Introduction
Adjustment entries are end-of-period journal entries made to recognize revenues and expenses in the correct period (matching principle). Common adjustments include outstanding expenses, prepaid expenses, accrued income, income received in advance, depreciation, bad-debt provisions, and closing stock.
Adjustments in accounting play an important role in reflecting the actual financial position of the company through its financial records. They help to match revenues and expenses to the correct accounting period, hence giving a clear and accurate picture of business performance. Adjustment entries are done at the end of an accounting period to rectify mistakes, record pending transactions, and comply with accrual accounting principles. This blog explains what adjustments are, their types, how they’re recorded, and where a Profit & Loss Adjustment Account fits.
What is Adjustment?
In accounting, adjustments are end-of-period entries that ensure transparent, accurate results. These adjustments ensure that every income and expense item is properly accounted for, whether or not payment has been made or received. Put simply, adjustments apply the matching principle—recognizing revenues and related expenses in the same period, thus complying with the accrual basis of the accounting method. For instance, if a company has unsettled rent or wages at the end of the year, then those expenses will be recorded via adjustment entries and not just written off. The financial statements without these entries would not only reflect an incomplete but also a deceiving view of the company’s true performance and condition. Adjustments are the means by which every penny made or lost within that time frame has been booked properly, thus keeping the Profit and Loss Account and the Balance Sheet accurate and transparent.
Types of Adjustments in Accounting
Adjusting entries play an essential role in maintaining accurate and complete financial records. These entries are a means of assigning transactions to the right accounting period even if no cash has been exchanged in the meantime. You will find below the common types that are most widely used in accounting, i.e., adjustments.
Outstanding Expenses
Outstanding expenses are liabilities that have been incurred but not yet paid by the end of the accounting period. A few illustrations of outstanding expenses are the unpaid salaries, rent, electricity, and interest on loans. They’re recorded in the period incurred, so profit is measured accurately.
Prepaid Expenses
Prepaid expenses are the transactions that have been paid in advance for goods or services that will be utilized in the upcoming accounting periods. Common prepaid expenses include insurance premiums, rent, and software subscriptions paid in advance. The recording of prepaid items guarantees that only the part that belongs to the current period is treated as an expense.
Accrued Income
Accrued income is income that a business has made but has not yet been paid for. It could be interest on investments, rent received, or service fees. The treatment of accrued income ensures that the whole revenue for the accounting period is recognized, even if the cash has not come in.
Income Received in Advance
This situation occurs when a business gets paid before it delivers the goods or services. For example, advance payments from customers or clients are such cases. The accounting treatment of this then makes sure that the revenue is recognized only when earned in accordance with the accrual concept.
Depreciation
Depreciation is the systematic allocation of an asset’s cost over its useful life, for example, equipment, vehicles, or buildings, due to physical deterioration or usage over time. However, showing depreciation will not only cause assets to be correctly valued on the balance sheet but also result in the corresponding expense being recognized in the profit and loss account.
Bad Debts and Provisions
Bad debts arise when it becomes unlikely that customers will pay their outstanding dues. A provision for bad debts is an allowance created by the company to anticipate potential credit losses. By taking such transactions into account in the financial statements, it is guaranteed that the amount shown as profit would not include the losses, and the financial picture would be truthful.
Closing Stock
Closing stock is the value of inventory on hand and unsold at period end. The closing stock amount is included in the adjustments so that only the cost of sold goods is deducted from the revenue, thus, a correct gross profit figure is obtained.
Accounting Adjustment Entry
An adjustment entry is a kind of journal entry made at the end of an accounting period to ensure that the financial records tell the true financial position of a business. These entries are required to rectify any omissions, recognize outstanding expenses or incomes, and deal with prepayments or accruals. The main purpose of adjustment entries is to align ledger balances with the company’s actual financial position, following the accrual principle of accounting.
Let us take an example where a company has an outstanding rent of ₹10,000, which has not been paid by the end of the month. The adjustment entry would be:
Rent Expense A/c …… ₹10,000 (Debit)
To Outstanding Rent A/c …… ₹10,000 (Credit)
This means that the rent expense, although not yet paid, will still appear in the Profit and Loss Account of the period, hence ensuring the proper matching of expenses and revenues.
