Need for Adjustments in Final Accounts

The preparation of a Trial Balance confirms the arithmetical accuracy of the ledger, but it is merely a starting point for preparing the final accounts. The Trial Balance is a list of balances as they stand on a particular day, based on transactions that have been recorded. However, to present a true and fair view of a business's financial performance and position, we must adhere to the accrual concept of accounting and the matching principle.

The Accrual and Matching Principles

The accrual concept dictates that revenues should be recognized when they are earned (regardless of when cash is received) and expenses should be recognized when they are incurred (regardless of when cash is paid). The matching principle is a direct consequence of this, stating that the expenses incurred in an accounting period should be matched against the revenues earned in the same period to determine the correct profit or loss.

Business operations are continuous and do not stop neatly at the end of an accounting year. This creates situations where a single transaction can span two or more accounting periods. Without adjusting for these overlaps, the financial statements would be misleading. Therefore, adjusting entries are required at the end of the accounting period to account for all such items.

Common Items Requiring Adjustment

The need for adjustments typically arises from the following categories of items:

1. Outstanding Expenses

These are expenses that have been incurred during the current accounting period but have not yet been paid. To adhere to the matching principle, these expenses must be recognized in the current year. They represent a current liability for the business.

Adjusting Journal Entry:

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2. Prepaid Expenses (Unexpired Expenses)

These are expenses that have been paid in advance during the current period, but the benefit of which will extend to the next accounting period. The portion of the expense whose benefit is yet to be received is not an expense of the current year; it is a current asset.

Adjusting Journal Entry:

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3. Accrued Incomes (Incomes Earned but not Received)

These are incomes that have been earned during the current accounting period but have not yet been received in cash. According to the accrual concept, this income must be recognized in the current year. It represents a current asset for the business.

Adjusting Journal Entry:

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4. Incomes Received in Advance (Unearned Incomes)

These are incomes that have been received in cash during the current period but have not yet been earned. This represents a liability for the business, as it has an obligation to provide goods or services in the future to justify this income.

Adjusting Journal Entry:

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Adjustments for Non-Cash and Other Items

Besides the above, certain items are not recorded in the day-to-day course of business and must be accounted for at the end of the year through adjustments:

• Closing Stock: The value of unsold goods at the year-end.

• Depreciation: The non-cash expense representing the wear and tear of fixed assets.

• Bad Debts and Provisions: Writing off irrecoverable debts and creating provisions for potential future bad debts (Provision for Doubtful Debts) and for discounts to be allowed on debtors (Provision for Discount on Debtors).

• Interest on Capital: An internal transaction to measure the true profitability of the business by treating the proprietor's capital as an investment.

• Manager's Commission: Commission payable to the manager on the year's profit.

The Dual Effect of Adjustments

A crucial rule to remember is that every adjustment has a dual effect and must be reflected in two places in the final accounts to complete the double entry. This is because adjustment entries are passed in the journal and affect two accounts.

By making these adjustments, the financial statements are transformed from a simple summary of recorded transactions into a comprehensive report that provides a true and fair view of the financial performance and position of the business.

Adjustment for Closing Stock

Meaning and Purpose

Closing Stock (or Closing Inventory) represents the value of goods that a business has purchased or manufactured for the purpose of resale but which remain unsold at the end of the accounting period. It is a fundamental adjustment required to correctly calculate the profit for the current period and to accurately present the financial position.

The primary reason it is treated as an adjustment is that its value is typically ascertained only by a physical stock-taking or count conducted on the last day of the accounting period, which is usually after the trial balance has been prepared. Therefore, it does not appear in the trial balance itself.

Valuation Principle

The valuation of closing stock follows the principle of conservatism (prudence), which states that it should be valued at cost or net realisable value (NRV), whichever is lower. This ensures that potential losses from a fall in value are anticipated, but potential gains are not.

• Cost: The purchase price of the inventory plus any direct costs incurred to bring it to its present location and condition (e.g., freight inwards, customs duty).
• Net Realisable Value (NRV): The estimated selling price in the normal course of business, less the estimated costs necessary to make the sale (e.g., selling commission, packaging).

Adjusting Journal Entry

To incorporate the value of closing stock into the books of accounts at the end of the year, the following adjusting journal entry is passed. This entry creates an asset account for the stock and adjusts the trading account.

