Need for Adjustments

The Need for Adjustments in Final Accounts

The accrual concept of accounting is the foundation of why adjustments are necessary. Under this concept, profit or loss for a year is not determined by the cash actually received or paid during that year. Instead, it is determined by the revenues that belong to the year and the expenses that belong to the year, regardless of when cash changes hands.

Consider an insurance premium of ₹1,200 paid on July 1, 2016. A general insurance policy typically covers 12 months. If the accounting year ends on March 31, 2017, only 9 months of that policy (July 2016 to March 2017) relate to the current year. The remaining 3 months (April to June 2017) relate to the next accounting year. Therefore, the expense that should be charged to the profit and loss account for 2016-17 is only ₹900 (₹1,200 – ₹300). The ₹300 is not an expense of this year.

Now take salaries. Suppose salaries for March 2017 were paid on April 7, 2017. The salaries account for 2016-17 would not include this payment because it was made in the next year. Yet, the employees worked in March 2017, so the expense belongs to 2016-17. This unpaid amount is called outstanding salaries. It must be brought into the books and added to the salaries already paid (for April 2016 to February 2017) before debiting the total to the profit and loss account.

Similarly, there may be incomes that have been earned during the year but not yet received in cash (accrued income), and incomes that have been received in cash but relate to a future period (income received in advance). All these items need adjustment.

Beyond these, certain items are not recorded on a day-to-day basis — depreciation on fixed assets, interest on capital, bad debts, provisions, and manager's commission. These are adjusted only at the time of preparing the final accounts.

The single purpose of all adjustments is to ensure that the final accounts reveal the true profit or loss and the true financial position of the business. Without adjustments, the financial statements would not present a true and fair view.

Items That Usually Need Adjustment

1. Closing stock
2. Outstanding expenses
3. Prepaid / Unexpired expenses
4. Accrued income
5. Income received in advance
6. Depreciation
7. Bad debts
8. Provision for doubtful debts
9. Provision for discount on debtors
10. Manager's commission
11. Interest on capital

How Adjustments Are Recorded

When preparing financial statements, you are given a trial balance and additional information about adjustments. Every adjustment affects two places in the final accounts to complete the double entry. For example, an outstanding expense will appear as an addition to the expense in the Profit and Loss Account (debit side) and also as a liability in the Balance Sheet.

The textbook provides the trial balance of Ankit as on March 31, 2017, with the additional information that closing stock is ₹15,000. This trial balance will be used throughout the chapter to demonstrate how each adjustment is recorded.