15 Adjustment Entries
Dr SS Narta
LEARNING OBJECTIVES:
After studying the module students may be able to understand what is an adjustment entry and main items that need to be adjusted in the books of accounts along with a hypothetical example. Also need for passing adjustment entries is also highlighted.
INTRODUCTION:
The main objective behind preparing the final statements is to judge the financial strength of any enterprise. An organisation maintains a proper record of the transactions being carried out throughout the year not due to the compulsion of the law, but in order to get an overview of the entire working of the business and find out the amount of profits earned and the amount of losses incurred. In order to satisfy the above mentioned objectives a set of statements including the trading and profit and loss account and the balance sheet are prepared, collectively known as final accounts. Preparing final accounts is the last step in the entire accounting cycle, which gives a conclusive and important overview of the working of the business throughout the accounting year.
The preparation of the accounts is not error free, but certainly includes some sort of error either due to human mistakes or due to some technical fault in recording. The error may be in the form of either partially omitting any entry or error in updating certain revenue and expense accounts. It is certainly not possible to re-prepare the entire line of accounts right from the very beginning, so in order to rectify the mistakes certain adjustment entries are passed at the end of the accounts to update certain revenue and expense accounts.
MEANING OF ADJUSTMENT ENTRIES:
As the name suggest, adjustment entries (also known as correcting entries) means entries passed in order to adjust some unadjusted accounts. These are the journal entries passed/ prepared at the end of accounting year, in order to meet up the matching principle of accounting. The matching principle of accounting states that there should be a match between the expenses and the revenues in one accounting year. In simple terms it means that the expenses incurred need to be matched up to the same accounting period in which the revenue was earned by paying those expenses.
Adjustment entries are an important part for every organisation, as passing the adjustment entries at the end will ensure that the matching concept has been followed properly, and that the true and a fair image of the organisation is being highlighted.
The main types of accounts that need to be adjusted are:
- Prepaid expenses: these include the sum of expenses already paid for by the company and that the benefit will be availed in the later stages to come. Example: an insurance amount paid at the starting of accounting year, and the benefits will be availed in the later stages to come.
- Unearned revenues: also known as income received in advance. It means that the said revenues are not earned in the same accounting year, but still has been received. Simply it means that the company have received the income in advance but they have not rendered the services for the same. Example: a company has received the payment for delivering the goods at customer’s shop but have still not delivered the goods.
- Accrued/ Outstanding expenses: these are the expenses that have not been paid yet by the company. These are due to be paid, but not yet paid. That means the payment has not been made by the company. Example: a business firm pays Rs 60000 per annum to an employee. But during the year only 58000 have been paid, this means that Rs 2000 (60000- 58000) are considered as not paid/ outstanding on the part of the company.
- Accrued Income: this is that portion of the net income that have been earned but not yet received by the company. It means that the income was due to be received but still it has not been received. Example: if the business has invested Rs 30000 @ 5%. The interest earned is Rs 1500. And if only Rs 1000 has been receives, so the remaining amount of Rs 500 will be termed as accrued income.
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ADJUSTMENTS:
Adjustments are made in the accounts at the end so as to satisfy the matching concept and passing adjustment entries is an important part for every organisation. Organisations while preparing trading and profit and loss account pass adjustment entries for some of the items, and ensure that the expenses actually paid and the income actually earned are recorded in the accounts. And that the entries in order to adjust the unearned revenue or prepaid expenses are passed well in advance.
Trading account is prepared in order to find out the gross margin/ profit or loss earned or incurred while trading in the market. The net result of the trading account is the gross profit or gross loss. Profit and loss account is prepared in order to find out the net profit/ loss of the business. The result is either net profit or net loss.
Following are some of the important items, explained in detail which needs to be adjusted:
1) CLOSING STOCK:
Closing stock means the stock that is not sold during the year and remains as a left over portion with the business after the end of the accounting year. Stock is always valued at realisable value or cost, whichever is less.
Adjustment Entry: Stock A/C….Dr.
