Adjusting entries and their purpose
An adjusting entry is an entry that brings the balance of an account up-to-date to find the correct balance and correct information at the end of an accounting period.
Before explaining adjusting entries, let us know about accounting adjustments, why we need adjustments, and the effects of accounting adjustments.
The main object of maintaining the Accounts of a business is to ascertain the net results after a certain period, usually at the end of a trading period. For this purpose, the businessman prepares “Final Accounts” i.e. Trading Account, Profit & Loss Account and Balance Sheet. we prepare Final Accounts straight away with the amounts given in Trial Balance. But, in practical Trial Balance does not provide true and complete financial information because some transactions are needed to be adjusted to arrive at the true profit. Before making adjustments it is better to understand first that what are the adjustments? Why adjustments are needed?
An adjustment means to make a correct record of a transaction which has not been recorded or which has been entered but in an incomplete or wrong way. If the final Accounts are to be prepared correctly, these must be dealt with properly. The recording of such transactions in the books is known as making the adjustments at the end of the trading period.
It is possible that some transactions are missed from the records and some are not recorded properly. These transactions must be properly dealt with before the preparation of financial statements. The recording of such transactions in the books is known as adjustments. An adjustment can also be defined as to make a correct record of a transaction that has not been entered or which has been recorded only in an incomplete or wrong way.
Why Adjustments are needed?
Application of Matching Concept and Realization Concept
According to “Matching Concept” the revenue of the current year must be matched against all the expenses of the current year which have been incurred to produce such revenue. According to “Realization Concept” all revenues earned during the current year are recognized as revenue of the current year whether cash has been received or not. Similarly, all expenses incurred during the current year are recognized as expenses of the current year whether cash has been paid or not.
Therefore, it is considered essential that only those items of expenses, losses, incomes and gains should be included in Trading and Profit and Loss Account which relate to the current accounting period. Because there may be expense or income in the Trial Balance, part of which relates to the next year or there may be outstanding expenses or unearned income are not disclosed in the Trial Balance. If final accounts are prepared without considering these items the trading results i.e. Gross Profit and Net Profit will be wrong and accounts thus prepared will not serve any useful purpose.
Therefore, it is necessary to find out the transactions relating to the current accounting period which have not been recorded so far or which have been entered but in incomplete or in a wrong way. They must be properly recorded before the preparation of final accounts.
Effect of Adjustments
Students should carefully note that every adjustment has at least two effects due to double entry. An adjustment may affect Trading Account and Profit and Loss Account or it may affect Trading Account and Balance Sheet or it may affect Profit and Loss Account and Balance Sheet Or it may affect both sides of Balance Sheet. These adjustments are made by passing “Adjusting Entries”.
Explanation of Adjusting Entries
It is a normal to make entries in the accounting records on cash basis (revenues and expenses actually received and paid). However, there is a need to formulates accounting transactions based on accrual convention. The accrual convention demands that the right to receive cash and the obligation to pay cash to be accounted for. This necessitates the adjusting entries to be passed through general journal. In addition, there is a need to account for reserves and provisions, losses on assets, incomes on liabilities, interest on owner’s equity, interest on drawings, etc., and most importantly the closing stock (ascertained after closing the books of accounts for the year/period).
It has already been mentioned that it is essential to update and correct the accounting records to find the correct and true profit or loss of the business. The process of updating and correction is done through some journal entries that ate made at the end of an accounting year, Thus the entries which are made at the end of the accounting year to update and correct the accounting records are called adjusting entries.
Objectives/purpose of adjusting entries:
Following are the main objectives of adjusting entries:
- To show a fair record of all expenditures and all revenues relating to the period whether such expenditure has been actually paid or not and whether such income has been received or not.
- To correct the errors if found so that the result disclosed by the financial statements may be as reliable as possible.
Kinds of adjusting entries:
The number and variety of adjustments necessary at the end of an accounting period vary with the nature of the business. The most common adjustments related to expense and revenue are as follows:
- Closing stock
- Outstanding expenses
- Accrued income
- Prepaid expense
- Income received in advance
- Provision for bad and doubtful debts
- Recovery of bad debts
- Provision for discount on debtors
- Provision for discount on creditors
- Interest on capital
- Interest on drawings