Treatment in Final Accounts

As with all adjustments given outside the trial balance, the closing stock has a dual effect and appears in two places in the final accounts:

1. In the Trading Account: The closing stock is shown on the credit side of the Trading Account.

   • Important: Its placement here does not mean it is an income. Its purpose is purely to adjust the expenses. The debit side of the Trading Account contains the total cost of goods available for sale (Opening Stock + Net Purchases + Direct Expenses). By crediting the Closing Stock, we effectively subtract the cost of unsold goods from the cost of goods available for sale. The resulting figure on the debit side represents the true Cost of Goods Sold (COGS) for the period.

     $COGS = (Opening\ Stock + Net\ Purchases + Direct\ Expenses) - Closing\ Stock$

2. In the Balance Sheet: The closing stock is shown on the assets side under the head 'Current Assets'.

   • This is because the unsold stock is an economic resource owned by the business, which is expected to be sold and converted into cash in the next accounting period. This same closing stock figure becomes the Opening Stock for the subsequent year.

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Special Case: Closing Stock appearing inside the Trial Balance

Occasionally, the closing stock may appear inside the trial balance. This indicates that the adjusting entry has already been passed before the trial balance was prepared, usually by adjusting it against the purchases account (the entry passed would be: $Closing\ Stock\ A/c\ Dr.\ To\ Purchases\ A/c$). The 'Purchases' account in the trial balance is then referred to as 'Adjusted Purchases'.

In such a rare scenario, the treatment is different because the dual effect has already been partially completed:

• The Closing Stock will NOT be shown on the credit side of the Trading Account, as its effect has already been incorporated into the 'Adjusted Purchases' figure appearing on the debit side.

• It will be shown ONLY on the Assets side of the Balance Sheet.

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Adjustment for Outstanding Expenses

Meaning and Principle

Outstanding Expenses, also known as accrued expenses or expenses due but not paid, are costs that have been incurred by the business during the current accounting period but for which payment has not been made by the end of that period. The benefit of these services or goods has already been received by the business.

The accrual concept and the matching principle of accounting mandate that all expenses related to the current year's revenue must be accounted for in the same year, regardless of when the cash is actually paid. For example, if salaries for the month of March are paid in April, the salary expense for March still belongs to the financial year ending on March 31st. Ignoring this unpaid amount would understate the expenses and overstate the profit for the current year, leading to a misleading financial picture.

Adjusting Journal Entry

To bring these unpaid expenses into the books of accounts and to recognize the corresponding liability, the following adjusting journal entry is passed at the end of the accounting period:

Logic of the Entry:

• The Concerned Expense Account is debited to increase its balance, ensuring that the total expense recognized for the period is the true amount incurred, not just the amount paid.

• The Outstanding Expense Account is credited. This is a new liability account (a personal account representing the person/entity to whom the amount is owed) that acknowledges the business's obligation to pay this amount in the future.

Treatment in Final Accounts

This adjusting entry has a dual effect on the financial statements:

1. In the Trading and Profit and Loss Account: The amount of the outstanding expense is added to the respective expense account on the debit side.

   • If the expense is a direct expense (e.g., Wages), it is added to Wages on the debit side of the Trading Account.

   • If the expense is an indirect expense (e.g., Salary, Rent), it is added to that expense on the debit side of the Profit and Loss Account.

2. In the Balance Sheet: The 'Outstanding Expense' account represents a debt owed by the business. It is therefore shown on the liabilities side under the head 'Current Liabilities'.

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Special Case: Outstanding Expense appearing inside the Trial Balance

If an item like 'Outstanding Salaries' appears inside the trial balance, it signifies that the adjusting entry has already been passed before the trial balance was prepared. The debit aspect of the entry has already increased the balance of the Salaries account, and the credit aspect has created the Outstanding Salaries account.

In this situation:

• The 'Salaries' account in the trial balance already reflects the total expense for the year (paid + outstanding).

• Therefore, no further adjustment is needed in the Profit and Loss Account. The salaries figure from the trial balance is taken directly.

• The 'Outstanding Salaries' amount from the trial balance is shown ONLY on the liabilities side of the Balance Sheet.

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Adjustment for Prepaid Expenses

Meaning and Principle

Prepaid Expenses, also known as unexpired expenses or expenses paid in advance, are costs that have been paid in cash during the current accounting period, but the benefit of which has not yet been fully received. A portion of the benefit will be received in the next accounting year.

According to the matching principle, only those expenses that relate to the revenue earned in the current period should be charged to the Profit and Loss Account of the current year. The portion of the expense whose benefit relates to a future period is not an expense of the current year. Instead, it represents a right to receive a future economic benefit (e.g., the right to occupy a rented premise in the future) and is, therefore, treated as a current asset.

