Why is it necessary to record the adjusting entries in the preparation of final accounts?

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Q. Why is it necessary to record the adjusting entries in the preparation of final accounts?

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Concept understanding — Accrual Basis Accounting

Accrual Basis Accounting – A First Look

Think about a newspaper delivery. You pay for a month's subscription at the start. The newspaper company gets your money on 1st April, but it hasn't earned that money yet — it still has to deliver papers for the next 30 days. The company's profit for April isn't the cash it collected; it's the revenue from the papers actually delivered in April.

That's the core intuition behind accrual accounting: record income when it is earned, not when cash is received; record expenses when they are incurred, not when cash is paid.

The Precise Meaning

Under the accrual basis, transactions are recorded in the books of account at the time they occur, regardless of when the actual cash changes hands.

Revenue is recognised when the goods are sold or services are rendered — even if the customer will pay later.
Expenses are recognised when the benefit is consumed or the liability arises — even if the payment will be made later.

This is the opposite of cash basis accounting, where you record only when cash is received or paid.

Important

The accrual basis is mandatory under the Companies Act, 2013 for all companies, and it is the foundation of the Generally Accepted Accounting Principles (GAAP) followed in India.

Why It Matters

Accrual accounting gives a true and fair view of the business's financial performance and position.

Matching Principle: Expenses are matched with the revenues they help generate in the same period. If you sell goods in March but receive payment in April, the sale belongs to March's profit calculation, not April's.
Realistic Profit: Profit under accrual basis reflects the actual economic activity of the period, not just the timing of cash flows.
Better Decision-Making: Owners, investors, and creditors see what the business has earned and owes, not just what it has in the bank.

Watch out

A common mistake: thinking profit equals cash in hand. Under accrual accounting, a business can show a healthy profit but have very little cash (if most sales are on credit), or show a loss but have plenty of cash (if it collected old debts while making few new sales).

Accounting Treatment – The Journal Entries

Accrual accounting gives rise to two special types of accounts: Outstanding Expenses and Accrued Incomes (also called Prepaid Expenses and Unearned Incomes on the other side).

1. Outstanding Expenses (Expense incurred but not yet paid)

Example: Salary for March is ₹50,000, but it will be paid in April.

Journal Entry (at the end of March):

Date	Particulars	Debit (₹)	Credit (₹)
March 31	Salary A/c Dr.	50,000
	To Outstanding Salary A/c		50,000
	(Being salary for March due but not paid)

Debit: Salary A/c (expense is recorded in the period it belongs to)
Credit: Outstanding Salary A/c (a liability — the business owes this money)

When paid in April:

Date	Particulars	Debit (₹)	Credit (₹)
April 10	Outstanding Salary A/c Dr.	50,000
	To Cash/Bank A/c		50,000
	(Being outstanding salary paid)

2. Accrued Income (Income earned but not yet received)

Example: Commission earned ₹20,000 in March, but will be received in April.

Journal Entry (at the end of March):

Date	Particulars	Debit (₹)	Credit (₹)
March 31	Accrued Commission A/c Dr.	20,000
	To Commission Income A/c		20,000
	(Being commission earned but not received)

Debit: Accrued Commission A/c (an asset — the business is owed this money)
Credit: Commission Income A/c (revenue is recorded in the period it was earned)

When received in April:

Date	Particulars	Debit (₹)	Credit (₹)
April 15	Cash/Bank A/c Dr.	20,000
	To Accrued Commission A/c		20,000
	(Being accrued commission received)

3. Prepaid Expenses (Expense paid in advance)

Example: Insurance premium of ₹12,000 paid on 1st January for the full year.

Journal Entry (at the end of the accounting year, say 31st March):

Only 3 months' insurance (Jan–Mar) has been used. The remaining 9 months' worth (₹9,000) is still an asset.

