Why are adjustments important in final accounts?
Businesses rely on their accountants to report accurate information. The owners and managers use this information to make decisions on behalf of the business. The accountant records financial transactions throughout the month as they occur. They receive documentation for each transaction, such as invoices or customer deposits. Sometimes at the end of the month, they also record adjusting entries. Adjusting entries update the financial records for events that have occurred, but no document for a transaction exists.
Adjusting entries bring the account balances current as of the last day of the month. This means that events that have not been documented yet are recorded through these entries. An example of an adjusting entry includes recording wages for the last days of the month for which employees have not been paid yet. Another example would be to record the electricity used through the end of the month even though a bill has not been received.
The idea behind recording adjusting entries lies with the matching concept. The matching concept records the cost of doing business during the same business that the company earns the revenue. The financial records then communicate the activities that occurred rather than the actual money that was transferred. These include providing services for customers and billing them later for the work or receiving inventory and paying for it the following month.
Adjusting entries allow the accountant to communicate a more accurate picture of the company’s finances. The owner can read through the financial statements knowing that everything that occurred during the month is reported even if the financial part of the transaction will occur later. A financial statement prepared without considering adjusting entries would misrepresent the financial health of the company.
Meaning of Adjustments:
Adjustment entries are those entries which need to be passed at the end of the accounting period so that the true profit or loss and fair financial position of the business can be shown. Trial Balance is the base for preparing final accounts of any business enterprise. To see the arithmetical accuracy we record all balances of debits and credits extracted from ledger accounts, including cash book in this statement. There are possibilities that some such items, as were not detected at the time of preparing trial balance, could hence not be shown in the trial balance.
For example, closing stock cannot be estimated during the accounting year and is usually valued after the accounting year is over. Similarly, depreciation is charged on fixed assets at the end of the accounting year. In the same parlance, there are innumerable important items that may not find a place in the trial balance.
As per Generally Accepted Accounting Principles (GAAP), all these items are very important and critical to calculate the actual earnings and thus show assets and liabilities at their true and fair values.
From the above it is clear that these items must be shown in the final accounts of business enterprise because without showing the impact of these items we cannot say that books of accounts show true and fair view of the business enterprise. It is also true that the ultimate impact of these items must show itself in trading and Profit & Loss Account and Balance Sheet.
Now question arises as to how these items can be shown when all the ledger accounts must have been closed. The only option available is to pass adjusting entry for each and every such item in such a manner that the true and ultimate impact on Trading and Profit & Loss Account and Balance Sheet can be shown. Following the double entry system, adjustment entries are to be posted to at least two accounts.
Types Of Adjusting Entries
Adjusting entries are primarily of six types:-
These entries help a business to report all the revenues it earns during the accounting period. There might be a case when a company has already provided a service, but it has not yet got the payment for the same. So, accrual type adjusting entries are shown in the financial statements to account for such revenues.
Just like the accrued income or revenue, a company should only record the expenses that it incurs. A business must report an expense even if it does not pay for it. Take for example; a company hires a worker from on a contract basis. The company is expecting to get an invoice on January 2nd and remit the payment on January 10th. However, the services of the worker were availed in December. Therefore, the company needs to account the expense and liability as of December 31.
Deferred expenses are the payment made in the present for future expenses. One must refer these payments as deferred until the expenses expire or the company avails the service. For example, a company pays $10000 on December 25 towards vehicle insurance for the six-month period starting January 1. This means the insurance is prepaid for a period between December 25th and December 31.
It is in relation to the use of a fixed asset in the business. Examples of fixed assets are machinery, equipment, vehicles, furniture and so on. Usually, a company depreciates an asset at a certain rate that has a useful life for more than one year. Through depreciation, the company allocates the cost of the asset as an expense in the accounting periods in which the company uses the asset. For instance, a machine costing $50000 with no salvage value and useful life of 20 years will result in a monthly depreciation expense of $50000/240 (20*12).
If the company receives any amount as advance before earning, it should mention it as a liability in the current accounting period. For instance, a company gets an advance of $5000 for offering a service that it will offer at a later date. As on December 31st, the company should determine the portion of the service that it has already delivered. This portion will come as income, and the balance will be deferred revenue.
DOUBTFUL ACCOUNTS OR BAD DEBTS
Not all debtors pay their dues. To account for this, the company makes provision for bad debts, and it needs to update the balance regularly to account for more bad debt or bad debt making payment.
Purpose of Adjusting Entries
The main purpose of adjusting entries is to update the accounts to conform with the accrual concept. At the end of the accounting period, some income and expenses may have not been recorded, taken up or updated; hence, there is a need to update the accounts.
If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when reported in the financial statements. For this reason, adjusting entries are necessary.
What are adjusting entries? Why are they necessary for preparing final accounts?
Entries which are given outside the trial balance are called adjustment entries, to record those entries a proper treatment is required according to the double entry system. Here it is to be remembered that all adjustments given outside the Trial Balance are posted at two places. Adjustment is generally done for those items which are omitted or entered with the wrong amount and/or recorded under wrong heads.
The following are reasons for recording or incorporating these adjustment entries in preparation of final account.
- Through these adjustment entries we come to know the actual figure of profit or loss
- Because of these adjusting entries we can assess the true financial position of an organisation based on accrual basis of accounting
- These adjustment entries enable us to records the omitted entries and help in rectifying all those errors.
- These adjusting entries help in providing depreciation and making different provisions, such as Bad Debts and Depreciation.