For example, if an annual insurance premium is paid on October 1st, and the accounting year ends on March 31st, the premium for the first six months (Oct-Mar) is an expense for the current year, while the premium for the next six months (Apr-Sep) is a prepaid expense for the next year.

Adjusting Journal Entry

To defer the unexpired portion of the expense to the next accounting period, the following adjusting journal entry is passed at the end of the year:

Logic of the Entry:

• The Prepaid Expense Account is debited. This creates a new asset account that will be shown in the Balance Sheet.

• The Concerned Expense Account is credited. This reduces the balance of the expense account, so that only the amount pertaining to the current year is left to be transferred to the Profit and Loss Account.

Treatment in Final Accounts

This adjusting entry has a dual effect on the financial statements:

1. In the Trading and Profit and Loss Account: The amount of the prepaid expense is deducted from the total amount paid for that expense on the debit side.

2. In the Balance Sheet: The 'Prepaid Expense' account represents an asset. It is therefore shown on the assets side under the head 'Current Assets'.

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Special Case: Prepaid Expense appearing inside the Trial Balance

If an item like 'Prepaid Insurance' appears inside the trial balance, it signifies that the adjusting entry has already been passed before the trial balance was prepared.

In this situation:

• The 'Insurance' account in the trial balance already reflects only the expense for the current year (as the prepaid portion has been removed).

• Therefore, no adjustment is needed in the Profit and Loss Account. The insurance figure from the trial balance is taken directly.

• The 'Prepaid Insurance' amount from the trial balance is shown ONLY on the assets side of the Balance Sheet.

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Adjustment for Accrued Income

Meaning and Principle

Accrued Income, also known as income earned but not received or outstanding income, is revenue that the business has earned by providing goods or services during the current accounting period, but for which the cash has not yet been received by the end of that period.

The accrual concept of accounting dictates that revenue should be recognized when it is earned, not when the cash is received. Therefore, even though the money has not been collected, this income rightfully belongs to the current period and must be included in the financial statements to ascertain the true profit and present an accurate financial position. Ignoring accrued income would understate the revenue and profit for the current year, as well as understate the assets of the business.

Adjusting Journal Entry

To recognize the income that has been earned but is yet to be received, the following adjusting journal entry is passed at the end of the accounting period:

Logic of the Entry:

• The Accrued Income Account is debited. This creates a new asset account (representing a receivable) that will be shown in the Balance Sheet.

• The Concerned Income Account is credited. This increases the balance of the income account, ensuring that the total income recognized for the period is the true amount earned, not just the amount received in cash.

Treatment in Final Accounts

This adjusting entry has a dual effect on the financial statements:

1. In the Profit and Loss Account: The amount of the accrued income is added to the respective income account on the credit side.

2. In the Balance Sheet: The 'Accrued Income' account represents the business's right to receive cash in the future. It is an asset and is therefore shown on the assets side under the head 'Current Assets'.

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Special Case: Accrued Income appearing inside the Trial Balance

If an item like 'Accrued Commission' appears inside the trial balance, it signifies that the adjusting entry has already been passed before the trial balance was prepared.

In this situation:

• The 'Commission Received' account in the trial balance already reflects the total income earned for the year (received + accrued).

• Therefore, no adjustment is needed in the Profit and Loss Account. The commission figure from the trial balance is taken directly.

• The 'Accrued Commission' amount from the trial balance is shown ONLY on the assets side of the Balance Sheet.

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Adjustment for Income Received in Advance

Meaning and Principle

Income Received in Advance, also commonly known as unearned income, refers to cash or other assets received from a customer for goods or services that are yet to be provided by the business. Although the cash has been received in the current accounting period, the income has not yet been earned.

According to the accrual concept and the revenue recognition principle, income should only be recognized in the period in which it is earned, not when the cash is received. Therefore, any amount received that pertains to a future accounting period cannot be treated as income for the current year. Instead, it represents a liability for the business because there is an obligation to either deliver the goods/services in the future or refund the money. Ignoring this adjustment would overstate the income and profit for the current year and understate the liabilities of the business.

Adjusting Journal Entry

To defer the recognition of this unearned income to the next accounting period, the following adjusting journal entry is passed at the end of the year:

Logic of the Entry:

• The Concerned Income Account is debited. When the cash was initially received, the full amount would have been credited to the Income account. This debit entry reduces the balance in the Income account, so that only the amount actually earned in the current period remains.