Date	Particulars	Debit (₹)	Credit (₹)
March 31	Prepaid Insurance A/c Dr.	9,000
	To Insurance A/c		9,000
	(Being insurance prepaid for the remaining period)

Debit: Prepaid Insurance A/c (asset)
Credit: Insurance A/c (reduces the expense to only the consumed portion)

4. Unearned Income (Income received in advance)

Example: Rent received ₹30,000 on 1st March for three months (March, April, May).

Journal Entry (at the end of March):

Only one month's rent (₹10,000) has been earned. The remaining ₹20,000 is a liability.

Date	Particulars	Debit (₹)	Credit (₹)
March 31	Rent Income A/c Dr.	20,000
	To Unearned Rent A/c		20,000
	(Being rent received in advance for April and May)

Debit: Rent Income A/c (reduces the income to only the earned portion)
Credit: Unearned Rent A/c (liability — the business owes the service)

Format in Financial Statements

These accrual adjustments appear in the Profit and Loss Account and the Balance Sheet.

Profit and Loss Account (extract)

Particulars	Amount (₹)	Particulars	Amount (₹)
Expenses:		Incomes:
Salary (including outstanding)	50,000	Commission (including accrued)	20,000
Insurance (after deducting prepaid)	3,000	Rent (after deducting unearned)	10,000

Balance Sheet (extract)

Liabilities	Amount (₹)	Assets	Amount (₹)
Current Liabilities:		Current Assets:
Outstanding Salary	50,000	Accrued Commission	20,000
Unearned Rent	20,000	Prepaid Insurance	9,000

A Formula That Appears in Practice

For calculating interest on capital (a common accrual adjustment in partnership accounts):

Interest on Capital = Capital × Rate of Interest × (Period / 12)

For example, if a partner's capital is ₹2,00,000 and interest is allowed at 10% per annum for 6 months:

Interest = 2,00,000 × 10/100 × 6/12 = ₹10,000

This interest is an expense for the firm (debited to Profit and Loss Appropriation A/c) and income for the partner (credited to the partner's Capital/Current A/c), even if no cash changes hands — a perfect example of accrual accounting in action.

The Big Picture

Accrual basis is not just a rule — it is the language that tells the true story of a business. Cash is just one character in that story. The real plot is about when value is created, when obligations arise, and when economic benefits are actually earned or consumed. Every journal entry you will learn in Class 12 — from depreciation to provision for doubtful debts — is built on this foundation.

Adjusting entries bring into the books items not yet recorded (or wrongly recorded) so that the final accounts follow the accrual and matching principles and show a true and fair profit and financial position.

Why adjusting entries are necessary.

Accrual concept. Revenue and expenses are recognised when they are earned or incurred, not when cash moves. Adjusting entries record outstanding expenses, prepaid expenses, accrued income and income received in advance accordingly.
Matching principle. Expenses must be matched with the revenues of the same period. Depreciation, bad debts and provisions are adjusted so that the period bears its fair share of cost.
True profit. Without adjustments the Profit & Loss A/c would show a wrong net profit (e.g. omitting outstanding wages overstates profit).
True financial position. The Balance Sheet must show all assets and liabilities, including prepaid expenses (asset), outstanding expenses (liability) and closing stock (asset).
Completeness. Some items (closing stock, depreciation, interest on capital) never appear in the trial balance and can enter the books only through adjusting entries.

Common adjustments and their dual effect

Adjustment	Effect 1 (P&L A/c)	Effect 2 (Balance Sheet)
Outstanding expense	Add to the expense (debit)	Current liability
Prepaid expense	Deduct from the expense	Current asset
Accrued income	Add to the income (credit)	Current asset
Income received in advance	Deduct from the income	Current liability
Closing stock	Credit of Trading A/c	Current asset
Depreciation	Debit (expense)	Deduct from the asset

✓Final answer

Adjusting entries are essential so that all expenses and incomes of the period are recognised (accrual and matching) and the Trading, Profit & Loss Account and Balance Sheet present a true and fair view of profit and financial position.

Same / Similar Concept — real previous-year questions on the same or a closely similar concept, not this exact question.