Adjustment of Profit and Loss Account
A Profit & Loss Adjustment Account (in traditional texts) records corrections affecting income or expenses, thereby adjusting reported profit. This account may be utilized in case errors or omissions are detected, from either the past accounting periods or after the Profit and Loss Account has been prepared. For instance, if some income was not accounted for in the earlier records or an expense was overstated, such mistakes will be corrected through the Profit and Loss Adjustment Account. By taking these steps, companies are guaranteeing that their claimed profit represents their actual financial performance for the period and that their errors are rectified without the need to disturb other accounts. This account not only assists in maintaining accurate profit computations but also safeguards the fairness and transparency of financial reporting, which is a critical aspect for the stakeholders, investors, and management. In the same manner, adjustments are carried out for accrued income, which is the case when interest has been earned but not yet received; prepaid expenses, for instance, insurance that has been paid for in advance; and depreciation, which is a method of distributing the cost of a fixed asset over its useful life. The adjustment of each time period’s revenue and expense, respectively, ensures that the actual profitability is depicted.
Importance of Accounting Adjustments
Accounting adjustments are essential for accuracy and reliability. Here’s why the adjustments are so prominent:
Ensure Accuracy
Adjustments serve the purpose of bringing to light and fixing any such issues as incomplete recording, errors, or misstatements in the accounts before financial statements are ready for use. For instance, if an expense account is omitted or an income entry is missed, the necessary adjustment would guarantee that in the Profit and Loss account, the actual amounts are recorded. Accurate accounting prevents discrepancies and strengthens reporting reliability.
Match Revenues and Expenses
The matching principle is one of the most important principles in accounting, which signifies that the revenue recognized and the related expenses incurred should be recorded in the same period. Adjustments guarantee that all profits and losses are properly matched with the period in which they occurred. This practice assures that the profits are computed accurately and show the true performance of the business.
Aid in Decision-Making
Accurate and up-to-date financial data are essential for management decision-making. The adjusted accounts are of great assistance in cost evaluation, pricing strategy setting, budget planning, and making decisions regarding expansion or investment. If adjustments are not made, the management might depend on incomplete data, which would result in making wrong decisions and incurring financial risks.
Compliance and Transparency
Accounting adjustments are a means of demonstrating compliance with the standard accounting practices and laws. Additionally, they contribute to openness, which in turn gains the trust of investors, auditors, bankers, and other parties involved. The adjustments are the ones that guarantee the financial reports show accurately and fairly the financial status of the company.
Reflect True Financial Position
Adjustments ensure profits, assets, and liabilities are reported correctly. If not, the profits might prove to be either artificially high or low, and the financial reports could be misleading regarding the company’s condition. Accurate adjustments help companies avoid unexpected discrepancies and maintain sound financial management.
Conclusion
Although often small, accounting adjustments prevent misstatements that could mislead users about a company’s financial health. They ensure that both revenues and expenses are placed in the right accounting period, thus showing a real picture in the Profit and Loss Account as well as the Balance Sheet. All these entries, together with the Profit and Loss Adjustment Account, ensure the validity of financial records, aid in tax compliance, and increase the trust of investors. Tools like EnKash make adjustments faster and more reliably, improving audit readiness, financial control, and decision-making.
FAQs
1. What are adjustment entries in accounting?
Adjustment entries are journal entries made at the end of an accounting period to record unpaid expenses, unearned income, or accrued revenues so that financial statements remain accurate.
2. What is an example of adjustment?
Depreciation is one example. It reduces the value of assets each year to reflect their actual worth.
3. Can adjustments affect taxes?
Yes. Correct accounting adjustments ensure accurate computation of taxable income, preventing over- or underpayment of taxes, which will aid companies in avoiding paying more or less than what is required by law in terms of taxes.
4. What is the difference between a normal entry and an adjustment entry?
A normal entry captures daily transactions, whereas adjustment entries are for error corrections, and also accounting for prepaid and accrued items, and making sure that the figures represent the proper time period.
5. What are the effects of adjustments on the Profit and Loss Account?
All pertinent incomes and expenses are assured to be recorded, thus providing a clear view of the profits made in that specific period.
6. What happens if adjustments are not made?
If adjustments are ignored, then the profits may be overstated or understated, the financial statements may be misleading, and the decisions made based on them could be wrong.
