Adjustments in Final Accounts

In real business, several events that affect the year's true profit and true financial position are often not yet recorded in the books by the time the trial balance is drawn up — because no source document (bill, voucher) exists for them yet, even though they have genuinely happened. Adjustments are exactly these unrecorded items, given separately (outside the trial balance) as additional information, each of which must be entered in two places — following the double-entry principle — so that both Final Accounts (Trading/P&L) and the Balance Sheet reflect them correctly. This 'appears twice' rule is the single most important mechanical fact to remember about every adjustment in this chapter.

1. Closing Stock. The value of unsold goods on the last day of the year, valued at cost price or net realisable (market) value, whichever is lower (the principle of conservatism). Entered: (i) credit side of Trading Account, and (ii) asset side of Balance Sheet (under Current Assets).

2. Outstanding (Unpaid) Expenses. An expense that has been incurred (belongs to the current year) but not yet paid — e.g., wages for March unpaid as on 31st March. Entered: (i) added to the relevant expense in the Trading/P&L Account (increasing the expense, so profit falls by the correct amount), and (ii) shown as a Current Liability in the Balance Sheet (it is a genuine amount the business still owes).

3. Prepaid (Unexpired) Expenses. An expense that has already been paid during the year but relates partly (or wholly) to the next accounting year — e.g., insurance premium paid in advance covering the next six months. Entered: (i) deducted from the relevant expense in the P&L Account (reducing the expense, since only the current year's portion should be charged), and (ii) shown as a Current Asset in the Balance Sheet (the business has a genuine claim to the benefit next year).

4. Accrued (Outstanding) Income. Income that has been earned during the year but not yet received — e.g., interest on investments earned but not yet collected. Entered: (i) added to the relevant income in the P&L Account (crediting the full amount actually earned), and (ii) shown as a Current Asset in the Balance Sheet (the business has a right to receive it).

5. Unearned (Income Received in Advance). Income that has been received during the year but relates partly to the next year's services/benefit not yet delivered — e.g., rent received in advance for the next quarter. Entered: (i) deducted from the relevant income in the P&L Account (only the earned portion should be credited this year), and (ii) shown as a Current Liability in the Balance Sheet (the business owes the corresponding service/refund next year).

6. Depreciation. The fall in value of a fixed asset due to use and passage of time (studied fully in the previous chapter). Entered: (i) debit side of the Profit and Loss Account as an expense, and (ii) deducted from the concerned asset on the asset side of the Balance Sheet.

7. Bad Debts (further/additional). An amount owed by a debtor that has, during finalisation, become genuinely irrecoverable (in addition to any bad debts already written off and appearing in the trial balance). Entered: (i) added to Bad Debts in the P&L Account (debit side), and (ii) deducted from Sundry Debtors on the asset side of the Balance Sheet.

8. Reserve for Doubtful Debts (RDD) / Provision for Doubtful Debts. A prudent estimate, made at year end, of debtors who are likely to default even though they have not yet actually done so — created as a percentage of the (good) debtors remaining after deducting further bad debts. Entered: (i) debited (as a fresh charge, or the increase over any existing RDD in the trial balance) to the Profit and Loss Account, and (ii) deducted from Sundry Debtors (after already deducting further bad debts) on the asset side of the Balance Sheet — so debtors are shown at the amount genuinely expected to be collected.

9. Reserve (Provision) for Discount on Debtors. A further, smaller provision (calculated on the debtors remaining after deducting RDD) to allow for cash discount the business expects to have to give to debtors who pay promptly. Entered: (i) debited to the Profit and Loss Account, and (ii) further deducted from Sundry Debtors in the Balance Sheet (after RDD).

10. Goods Withdrawn by Proprietor for Personal Use. Goods (not cash) taken by the owner from business stock for personal/domestic use. Entered: (i) deducted from Purchases in the Trading Account (since these goods were never actually sold to a customer), and (ii) added to Drawings, which is then deducted from Capital in the Balance Sheet.

11. Goods Distributed as Free Samples (for Advertisement). Goods given away, at cost, to promote the business. Entered: (i) deducted from Purchases in the Trading Account, and (ii) shown as an Advertisement expense on the debit side of the Profit and Loss Account. …