Showing the 12 most recent of 22 on this concept.

CBSE 2026Set ANNUAL1 mark
$Q. Fill in the blank: Depreciation is ________ in profit and loss account.$
›Reveal solutionSolution

Answer: Debited in the Profit & Loss Account.

Depreciation is an expense (loss in the value of an asset used during the year), so it is debited to the Profit & Loss Account and deducted from the asset in the Balance Sheet.

✓Final answer
$Debited in the Profit & Loss Account.$
CBSE 2026Set ANNUAL1 mark
$Q. State whether True or False: Outstanding salary account is a personal account.$
›Reveal solutionSolution

The statement is True.

Outstanding salary represents the persons (employees) to whom salary is due, so it is a representative personal account. Hence the statement is true.

✓Final answer
$True.$
CBSE 2025Set MARCH1 markMCQ
$Q. Outstanding rent is a/an :$
(a) Liability
(b) Asset
(c) Expense
(d) Income
›Reveal solutionSolution

The correct answer is (a) Liability.

Under the accrual concept, an expense is recorded in the year it relates to, whether or not it is paid. "Outstanding rent" means rent for the current accounting year that has not yet been paid.

Its treatment:

Statement Treatment
Profit & Loss Account Added to rent paid (to charge the full year's rent)
Balance Sheet Shown on the liabilities side as a current liability

Because the business still owes this money, outstanding rent is a liability, not an asset, income or a plain expense on its own.

✓Final answer
$(a) Liability.$
CBSE 2025Set ANNUAL1 mark
$Q. Fill in the blank: Interest on Drawings is recorded in ________ side of profit and loss account.$
›Reveal solutionSolution

Answer: Credit side.

Interest charged on a partner's/owner's drawings is a gain to the business, so it is recorded on the credit side of the Profit & Loss Account (and added to capital/deducted from drawings).

✓Final answer
$Credit side of the Profit & Loss Account.$
CBSE 2025Set ANNUAL1 mark
$Q. Fill in the blank: Expenses paid in current year, which are related to next year, is called ________.$
›Reveal solutionSolution

Answer: Prepaid expenses.

An expense paid during the current year but whose benefit relates to the next year is a prepaid (unexpired) expense. It is deducted from the expense and shown as a current asset.

✓Final answer
$Prepaid (unexpired) expenses.$
CBSE 2024Set MARCH1 mark
$Q. Prepaid expenses are assets of the business. (State True/False)$
›Reveal solutionSolution

The statement is True.

A prepaid expense is an expense paid in advance for which the benefit has not yet been fully received (e.g. insurance paid for the next year). Since the business is entitled to that future benefit, it is shown as a current asset in the balance sheet. Hence the statement is correct.

✓Final answer
$True — prepaid expenses are current assets of the business.$
CBSE 2023Set MARCH1 markMCQ
$Q. Prepaid insurance is a/an ________ .$
(a) Asset
(b) Liability
(c) Expense
(d) Revenue
›Reveal solutionSolution
Prepaid insurance is an asset (a current asset) — option (a).

From the Kerala Plus One (DHSE) Accountancy chapter Financial Statements – II (adjustments), under the accrual/matching concept:

Prepaid (unexpired) expense = an expense paid in the current year whose benefit will be enjoyed in the next accounting period.

Only the expired portion is charged to the current year's Profit & Loss A/c; the unexpired (prepaid) portion is carried forward.

Because the firm has already paid and is entitled to the future service, prepaid insurance represents a resource — it is shown on the assets side of the balance sheet as a current asset.

✓Final answer
$(a) Asset. Prepaid insurance is a current asset (a prepaid/unexpired expense carried to the next period).$
CBSE 2023Set ANNUAL1 markMCQ
$Q. Outstanding electricity charge is a/an$
(a) Artificial Personal Account
(b) Real Account
(c) Nominal Account
(d) Representative Personal Account
›Reveal solutionSolution

Outstanding electricity charge is a Representative Personal Account.

