How do Accounting Adjustments Work?
Accounting adjustments are company transactions that haven't been recorded yet. Supplier invoices, customer billings, and cash receipts document most transactions. The accounting software's module for such transactions creates an accounting record for the user.
If such transactions have not been documented by the end of an accounting period or the entry erroneously describes the transaction's effect, the accounting staff corrects entries. Generally Accepted Accounting Principles or International Financial Reporting Standards are used to alter the company's financial statements. Adjustments in accounting are primarily utilized in accrual accounting.
When a corporation changes accounting principles, preceding periods may need accounting modifications. Such a change is carried back to compare financial performance across accounting periods.
Some Accounting Adjustments Examples
The following are some examples of accounting adjustments:
Incorporating or subtracting from an allowance for doubtful accounts or an inventory obsolescence reserve.
Recognizing earnings from sources for which bills have not yet been sent.
Revenue that has been invoiced but has not yet been earned is deferred.
Recognizing Expenses Before Receiving Supplier Invoices
Putting the writing off costs until the business uses the corresponding asset later.
Expenses that have already been paid for are included in this calculation.
Why are Adjusting Journal Entries Important?
Because many businesses operate on a credit or post-payment basis, where products may be delivered at a later date than payment is received, it is not uncommon for an accounting period to finish with an outstanding credit or prepayment invoice. Journal adjustment entries are used to balance any discrepancies in the timing of payments and expenditures. There would be unsettled transactions that have yet to close if the journal did not allow for altering entries.
Types of adjustments
There are just five distinct sorts of adjusting entries, and the distinctions between them are straightforward, so don't let the prospect of creating them scare you off. Below, you'll find detailed explanations of each kind, including some illustrative examples and instructions for filling them out.
Accrued Revenues - Accrued revenue is the amount of money earned in one accounting period that isn't counted until a subsequent period.
Accrued Expenses - After getting a handle on how accumulated income works, adjusting incurred expenses should be a breeze. They are the costs you incurred in one time period but paid for in another.
Deferred Revenues - Deferred income occurs when a customer pays you in advance. It's essential to report the income in the month you provide the service and incur the prepaid costs, even if you're being paid now.
Prepaid Expenses - Similar to delayed income, prepaid expenses may be used in the future. Instead of deducting the cost over the period it pertains to, and you make a one-time payment in this situation.
Depreciation Expenses - Depreciation is the practice of writing off the cost of an item over a more extended period than the asset's useful life. This is generally done for expensive acquisitions like machinery, automobiles, and structures. You will see a change to the overall cumulative depreciation amount on your balance sheet after any accounting Period in which depreciation occurred. Depreciation is an ongoing cost that will be shown as an expenditure each time it is paid.
Which depreciation method you pick will significantly impact how depreciation is recorded in your financial statements. This transaction involves a substantial amount of money. Thus it's rather involved.
Journal Entries For Adjustments in Final Accounts
Conclusion
When using the accrual method of accounting, adjusting journal entries are made to document transactions that have happened but have not been appropriately documented. Following the close of an accounting period, companies must make necessary adjustments to their general ledger to ensure compliance with the matching and revenue recognition standards.
Accruals, deferrals, and estimations are the most prevalent forms of revising journal entries. Accrual accounting requires its usage at the end of each accounting period. Cash accounting eliminates the requirement for corrective journal entries for businesses.
FAQs on Accounting Adjustments Simplified
1. What are accounting adjustments and why are they necessary in financial accounting?
Accounting adjustments are journal entries made at the end of an accounting period to record revenues and expenses that have not yet been recorded. They are necessary under the accrual basis of accounting to ensure that financial statements accurately reflect the company's performance and financial position, by adhering to the matching principle and the revenue recognition principle.
2. What are the main types of adjusting entries a Commerce student should know for the 2025-26 session?
The primary types of adjusting entries, as per the CBSE/NCERT syllabus, are:
- Accrued Revenues: Revenue that has been earned but not yet received in cash or recorded.
