Adjustments in Final Accounts with Example - Different Types of Adjusting Entries

Here we discuss about the adjustments in Final Accounts with example. It is very important topic of Accounting. Adjustments are made at the end of accounting period.

For finding Financial Performance (Net Profit) of the Business, there are two systems of ascertaining Net Income of the business.

1. Cash System of Accounting

2. Accrual System of Accounting

1)   Cash System of Accounting

Under this system, transactions are recorded only when cash is received or paid. This system ignores the important accounting concept called Matching Concept.

For Example, In 2014, we sold goods for Rs.50000 and received Cash for Rs.30000. In this case Rs.20000 is not recorded in the year 2014. It is recorded only when Cash is received for such amount.

2) Accrual System of Accounting

Accrual system emphases on Matching Concept of Accounting. We record transaction with the full amount whether the Cash received in part or full.

For Example, In 2014, the amount of goods sold for Rs.50000. Only Rs.30000 had been received in Cash and remaining Rs.20000 was not paid by our customer to us. So we record the entry with full amount in 2014 and match all the expenses with current revenues of the same year.

There are some cases where some accounts need to be adjusted due to Accrual Basis of Accounting or we must consider Matching Concept to give true and fair view of financial statements.

For Example, Out of total Salaries of Rs.50000, only Cash for Rs.30000 paid to employees for services rendered at the of the accounting period, then we may record the entry with full amount as shown below:

Salaries a/c  50000

             Outstanding Salaries a/c 50000

So in that case adjustments are made and adjusting entries are recorded. Adjustments are always made before the closing of accounting period or closing entries for true and fair view of financial statements.

Types of Adjustments or Different Types of Adjusting Entries

It is to be noted that Adjusting Entries affect either an account shown on Income Statement or on the Balance Sheet.

Below are the Major Types of Adjusting Entries:

1. Accrued / Outstanding Expenses / Expenses Payable

The expenses actually incurred by the business during the accounting period but the business does no pay the full or partial payment for the services rendered by the employees.

For Example, Total Salaries for the accounting period 2014, starting from 1^st January to 31^st December, was Rs.60000, but only Rs.50000 paid on 30^th November. Now the salary of Rs.10000 for the December is outstanding or accrued. It is Current Liability for the business and appear on the Balance Sheet. The following adjusting entry is made for salaries payable:

Salaries a/c    10000

         Outstanding Salaries a/c   10000

This entry is reversed when the business is actually paid Rs.10000 to employees.

2. Prepaid Expenses / Expenses Paid in Advance

Expenses paid in advance for which services has not been rendered.

For Example, Rent Paid In Advance for the period of October, 2014 to February 2015 and for which the business not received the benefits.

Note: Prepaid Expense for per month = 50000/5 = 10000

There are two methods for recording prepaid expenses.

        i.   When we record the prepaid expense as an expense initially

      ii.   When it is treated as an asset at the start

                       i.   When we record the prepaid expense as an expense initially

Under this method, the following entries are recorded

When Cash paid in advance of Rs.5000, as in our example:

Rent a/c 50000

          Cash a/c 50000

As the financial statements prepare at the end of December 2014, so rent is prepaid for two months:

Prepaid Rent a/c 2000

                     Rent a/c 20000

                     ii.   When we record the prepaid expense as an asset initially

The following entry is passed

Prepaid Expenses a/c 50000

                              Rent a/c  50000

At the end of the month we passed the following adjusting entry:

 Rent a/c   20000

                      Prepaid Rent a/c 20000

The above entry shows that we get the benefit for the services of Rs.30000, so at the end of the accounting period, we credit the Prepaid Rent (Asset) and debit the Rent (Expense).

3. Accrued Revenue / Revenue Receivable

Revenue / Income earned but did not actually received it.

For Example, we record following entry for the rent receivable or accrued rent accrued for two months:

Accrued Rent a/c 2000

                        Rent Revenue a/c 2000

Accrued Revenue is shown as Current Asset in the Balance Sheet.