Accounts are classified as Personal, Real and Nominal. Within personal accounts, a representative personal account stands for a person or group of persons indirectly — e.g. outstanding expenses, prepaid expenses, accrued income. 'Outstanding electricity charge' represents the amount still payable to the electricity authority, so it is a representative personal account, not a nominal account (the electricity expense itself is nominal, but the outstanding liability is representative personal).

✓Final answer
$Option (d) Representative Personal Account.$
CBSE 2023Set ANNUAL1 markMCQ
$Q. Prepaid legal charge is a/an$
(a) Artificial Personal Account
(b) Real Account
(c) Nominal Account
(d) Representative Personal Account
›Reveal solutionSolution

Prepaid legal charge is a Representative Personal Account.

A representative personal account represents a person or group indirectly. Prepaid (unexpired) expenses such as prepaid legal charges represent the party to whom payment has been made and from whom the benefit/service is still due, so they are treated as representative personal accounts and shown as an asset in the Balance Sheet.

✓Final answer
$Option (d) Representative Personal Account.$
CBSE 2022Set MARCH1 markMCQ
$Q. Statement of affairs is prepared to find out ________.$
(a) Capital
(b) Net profit
(c) Total assets
(d) Total liabilities
›Reveal solutionSolution

A Statement of Affairs is prepared to find out Capital — option (a). Kerala Plus One (DHSE) Accountancy, Accounts from Incomplete Records.

Under incomplete records (single entry), proper ledger accounts and a capital account are not maintained, so capital cannot be read off directly. A Statement of Affairs is prepared — a rough balance sheet listing all known assets on one side and all known liabilities on the other. The difference is the capital:

Capital = Total Assets − Total Liabilities

A Statement of Affairs is drawn up at the beginning and again at the end of the year; the two capital figures (after adjusting drawings and fresh capital) are then compared to estimate profit under the net-worth / statement-of-affairs method. But the immediate purpose of preparing the statement itself is to ascertain capital.

✓Final answer
$The correct option is (a) Capital — the balancing figure Assets - Liabilities.$
CBSE 2022Set ANNUAL1 markMCQ
$Q. Outstanding office rent is a/an$
(a) expense
(b) asset
(c) income
(d) liability
›Reveal solutionSolution
Outstanding rent = expense incurred but not paid; the unpaid amount owed to the landlord is a current liability.

Under the accrual concept, rent for the period is charged as an expense to the Profit & Loss Account whether or not it is paid.

The portion not yet paid (outstanding) is still owed by the business, so it is a current liability appearing on the liabilities side of the Balance Sheet.

As an account type it is a Representative Personal Account, but when asked what it is on the Balance Sheet, it is a liability.

This follows the adjustment-entry rules in the CHSE Odisha +2 Accountancy syllabus (final accounts with adjustments), consistent with the NCERT/CBSE accrual framework.

✓Final answer
$(d) liability.$
CBSE 2022Set ANNUAL1 markMCQ
$Q. Pre-paid insurance is a$
(a) Personal Account
(b) Real Account
(c) Nominal Account
(d) Representative Personal Account
›Reveal solutionSolution
Prepaid insurance represents a future benefit already paid for; such representative balances are Representative Personal Accounts.

A Representative Personal Account represents a person or group of persons indirectly — e.g. prepaid (unexpired) and outstanding items.

Insurance paid in advance means the insurer owes the business future cover; the prepaid balance represents that party, so it is a Representative Personal Account.

On the Balance Sheet the same item is shown as a current asset, but by account classification it is a representative personal account.

This matches the account-classification rules taught in CHSE Odisha +2 Class-12 Commerce Accountancy, aligned with the NCERT/CBSE curriculum.

✓Final answer
$(d) Representative Personal Account.$

Statement	Treatment
Profit & Loss Account	Added to rent paid (to charge the full year's rent)
Balance Sheet	Shown on the liabilities side as a current liability

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Q.Why is it necessary to record the adjusting entries in the preparation of final accounts?

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