• The Income Received in Advance Account is credited. This creates a new liability account that will be shown in the Balance Sheet, representing the business's obligation to the customer.

Treatment in Final Accounts

This adjusting entry has a dual effect on the financial statements:

1. In the Profit and Loss Account: The amount of income received in advance is deducted from the total amount of that income shown on the credit side.

2. In the Balance Sheet: The 'Income Received in Advance' account represents an obligation to a third party. It is therefore shown on the liabilities side under the head 'Current Liabilities'.

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Special Case: Income Received in Advance appearing inside the Trial Balance

If an item like 'Rent Received in Advance' appears inside the trial balance, it signifies that the adjusting entry has already been passed before the trial balance was prepared.

In this situation:

• The 'Rent Received' account in the trial balance already reflects only the income earned for the current year.

• Therefore, no adjustment is needed in the Profit and Loss Account. The rent received figure from the trial balance is taken directly.

• The 'Rent Received in Advance' amount from the trial balance is shown ONLY on the liabilities side of the Balance Sheet.

Answer:

Adjustment for Depreciation

Meaning and Principle

Depreciation is the systematic and rational allocation of the cost of a tangible fixed asset over its estimated useful life. It is a non-cash business expense that represents the reduction in the value of an asset due to factors like wear and tear from use, passage of time (effluxion), or technological obsolescence. Fixed assets are used in the business to generate revenue for more than one accounting period. Therefore, according to the matching principle, a portion of the asset's cost must be charged as an expense in each period that benefits from its use.

Depreciation is not recorded on a day-to-day basis; instead, it is calculated and recorded at the end of the accounting period as an adjustment. This ensures that the profit for the period is not overstated (by correctly matching costs with revenues) and the value of the asset on the Balance Sheet is not overstated (by presenting it at its realistic written down value).

Adjusting Journal Entry

There are two methods to record the adjusting entry for depreciation.

Method 1: Depreciation Charged Directly to Asset Account

In this method, the depreciation amount is directly credited to the asset account, reducing its book value.

Method 2: Using a Provision for Depreciation Account

In this method, the asset account remains at its original cost. The depreciation is accumulated in a separate account called 'Provision for Depreciation' or 'Accumulated Depreciation'.

Treatment in Final Accounts

Regardless of the journal entry method used, the treatment in the final accounts is as follows:

1. In the Profit and Loss Account: Depreciation is an indirect, non-cash operating expense. The amount of depreciation for the current year is shown on the debit side of the Profit and Loss Account.

2. In the Balance Sheet: The presentation on the assets side depends on the method used:

   • If Method 1 is used, the depreciation is deducted from the opening book value of the concerned fixed asset. The asset is shown at its closing written down value.

   • If Method 2 is used, the asset is shown at its original cost, and the total accumulated depreciation (from the 'Provision for Depreciation Account') is shown as a deduction from the original cost to arrive at the written down value.

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Special Case: Depreciation appearing inside the Trial Balance

If 'Depreciation' appears as a debit balance inside the trial balance, it means the adjusting entry (debiting Depreciation and crediting the Asset/Provision account) has already been passed. In this situation:

• The Depreciation amount from the trial balance is shown ONLY on the debit side of the Profit and Loss Account.

• It is NOT adjusted again in the Balance Sheet, as the asset's value in the trial balance is already the post-depreciation figure (or the Provision account already has the updated balance).

Answer:

Adjustments for Bad Debts and Provisions on Debtors

When a business sells goods on credit, it creates an asset known as 'Sundry Debtors'. However, there is always a risk that some debtors may fail to pay their dues. The principle of prudence requires that such potential losses be anticipated and accounted for in the same period the related sales were made. This leads to a series of related adjustments to ensure that Sundry Debtors are shown at their estimated net realizable value in the Balance Sheet.

These adjustments must be carried out in a specific, logical sequence: 1. Further Bad Debts → 2. Provision for Doubtful Debts → 3. Provision for Discount on Debtors.

1. Further Bad Debts

Meaning

Sometimes, after the trial balance has been prepared but before the final accounts are finalized, the business receives confirmed information that a specific debtor has become insolvent and the amount due from them is now irrecoverable. These are known as Further Bad Debts or 'bad debts of adjustment'. They are a confirmed loss for the current period and must be written off before calculating any provisions.