- Accrued Expenses: Expenses that have been incurred but not yet paid in cash or recorded.
- Deferred Revenues (Unearned Revenue): Cash received before services or goods are provided.
- Prepaid Expenses: Cash paid for expenses that will benefit future accounting periods.
- Depreciation: The allocation of the cost of a tangible asset over its useful life.
3. Can you provide a simple example of an adjusting entry for a prepaid expense?
Certainly. Imagine a company pays ₹12,000 for a one-year insurance policy on January 1st. At the end of the first month (January 31st), one month of insurance has been used up. The adjusting entry would be to debit Insurance Expense for ₹1,000 (₹12,000 / 12 months) and credit Prepaid Insurance for ₹1,000, reflecting the portion of the asset that has been consumed.
4. What is the key difference between an accrued expense and a prepaid expense?
The key difference lies in the timing of the cash payment versus the incurrence of the expense. An accrued expense is an expense that has been incurred but not yet paid (e.g., salaries for the last week of the month). A prepaid expense is an expense that has been paid in advance but not yet incurred or used (e.g., annual rent paid upfront). Accrued expenses involve a future cash payment, while prepaid expenses involve a past cash payment.
5. Why is depreciation considered an accounting adjustment?
Depreciation is considered an accounting adjustment because it systematically allocates the cost of a tangible asset (like machinery or a building) over its useful life. It is not a cash transaction. The adjusting entry for depreciation ensures that the expense of using the asset is matched with the revenues it helps to generate in the same accounting period, following the matching principle, rather than recording the entire cost of the asset as an expense when it was purchased.
6. Why can't a business just use the cash basis of accounting to avoid making adjustments?
While the cash basis is simpler, it can provide a misleading picture of a company's profitability and financial health because it only recognizes transactions when cash changes hands. The accrual basis, which requires adjustments, provides a more accurate view by matching revenues to the period in which they are earned and expenses to the period in which they are incurred. This adherence to core accounting principles is crucial for stakeholders making informed decisions.
7. What is the impact on financial statements if a company forgets to make an adjustment for accrued revenue?
If an adjusting entry for accrued revenue is missed, both the balance sheet and the income statement will be incorrect. Specifically:
- The Income Statement will understate total revenues and, consequently, understate the net profit for the period.
- The Balance Sheet will understate assets (as the receivable amount is not recorded) and understate owner's equity (due to the understated profit).
This leads to a distorted view of the company's financial performance and position.
8. How do the 'matching principle' and 'revenue recognition principle' directly influence adjusting entries?
These two principles are the foundation for almost all adjusting entries.
- The Revenue Recognition Principle dictates that revenue must be recorded when it is earned, not when cash is received. This leads to adjustments for accrued revenues and deferred revenues.
- The Matching Principle dictates that expenses must be recorded in the same period as the revenues they help generate. This leads to adjustments for accrued expenses, prepaid expenses, and depreciation.
9. Beyond the common types, what is a reclassification entry and when is it used as an adjustment?
A reclassification entry is an adjusting entry that moves an amount from one general ledger account to another to ensure it is reported correctly in the financial statements. It doesn't change the total balance of assets or liabilities but corrects their classification. For example, if a long-term loan becomes due within the next year, an adjusting entry is made to reclassify it from a 'Long-Term Liability' to a 'Current Liability' on the balance sheet.
10. How does an adjustment for 'Provision for Doubtful Debts' work?
A 'Provision for Doubtful Debts' is an estimation adjustment made to anticipate that some customers may not pay their dues. Based on past experience, a company estimates a percentage of its accounts receivable that might become uncollectible. The adjusting entry involves debiting an expense account (Bad Debts Expense) and crediting a contra-asset account (Provision for Doubtful Debts). This matches the potential loss in the period the sale was made and reports receivables at their estimated realizable value.
