The whole essence of getting involved in the accounting process is to produce valuable, speedy and accurate accounting information that the end users of accounting information can rely on for economic decision making. To do this, business transaction information is captured on the fly – you will agree that doing things on the fly will mean that some sorts of accounting adjustments are needed at the end of the period just to ensure that things are the way they should be.
What is the meaning of accounting adjustment?
Have you ever wondered what it means when you hear accountants say that they are busy closing accounts for the period? The reason why accounts remain open even after the period in which they relate has closed is because of the fact that certain items needed to be adjusted.
It is a well-established and well-known fact that the meaning of accounting extensively documents that accounting is all about recording transactions, summarizing the transactions and ultimately the production of financial statements at the end of each period.
For accounting to live up to the expectations as highlighted in the importance of accounting, certain forecast and predictions will have to be made in certain circumstances. These forecasts and expectations sometimes give rise to valid reasons why financial statements may not fairly represent the affairs of an entity. Thereby making it pertinent for accounting adjustments to be made.
Journal entries are used to capture raw data from the source document. From the journals, they are transferred to the ledger before a trial balance is drawn up. From the trial balance, the final account is prepared.
Accounting adjustments are also done using journals. This is technically known as adjusting entries. Accountants rely on adjusting entries to properly balance accounts before preparing the financial statements.
Brief comment on Cash versus Accrual basis of accounting
Small businesses like barber shops and small dental practices may account for their revenues on a cash basis without breaking any law. The cash basis of accounting simply means recognizing revenue when cash is received and recognizing expenses when cash is paid. Life would have been rosier if accounting is this simple – as everyone would be their own accountant.
Companies using the pure cash basis of accounting do not have any business with accounting adjustment except when an error is made. Oh, I almost forgot to mention that the tax guys sometimes encourage companies to use the cash basis of accounting.
The accrual basis of accounting on the other hand recognizes revenue when sales are made or services are rendered. Expenses are recognized when incurred not minding when actual payment is made
This used to be a lot simpler but has become a bit complicated as revenue recognition rules continue to change – the latest as at the time of writing this is IFRS 15 & IFRS 17 – I will not bore you with their content just yet.
Accrual accounting method always give rise to the need to make some adjusting entries just to bring things up to speed.
When are accounting adjustments needed?
Accounting adjustments are basically needed under two conditions or categories. One being when there is a deferred item and the other being when there is an accrued item.
What is deferral in accounting?
Deferral in accounting simply means to delay or postpone. There are times when an activity that would result in outflow of economic resources are recorded in the balance sheet (statement of financial position) as an asset rather than as expenses in the income statement – a good example is prepayment. Adjusting entry is used to transfer data previously recorded in the balance sheet to the expense account.
There are also times when deferral applies to liabilities. Under liabilities, the transfer is made to revenue account. Deferrals consists of two types of adjusting entries: asset/expense adjustment and liability/revenue adjustment.
What is accrual in accounting?
This is just the opposite of deferral. Accruals means bringing future events forward to present day. The future events must have a cause-and-effect relationship with what has been done in the past or present.
Seven (7) types of adjusting entries and How to make accounting adjustment
Closing stock adjustments: closing stock is what is left in a company’s warehouse after a period’s activity – trial balance or balance sheet date. The adjustments to closing stock is required by accounting standards (complying with accruals / matching concept) as not doing so would result in understatement of profit.
Prepaid expenses (prepayments): these are payments that are not yet due but has already been paid upfront as at the date when the trial balance is prepared. Prepayments are also known as value of benefits not yet enjoyed by an organization but has been paid for as at balance sheet date.
The accounting adjustment for prepayment are as follows:
In the statement of profit and loss, deduct the prepayments from the expenses recorded to get the expenses incurred. The prepayment is shown under current assets in the balance sheet.
Accrued expenses (accruals): accruals on the other hand are expenses due but yet to be paid as at the balance sheet date. These are value of benefits already enjoyed but not yet paid for as at balance sheet date.
The accounting treatment for accruals in the final account are as follows:
Add the accrued expenses to the expenses shown on the trial balance to obtain the expenses incurred. Show the accruals under the current liabilities in the balance sheet.
Income received in advance: these are cash inflow received before they are due. They are incomes received post balance sheet date. Incomes received in advance are regarded as the value of obligations not yet fulfilled but for which payment has been received as at trial balance date.
The accounting treatment for incomes received in advance are as follows:
In the profit and loss account, deduct the incomes received in advance from income shown on the trial balance to get the incomes earned. Again, this is consistent with the matching concept in accounting. The incomes received in advance are shown under current liabilities in the balance sheet.
Accrued Incomes: the accrued incomes are incomes not yet received but are due as at trial balance date. Services has been rendered in fulfillment of obligations but no payment received yet.
The accounting treatment or adjustment for accrued incomes are as follows:
Add accrued incomes to the income figure on the trial balance to arrive at income earned figure. Show accrued incomes under current assets in the statement of financial position.
Bad debts: businesses some times transact without collecting cash immediately. This process creates receivables. Over time, some receivables become irrecoverable for various reasons ranging from the disappearance of a debtor to the person owing us filing for bankruptcy.
Accounting treatment or accounting adjustments for bad debt are as follows:
- When the bad debt has already been recorded in the trial balance: here, simply charge the bad debt to the profit & loss account.
- When the bad debts are yet to be recorded in the trial balance: here, the correct accounting adjustment to make is to charge the bad debt to the P&L as an expense and deduct same from the receivables balance. Technically speaking, debit bad debts accounts and credit receivable accounts.
Provisions: In accounting, provisions are liabilities or losses certain to be incurred or likely to be incurred but the amount and date is uncertain. Provision for depreciation and provision for bad debts are classic examples. Provisions are amounts set from the period’s profit with the sole aim of catering for a liability when it materilises.