Adjusting Entry

Treatment in Final Accounts

1. In the Profit and Loss Account: The amount of further bad debts is added to the existing bad debts (if any, from the trial balance) and the total is shown as an expense on the debit side.

2. In the Balance Sheet: The amount of further bad debts is deducted from the Sundry Debtors figure on the assets side. This is the first and most crucial step in arriving at the book value of debtors.

2. Provision for Doubtful Debts

Meaning

After writing off the confirmed bad debts, there might still be a risk that some of the remaining debtors will default in the future. A business cannot be certain which specific debtors will fail to pay, but based on past experience, it can estimate a certain percentage of its debtors may prove to be uncollectible. To account for this anticipated loss, a Provision for Doubtful Debts (also known as Provision for Bad and Doubtful Debts) is created.

Adjusting Entry

Treatment in Final Accounts

1. In the Profit and Loss Account: The amount debited to the P&L account is the net expense for the year. This is calculated as:
   Amount = (Bad Debts from Trial Balance + Further Bad Debts + New Provision) - Old Provision (from Trial Balance)

2. In the Balance Sheet: The total amount of the new provision is deducted from Sundry Debtors (after deducting further bad debts) on the assets side.

3. Provision for Discount on Debtors

Meaning

To encourage prompt payment from its customers, a business may offer a cash discount. It is prudent to anticipate that some of the 'good' debtors (those expected to pay) will take advantage of this discount in the next period. A Provision for Discount on Debtors is created to account for this future expense that relates to the current year's sales.

Adjusting Entry

Treatment in Final Accounts

This provision is calculated as a percentage of 'good' debtors only. The formula is:

$Good\ Debtors = Sundry\ Debtors - Further\ Bad\ Debts - New\ Provision\ for\ Doubtful\ Debts$

1. In the Profit and Loss Account: The amount of the provision is shown as a separate expense on the debit side. (Similar to the provision for doubtful debts, any existing provision for discount is also adjusted).

2. In the Balance Sheet: The amount of the provision is the final deduction from Sundry Debtors on the assets side to arrive at their net realizable value.

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Other Key Adjustments

Beyond the common adjustments for accruals and prepayments, several other items related to profit distribution and internal business transactions require adjustment at the end of the year to ensure the financial statements are accurate and complete.

1. Manager's Commission

Meaning and Purpose

To incentivize the manager to improve profitability, a business may offer a commission, which is calculated as a percentage of the net profit. This commission is an operating expense for the business and must be accounted for in the same period in which the profit was earned, based on the matching principle. The calculation of this commission can be done in two ways, depending on the agreement.

Calculation

The calculation depends on whether the commission is a percentage of the profit before or after deducting the commission itself.

• Commission on Profit before charging such commission:

  This is a straightforward calculation. The commission is simply the given percentage of the net profit figure arrived at before this commission has been deducted.

  $Commission = (Net\ Profit\ before\ Commission) \times \frac{Rate\ of\ Commission}{100}$

• Commission on Profit after charging such commission:

  This is a more complex calculation. Here, the commission is a percentage of the final profit that remains after the commission itself has been deducted as an expense. The formula is derived as follows:

  $Commission = (Net\ Profit\ before\ Commission - Commission) \times \frac{Rate}{100}$

  Rearranging this formula gives us:

  $Commission = (Net\ Profit\ before\ Commission) \times \frac{Rate}{100 + Rate}$

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Treatment in Final Accounts

1. In the Profit and Loss Account: The calculated commission amount is shown as an indirect expense on the debit side.

2. In the Balance Sheet: The 'Manager's Commission Outstanding' is shown as a current liability on the liabilities side.

2. Interest on Capital

Meaning and Purpose

Based on the Business Entity Concept, the business is considered separate from its owner. The capital contributed by the owner is treated as a form of internal loan to the business. To assess the true profitability of the business operations, interest may be calculated on this capital. Interest on Capital is an expense for the business and an income for the owner. This allows the business to see if it is earning a profit over and above the interest it would have had to pay on borrowed funds.

Adjusting Entry

The interest is an expense for the business and increases the owner's claim (capital) in the business. Therefore, it is debited to an expense account and credited directly to the Capital account.

Treatment in Final Accounts

1. In the Profit and Loss Account: Interest on Capital is a financial expense and is shown on the debit side.

2. In the Balance Sheet: The amount of interest is added to the Capital account on the liabilities side. This is because the interest, being an 'income' for the owner, increases their total equity in the business.

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