To Trading A/C Effect: closing stock will be recorded on the credit side of trading account and on the asset side of balance sheet.
2) PREPAID EXPENSES:
These are the expenses paid in advance before they become due to be paid. It means that the benefit of the services for whom payment have been made, will be availed in future. Example: XYZ Ltd had paid the insurance premium on Dec 31, 2014 which will expire on 30 April, 2015.
Adjustment Entry: Prepaid Insurance premium A/C….Dr.
To Insurance Premium A/C
Effect: will be deducted from the expenses, and shown in the profit and loss account. And will be recorded on the asset side of balance sheet.
3) ACCRUED INCOME:
Is the amount which have been already earned but not received by the yet. Example: amount of rent not yet received by the business which was expected to be received earlier is termed as accrued income.
Adjustment Entry: Accrued Interest A/C….Dr.
To Interest A/C
Effect: accrued interest will be added to the income and shown on the credit side of the profit and loss A/C, and on the asset side of the balance sheet.
4) DEPRECIATION:
It refers to the reduction in the value of asset (fixed) with time due to normal wear and tear or obsolescence. Depreciation is charged at some percent on the value of asset and is charged on the profit of that year. This helps in showing true financial position and depicting its true value in the balance sheet.
Adjustment Entry: Depreciation A/C…..Dr.
To Machinery A/C
Effect: depreciation is recorded on the debit side of P&L A/C. The asset side of balance sheet will hold the depreciation amount after being deducted from the amount of machinery.
5) BAD DEBTS:
The amount of debt which is not repaid by the debtors or which remain unrecovered in spite of the collection efforts are termed as bad debts. They are important to be adjusted in order to find the exact amount of sundry debtors.
Adjustment Entry: Bad Debts A/C……Dr.
To Sundry Debtors
Effect: bad debts will be written on the debit side of profit and loss account and on the asset side of balance sheet.
6) PROVISION FOR DOUBTFUL DEBTS:
Doubtful debts are those on which the company is doubtful, that whether the amount due will be paid or not. For such types of debts, a provision is created on the basis of conservatism approach i.e. one must anticipate the losses and not the profits. Provision for doubtful debts is created in terms of percentage keeping in mind the past experience.
Adjustment Entry: Profit and Loss A/C….Dr.
To Provision for Doubtful Debts A/C
Effect: it will be added in the amount of bad debts on the debit side of Profit and Loss Account and will be deducted from sundry debtors, on the asset side of balance sheet.
7) OUTSTANDING EXPENSES:
An expense is considered as outstanding if the amount of expense is not paid before the date it was supposed to be paid. So in order to highlight the fact, adjustment entry is supposed to be passed at the year end.
Adjustment Entry: Expense A/C…..Dr.
To Outstanding Expense A/C
Effect: it will be shown on the liability side of the balance sheet and debit side of trading or profit and loss account.
8) PROVISION FOR DISCOUNT ON DEBTORS:
If the sales are made on credit basis, then in order to get the early payments from the debtors, merchants declare of giving discounts to the debtors. This is known as provision for discount on debtors.
Adjustment Entry: Profit & Loss A/C…..Dr.
To provision for discount on debtors A/C
Effect: It will be presented on the debit side of profit and loss account. It will also be shown on the asset side of balance sheet by deducting it from the sundry debtors.
9) RESERVE FOR DISCOUNT ON CREDITORS:
Creditors arise when the transaction is done on credit basis, i.e. when the business purchases the goods and does not pay right away, instead promise to pay in the later date. And the creditors in order to speed up the collection from the business declares a discount if the payment is done within specific period. Such a discount on creditors in anticipated profits for the business and
adjustment entry need to be passed for the same.
Adjustment Entry: Reserve for discount on creditors A/C……Dr.
To Profit & Loss A/C
Effect: in the profit and loss account, it is shown on the credit side and in the balance sheet it is subtracted from sundry debtors on the liabilities side.