4. Unearned Revenue / Revenue Received in Advance / Unearned Income

Income / Revenue received but actually not earned is called Unearned Income / Revenue.

Explanation About Unearned Income

Unearned Income is the Current Liability for the company who received income, like fees, in advance from its clients but actually does not provide services to them at the time of receiving the payment of services.

For Example, a transport company receives Rs.7000 or $70 rent from its passengers for the journey From Lahore to Karachi or From New York to Washington. Now, it is the liability of the company to provide services to passengers. In other words, it is the current liability of the transport company to provide services of travelling to its passengers.

There are two accounting treatments for recording Unearned Income / Revenue:

                    i.   Initially recorded as an Income

                  ii.   Initially treated as  a Current Liability

                            

                      i.   Initially recorded as an Income

Under this method, unearned revenue / income or accrued revenue / income is recorded as an income with full amount and following entry is passed:

Cash a/c

       Income / Revenue a/c

For Example, if rent is received for six months from October 2014 to March 2015 in advance, then the entire amount received is credited to rent as:

Cash a/c 6000

         Rent a/c 6000

Note: Unearned Income / Revenue for 6 months = 1000/6 = 1000

At the end of accounting period, before preparing final accounts the following adjusting entry is passed for the remaining amount of rent actually earned by the business:

Rent Revenue a/c   3000

                       Unearned Income a/c 30000

                     ii.   Initially recorded as a Current Liability

The following entry is recorded for unearned Income / revenue at the start:

Rent Income a/c  6000

                       Unearned Income a/c  6000

At the end of accounting period before closing the accounts, we passed the following adjusting entry:

Unearned Income a/c  3000

                               Rent Income a/c 3000

5.  Depreciation / Amortization on Assets

“Depreciation is the systematic allocation of the cost the assets over its useful life”.

Note: Depreciation is for Tangible Non-Current Assets and Amortization is for Intangible Non-Current Assets.

Following entry is passed for Depreciation:

Depreciation a/c

                    Accumulated Depreciation a/c

Depreciation is an expense, so goes to Income Statement and Accumulated Depreciation is the total of depreciation from the previous years plus the depreciation for the current year, so it is deducted from the Cost of relevant Non-Current Asset in the Balance Sheet.

For Example, Cost of the Furniture is 50000, Depreciation for Furniture is 5000 for the year, and accumulated depreciation from the previous balance sheet is 10000, then we record the following entry for depreciation for the year in Statement of Comprehensive Income as:

Depreciation - Furniture a/c 5000

                     Accumulated Depreciation – Furniture a/c 5000

Now the total of Accumulated Depreciation - Furniture = 10000 + 5000 = 15000

Now the Cost of Furniture shown in the Balance Sheet as

Furniture  50000

Less: Accumulated Depreciation 15000

   Balance = 35000

6. Provision for Doubtful Debts / Allowances For Doubtful Debts

Debts are due from our customers for selling goods or services. Provision is an estimation of the debts which are uncertain that whether theses may be recovered or not from the customers for selling goods or services.

There are three forms of Debts

(i)  Good Debts

Debts which are recovered on time by our customers are called Good Debs. Every business is willing to give debts to good and credible customers, otherwise debts become bad or doubtful.

(ii)Bad Debts

Which become certain that these can not be recovered. The entry for recording bad debts is:

Bad Debts a/c

                    Debtors a/c

(iii) Doubtful Debts

These debts are uncertain which may or may not be recovered from the customers. These relate to future time which is always uncertain. Following is the entry for Doubtful Debts:

Doubtful Debts

                    Provision for Doubtful Debts

The reason for making estimation of debts is to follow the concept “anticipate no profits but provide for all possible loss”. Also, it is safe for the business to avoid uncertain losses and if there is any future profit then wait for it to be made.

Normally 2 to 5% are taken as a percentage of Account Receivable for the provision for doubtful debts.

The closing balance of Provision for Doubtful Debts ledger is deducted from Account Receivable in the Balance Sheet.

So it is all about the Adjustments in Final Accounts for the Accounting purposes. We also explain adjustments with example.