An adjusting entry is an entry that brings the balance of an account up to date. Adjusting entries are crucial to ensure the correct balance and correct information in an account at the end of an accounting period.
Before exploring adjusting entries in greater depth, let’s first consider accounting adjustments, why we need adjustments, and what their effects are.
The main objective 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, a business prepares “Final Accounts” (i.e., a Trading Account, Profit & Loss Account, and Balance Sheet). We prepare the Final Accounts straight away with the amounts stated in the Trial Balance.
However, in practice, the Trial Balance does not provide true and complete financial information because some transactions must be adjusted to arrive at the true profit.
Before making adjustments, it is important to understand first what adjustments are and why they are needed.
An adjustment involves making a correct record of a transaction that has not been recorded or that has been entered in an incomplete or wrong way. If the Final Accounts are to be prepared correctly, these must be dealt with properly.
Recording such transactions in the books is known as making adjustments at the end of the trading period.
Some transactions may be missing from the records and others may not have been recorded properly. These transactions must be dealt with properly before preparing financial statements.
The process of recording such transactions in the books is known as making adjustments. An adjustment can also be defined as making a correct record of a transaction that has not been entered, or which has been recorded in an incomplete or incorrect way.
Why Adjustments Are Needed?
Application of Matching Concept and Realization Concept
According to the matching concept, the revenue of the current year must be matched against all the expenses of the current year that were incurred to produce the revenue.
Also, according to the realization concept, all revenues earned during the current year are recognized as revenue for the current year, regardless of whether cash has been received or not.
Similarly, under the realization concept, all expenses incurred during the current year are recognized as expenses of the current year, irrespective of 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 the Trading and Profit and Loss Account relating to the current accounting period.
This is because there may be expense or income items in the Trial Balance, part of which relates to the next year, or there may be outstanding expenses or unearned income that are not disclosed in the Trial Balance.
If the Final Accounts are prepared without considering these items, the trading results (i.e., gross profit and net profit) will be incorrect. In this situation, the accounts thus prepared will not serve any useful purpose.
Therefore, it is necessary to find out the transactions relating to the current accounting period that have not been recorded so far or which have been entered but incompletely or incorrectly. They must be properly recorded before preparing the 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 the Trading Account and Profit and Loss Account or it may affect the Trading Account and Balance Sheet; it may also affect the Profit and Loss Account and Balance Sheet, or it may affect both sides of the Balance Sheet. These adjustments are made by passing adjusting entries.
Explanation of Adjusting Entries
It is normal to make entries in the accounting records on a cash basis (i.e., revenues and expenses actually received and paid). However, there is a need to formulate accounting transactions based on the accrual accounting convention.
The accrual accounting convention demands that the right to receive cash and the obligation to pay cash must be accounted for. This necessitates that adjusting entries are passed through the general journal.
In addition, it is necessary to account for reserves and provisions, losses on assets, incomes on liabilities, interest on owner’s equity, interest on drawings, 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 updating/correcting process is performed through journal entries that are made at the end of an accounting year. Therefore, the entries made that at the end of the accounting year to update and correct the accounting records are called adjusting entries.
Objectives/Purpose of Adjusting Entries
The 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 and whether such income has been received
- To correct errors when identified to increase the reliability of the results disclosed in financial statements
Types of Adjusting Entries
The number and variety of adjustments needed at the end of the accounting period differ depending on the size and nature of the business. The most common adjustments related to expenses and revenues 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