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PRACTICLE EXAMPLE:
A hypothetical trial balance of ABC Ltd as on April 30, 2014 is given under. With the help of which, trading and profit and loss account will be prepared, followed by the balance sheet.
TRIAL BALANCE
Additional Information:
- Stock on April 30 2014: Rs 78700
- 50% printing is to be carried forward as a charge
- Rate of depreciation on furniture @ 10%
- 5% provision on doubtful debts
- 2% for discount on debtors and creditors
- Prepaid insurance Rs 300
- Salaries outstanding Rs 600
- Carriage outstanding Rs 200
- Full year interest on deposit is charged on deposit with Mr X
SOLUTION:
Trading and Profit & Loss Account for the year ended April 30, 2014
Balance Sheet as on April 30, 2014
The above example explains the adjustments made on some of the important items such as bad debts, outstanding expenses etc. These are not the only items to be adjusted. The rest of the items that need adjustment are discussed below:
1) DEFERRED REVENUE EXPENDITURE:
It is that type of expenditure which is incurred only during the starting period, for some time and whose benefit is availed in the longer period. The entire amount cannot be written off all together, therefore it is written off in each year. Example: expenditure on radio expenditure is Rs 20000, which is spread over a period of 5 years. So the amount to be written off each year would be Rs 4000.
Adjustment Entry: Profit and Loss A/C……Dr. 4000
To advertisement A/C Dr. 4000
Effect: it is shown on the debit side of profit and loss account and on the asset side of balance sheet after deducting from capitalised expenditure.
2) RESERVE FUND:
It is the fund created out of the profit and is set aside for meeting any kind of future contingencies. A portion of the profit is set aside every year to be transferred to the reserve fund account.
Adjustment Entry: Profit and Loss A/C…..Dr.
To Reserve fund A/C
Effect: reserve fund is shown on the debit side of profit and loss account and on the liabilities side of balance sheet. In case reserve fund already exists in the balance sheet, then the amount will be added to the already existing amount.
3) HIDDEN ADJUSTMENTS:
Sometimes there are items present in the trial balance and need to be adjusted although there is no additional given. Example: In trial balance there are following balances:
Dr Cr
6% loan 20000
Interest on loan 800
The interest on loan @ 6% is Rs 1200 (20000*6%). But only Rs 800 have been paid, it is clear that Rs 400 (1200- 800) is considered as an outstanding loan.
Adjustment Entry: Interest on loan A/C……Dr. 400
To loan A/C 400
Effect: outstanding interest will be shown on the debit side of P&L A/C, whereas on the liabilities side of the balance sheet.
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NEED FOR PASSING ADJUSTMENT ENTRIES:
1) These entries are passed so as to depict the correct net profit and net loss in the profit and loss account.
2) To depict the true financial position of the business.
3) To match up the expenses paid with the revenue earned by paying such expenses in the same accounting period.
4) To find out the actual amount payable to the outsider as well as the correct expenses incurred.
SUMMARY:
Final accounts are prepared at the end of accounting period with the main aim of presenting a true and a fair picture of the business. And this true and fair picture will be depicted only when the business maintains the accounts fairly by passing the entries accordingly. Business tries to keep a balance between the revenues and the expenses and ensures that the matching principle is met properly. For this certain adjustment entries need to be passed at the end of the accounting period to depict a correct picture of the business.
Adjustment entries means entries passed in order to adjust some unadjusted items. Adjustment entries are essential to be passed by the business so as to find out the correct amount of expenses incurred against the amount of revenue generated falling under the same accounting period. Mainly adjustments are made for adjusting the prepaid expenses, accrued incomes, unearned revenues and outstanding expenses. Apart from these there are many more items which need to be adjusted by the business house such as reserve fund, deferred revenue expenditure, bad debts, depreciation, provision for discount on debtors and creditors, interest on drawings and capital etc.
Passing adjusting entries is a vital part in the entire accounting cycle and cannot be ignored by the business, as by ignoring the process of passing adjustment entries the true and fair image of the business will not be presented and also the matching concept of accounting will be violated.
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QUADRANT III
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