different prices, HKDSE requires two main cost flow assumptions:

• FIFO (First-In, First-Out): Assumes that the earliest purchased items are sold first. Therefore, closing inventory consists of the most recently purchased goods.
• AVCO (Weighted Average Cost): Calculates a weighted average unit cost for goods available for sale:

$ \text{Weighted Average Cost per unit} = \frac{\text{Total Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}} $

Goods on Sale or Return

If goods are sent to a customer on a "sale or return" basis, they remain our property until the customer confirms acceptance or the time limit expires. At period-end, unconfirmed goods must be included in our closing inventory at cost.

Inventory Loss: Normal vs. Abnormal

• Normal Loss: Unavoidable loss (e.g., natural evaporation). Absorbed into the cost of goods sold.
• Abnormal Loss: Avoidable or accidental loss (e.g., fire, theft). Recorded as an expense in the Income Statement and credited to Purchases/Inventory so it does not distort gross profit.

7. Summary of Adjusting Entries and Their Effects

Here’s a final cheatsheet to bring it all together. All these adjustments ensure the financial statements present a true and fair view!

Accrued Expense
Dr Expense
Cr Accrued Expense (Liability)
IS: Expense ↑, Profit ↓
SFP: Current Liabilities ↑

Prepaid Expense
Dr Prepaid Expense (Asset)
Cr Expense
IS: Expense ↓, Profit ↑
SFP: Current Assets ↑

Accrued Revenue
Dr Accrued Revenue (Asset)
Cr Revenue
IS: Revenue ↑, Profit ↑
SFP: Current Assets ↑

Revenue Received in Advance
Dr Revenue
Cr Revenues Received in Advance (Liability)
IS: Revenue ↓, Profit ↓
SFP: Current Liabilities ↑

Bad Debt Write-off
Dr Bad Debts Expense
Cr Trade Receivables
IS: Expense ↑, Profit ↓
SFP: Current Assets (Trade Receivables) ↓

Increase in Allowance for Doubtful Debts
Dr Bad and Doubtful Debts Expense
Cr Allowance for Doubtful Debts
IS: Expense ↑, Profit ↓
SFP: Net Trade Receivables ↓

Decrease in Allowance for Doubtful Debts
Dr Allowance for Doubtful Debts
Cr Reduction in Allowance for Doubtful Debts (Other Income)
IS: Other Income ↑, Profit ↑
SFP: Net Trade Receivables ↑

Depreciation
Dr Depreciation Expense
Cr Accumulated Depreciation
IS: Expense ↑, Profit ↓
SFP: Net Book Value of Non-Current Assets ↓

Closing Inventory (at Lower of Cost and NRV)
Dr Closing Inventory (SFP)
Cr Closing Inventory (Income Statement / COGS)
IS: Cost of Goods Sold ↓, Gross Profit ↑
SFP: Current Assets (Inventory) ↑

You've got this! Go through each adjustment one by one, understand the logic, and practice the journal entries. Good luck!

References

Business Subjects - Learning and Teaching Resources — Education Bureau (EDB), Hong Kong SAR Government
Circular Memorandum No. 172/2020: Updating of the BAFS C&A Guide — Education Bureau, Hong Kong SAR Government

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What is the fundamental difference between accrual accounting and cash accounting?

Accrual accounting recognises revenues when earned and expenses when incurred, whereas cash accounting only records them when cash is actually received or paid.

What are the adjusting journal entries and financial statement effects for an accrued expense?

Debit Expense, Credit Accrued Expenses (Current Liability). This increases expenses (lowering profit) and increases current liabilities on the Statement of Financial Position.

What are the adjusting journal entries and financial statement effects for a prepaid expense?

Debit Prepaid Expenses (Current Asset), Credit Expense. This decreases expenses (increasing profit) and increases current assets on the Statement of Financial Position.

How is a confirmed bad debt recorded in the books?

Debit Bad Debts Expense and Credit Trade Receivables to write off the specific uncollectible customer balance.

What is the purpose of the Allowance for Doubtful Debts and how is an increase in the allowance recorded?

It provides an estimate for potential future uncollectible debts under the Prudence Concept; an increase is recorded by Debiting Bad and Doubtful Debts Expense and Crediting Allowance for Doubtful Debts.

What is the distinction between capital expenditure and revenue expenditure?

Capital expenditure creates or enhances non-current assets and is shown on the Statement of Financial Position, while revenue expenditure covers day-to-day running or maintenance costs and is expensed in the Income Statement.

How is annual depreciation calculated using the straight-line method versus the reducing-balance method?

Straight-line: $ \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} $; Reducing-balance: $ (\text{Cost} - \text{Accumulated Depreciation}) \times \text{Depreciation Rate \%} $.

What are the steps to record the disposal of a non-current asset using a Disposal Account?

Transfer original cost to Dr Disposal, transfer accumulated depreciation to Cr Disposal, record proceeds to Cr Disposal, and close the remaining balance to Profit or Loss on Disposal.

What is the valuation rule for closing inventory under the prudence concept?

Closing inventory must be valued at the lower of historical cost and Net Realisable Value (NRV), where NRV is the estimated selling price less completion and selling costs.

How are normal inventory losses and abnormal inventory losses treated differently in financial accounting?

Normal losses are absorbed into the cost of goods sold, whereas abnormal losses are removed from purchases/inventory and charged as a separate operating expense in the Income Statement.

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